Published by Pensions and Investments

Commentary: Conflicts of interest destroy investment returns

By: Jon Hirtle

It is fascinating that well-intended fiduciaries continue to rely on investment advice that is encumbered by serious conflicts of interests.

The most sophisticated, successful investors in the world rely on the decision-making of full-time employees inside their own independent investment offices. Why? Because the structure of the independent multibillion-dollar investment office eliminates all material conflicts of interests and provides access to the best specialist investment talent in the world at wholesale rates. That, not surprisingly, means better returns, net of all costs, on average, over time.

The traditional investment industry grew up in simpler times and is riddled with conflicts of interest. “Buyer-beware” remains the watch phrase in that product-sales model. But in those simpler times it was easier to spot and avoid conflicts. Today, globalization and an explosion in the number of investment choices means complexity has skyrocketed and serious investors cannot logically rely on advice from a conflicted model.

What are the most egregious conflicts that confound decision-making and destroy value daily?

Conflict No. 1: Compensation varies by product

No sophisticated multibillion-dollar investor would ever tolerate an internal professional being paid more to use one growth manager over another, or to increase the allocation to an emerging international markets fund or to buy a stock off an initial public offering. Professionals in those world-class internal investment offices work only for the family or institution that created the office. The “I love my client, but I will make more money if I add some of our latest initial public offering (or the emerging markets fund or options strategy, etc.) into the portfolio and … maybe it will be OK …” conversation never happens at an independent investment office.

Yet every traditional bank and investment firm relies on that conflicted business model. Bad decisions destroy returns and good decisions are hard enough to make without the aggravating difficulty of differential compensation. Of course, conflicted firms always trumpet a “Chinese wall” between products and advice. Baloney. Conflicts of interests are unavoidable in their models and while it might help the bank succeed, it hurts investor performance.

Avoid the conflict

Build your own internal investment department staffed by professionals with deep expertise and supported by world-class data and multibillion-dollar access. Alternatively, select an experienced investment management firm that sells no products, where compensation therefore does not vary based on the investments they use or the asset allocation in your portfolio.

Conflict No. 2: Hidden fees and costs

Hidden fees and costs are even more insidious than the product-driven business model because they are harder to detect. It is plain that banks, brokers and the big fund groups sell products and are therefore conflicted; simple. Not so simple is revealing all the hidden fees charged by banks, brokers and consultants that confound good decision-making and eat away at net performance.

Does your adviser lead with a low up-front fee then charge high fees in the funds and partnerships that it uses to execute your program? The adviser has to get paid, but why obscure the fees? As a serious investor, you clearly want to know exactly what you are paying at all times, in total. Might it use its own internal product when a product from another firm has better net performance? That lost opportunity is a hidden cost. Might it be charging above-market rates for the internal products it is using to execute your program or sharing a hidden fee from external products they employ? Is the bank or broker also your custodian?

I can’t tell you how many times fiduciaries have explained that their adviser holds their assets “for free.” Really? How many financial institutions do you know that do anything for free? Any time you see “for free” or “no charge” you should hear “hidden fee.” Is your broker lending your securities and keeping the proceeds? That is a hidden fee. Does the bank sweep your cash into its own money market fund? That is a hidden fee. Does it charge for collecting dividends with a custody transaction charge? That is a hidden fee.

Hidden fees often vary by asset class, becoming a two-fold conflict with a hidden fee (conflict No. 2) that varies by product (conflict No. 1). The problem, once again, is the fundamental model. Banks and brokers have so many ways to hide fees it is impossible to aggregate the total cost without a full blown annual audit and … more fees.

Avoid the conflict

Rely on advisers whose structure reveals all fees. Bank and broker-dealer structures are full of ways to hide fees. Conversely, registered investment advisers are required by law to reveal all sources of revenue annually on Form ADV, which they are also required to make available to all clients.

In an increasingly complex investment marketplace, many investing decisions have become more difficult. But the decision to avoid conflicts that erode returns is simple: Beware of advisers whose compensation models and fee structures serve primarily their interests and detract from investment performance.

Original Story Link Here