KEY POINTS:
It is generally acknowledged, except perhaps by those people who used to buy finance company debentures and collateralised debt obligations (CDOs), that products offering high returns inevitably have higher risks.
The reality is, however, that the waters are murky, equity frequently masquerades as debt, and counter-intuitively some fixed interest investments are more risky than some shares and some Financial Planners of the Year apparently recommended Bridgecorp.
How are Mum and Dad to estimate the actual risk profile of a product? You could argue that high rates of initial commission or brokerage flag important warning signs to investors.
Commissions are generally paid by the promoter of a product, fund or company to financial advisers in return for recommending their clients buy that fund. Alternatively, under a fee-based system, the client generally pays a fee direct to the adviser who rebates any commission to the client. A major problem with the commission-based model is that as the financial planner is effectively on the payroll of the fund manager it isn't always clear that financial planners have the best interests of their clients at heart.
With commission, the adviser's choice of product can potentially be made on the basis of the return of the product to them rather than the return to their client. Why recommend Kiwi Bonds paying 0.5 per cent when Bridgecorp pays 3 per cent?
Complicating matters further, various protagonists of the commission model have over the years in New Zealand claimed that under this system no fees are payable by Mum and Dad.
In fact, while it's true that under the commission model the fund manager pays the fee to the adviser, the reality is that the former inevitably loads the price of the product by an amount at least equal to the commission. The proof of the existence of the fee is that there is usually a 5 per cent spread between the buy and sell price.
There is some evidence to suggest that extraordinarily high initial commissions indicate that the vendor is particularly keen to part company with the assets for sale, be they equity or debt, and the best way to incentivise their sales force is to pay much higher fees than they could earn elsewhere.
Historic examples of unusually high initial commission-paying products with consistently bad outcomes for Mum and Dad include Fortex bonds, a fixed interest investment which paid brokerage at the same rate as shares and well above that of comparable fixed interest offerings and subsequently self-destructed, Feltex shares, which had total initial flotation costs of almost 10 per cent and, more recently of course, finance company debentures which allegedly pay up to 3 per cent in commission plus various other incentives.
Retail investors need to know the extent to which their adviser is being remunerated and by whom - not just because the fees themselves are significant but because a relatively high fee may be an indicator of high risk and/or poor value.
Continuing the trail blazed by the likes of Fortex, Feltex and Bridgecorp, many of the more complex products promoted recently as being low risk, such as CDOs or credit linked notes, have unusually high commissions. Someone is paying these fees and Mum and Dad can be pretty confident that they are that someone.
Increasingly, it seems that high-risk products have high annual fees embedded into the product, the effect of which is that Mum and Dad take the risk while the extra returns are divided up between the fund manager and the adviser.
For example, the prospectus for one structured credit product reveals an initial commission of 2.75 per cent plus $600,000 in additional fees plus soft dollar benefits payable to brokers including conferences, travel and accommodation. How on earth could an ostensibly lower risk investment paying about 3 per cent or so more than 90-day bills sustain fees on this scale? The simple answer is the product isn't low risk but because of the burdensome fee structure it is low return.
In the UK, the chief regulatory authority, the Financial Services Authority (FSA), recently suggested that the whole commission-based financial advisory model was fundamentally flawed.
In a speech, the chairman of the FSA compared financial advisers to convict shippers in the 18th century and sent the message: Either work out a business model that encourages best practice or we will do it for you.
The FSA has just released a report setting out its thoughts as to how the business of selling financial advice could be improved. The current FSA proposal would see the financial advisory market split into two groups. High net worth individuals at the top end would be serviced by advisers with much higher qualifications than at present, on a fee-only basis. These clients will be sophisticated and their advisers can keep the tag independent. Everyone else will be serviced by advisers selling uniformly low commission, simple products - no CDOs, hedge funds or structured credit for Mum and Dad with $30,000 to invest.
The FSA's hope is that with simple-to-understand products paying the same level of low commission, investment advisers will more readily recommend the right products for their clients. New Zealand should watch the UK experiment closely.
* Brent Sheather is a Whakatane-based investment adviser
