Mandatory and Voluntary Disclosure Leads Advisors to Avoid Conflicts of Interest

Sunita Sah1,2 and George Loewenstein3

Abstract Professionals face conflicts of interest when they have a personal interest in giving biased advice. Mandatory disclosure—informing consumers of the conflict—is a widely adopted strategy in numerous professions, such as medicine, finance, and accounting. Prior research has shown, however, that such disclosures have little impact on consumer behavior, and can backfire by leading advisors to give even more biased advice. We present results from three experiments with real monetary stakes. These results show that, although disclosure has generally been found to be ineffective for dealing with unavoidable conflicts of interest, it can be beneficial when providers have the ability to avoid conflicts. Mandatory and voluntary disclosure can deter advisors from accepting conflicts of interest so that they have nothing to disclose except the absence of conflicts. We propose that people are averse to being viewed as biased, and that policies designed to activate reputational and ethical concerns will motivate advisors to avoid conflicts of interest. To read the full Paper click here 

The role of securities regulators in “educating ” financial Consumers

The role of securities regulators in “educating ” financial Consumers                   October, 2014

October is Investor Education Month in Canada so it's a good time to discuss the role of regulators in educating financial consumers. We support financial literacy for Canadians but have warned against depending on it as a tool against consumers making big mistakes and industry abuses. Laws and Codes , a Best interests standard and robust enforcement are needed to protect consumers - financial education and disclosure alone can't do the job.A Best interest standard and "merit regulation" would benefit investors far more than "investor education" which no matter how good it is, does not narrow most investors' competency/capability gap.

That being said, actions need to be taken until financial advice is delivered on a professional basis.

The MFDA prepares some excellent guidance materials for the dealers it regulates. It should do the same for its most important stakeholder - the mutual fund investor - materials that will explain their rights , how the MFDA protects them and where the bear traps are. We call this type of education Street proofing -getting investors primed to engage with Bay Street- improving awareness. If well done, it would increase the level of engagement that regulators have with Main Street and help prevent at least some complaints and potentially increase client satisfaction. It would help create a cadre of oonstructively critical and inquisitive investors determined to better understand the advice given and the nature of their investments.

Recently ,the Mutual Fund Dealers Association of Canada (MFDA) announced the launch of an investor education section on its website. In the new section, investors can find information about mutual funds, including information about fees and Fund Facts documents, as well as information on checking a salesperson's ( advisor's ) registration and disciplinary history, the MFDA /IPC investor insurance scheme , OBSI and advice on avoiding fraud and financial harm. Links to investor education resources from members of the Canadian Securities Administrators are adroitly used as well as other regulators and international organizations. Including the SIPA and FAIR Canada websites would be helpful too. Investors who are seniors / retirees can also review the seniors' section of the MFDA website which contains information about the assistance that the MFDA can provide to seniors, as well as a library of links to on-line resources directed towards Canadian seniors.A good MFDA communication plan should ensure it will be accesssed by many information hungry mutual fund investors.

This initial effort by the MFDA is welcomed but much more can and needs to be done. There are a number of areas that we think deserve special attention from the MFDA. These are primarily areas where we are receiving a lot of requests for additional information or where there have been a significant number of complaints. These include but are not limited to : Outside business activities, the risks of leverage, dealing with advisors that are dually registered ,"Free Lunch" Investment Seminars -Avoiding the Heartburn of a Hard Sell , Guide to filing a robust complaint , peeling back the DSC onion, completing a NAAF to prevent problems,What the heck is KYC and why it is important? , How mutual fund salespersons are paid , Understanding the impact of conflicts-of -interest, Understanding the difference between Best interests and Suitability, Understanding and using the Fund Facts Risk disclosure , Using the Account Statement for better investing outcomes, The difference between Suitable and Unsuitable investments and the meaning of “advisor “ titles and credentials ( could link to Glossary on IIROC website) . A forthright presentation in text and/or smart phone APPS of these tough issues will help reduce investor abuse / undue losses and improve investor outcomes.

Better design of forms would allow a certain amount of education to be embedded in the form itself.For instance, there have been numerous suggestions to make the New Account Application Form more meaningful and for Risk Profiling approaches to be documented and standardized.Online forms could be made “ intelligent ” and interactive . Such an approach is consistent with Just in Time delivery of information and education.

We would also like to see the MFDA ( and IIROC) issue timely ALERTS informing investors of specific issues and hazards prevalent at the time. This could include warnings about deceptive advertising ( a great example can be found at http://www.fca.org.uk/consumers/protect-yourself/misleading-adverts ), Betting the Ranch: Risking Your Home to Buy Securities , The signing of blank forms, explaining Return of Capital mutual funds, Alternative Funds Are Not Your Typical Mutual Funds , The risks and dangers of making financial side deals with your salesperson , Using the MFDA Whistle blower program, How to effectively use Fee disclosure and Performance reporting , Watch out for Misleading Titles and Designations , How to read the Fund Prospectus etc. ALERTS should also inform investors of ongoing Consultations and new or pending regulations/ rules of interest to retail investors. Investors would subscribe and have the ALERT sent directly to their email inbox. This kind of real time investor protection is vitally needed in today's fast paced investment world.

Investor education can also be effected by the use of Case Studies ( narrative and /or video) which showcase people's experiences with different investments and dealers. Such studies make investing issues real to main Street. It is well known that for retail investors , personal stories are more effective in conveying messages than dry facts. Given the wealth of data locked up in MFDA investigations and Enforcement Cases ,the MFDA should use Case studies to inform investors what can go wrong and how to protect against advisor /dealer malfeasance. Street proofing investors is a core element of investor protection.

Finally, a comprehensive Glossary of all the commonly found terms in the mutual fund industry would be extremely useful. A good example would be the one provided by Morningstar Canada. A simple link would do the job.

All documents , ALERTS and Warnings should be written in plain language and available in both English and French.

A similar set of ideas apply to IIROC but these would include additional topics uniquely relevant to the brokerage industry. Similarly, Securities Commissions could fill in the gaps for the Exempt market , in particular, Equity crowdfunding. By working collabartively with SRO's a robust Street proofing educational regime can be esttablished at reduced cost.

Financial literacy topics such as portfolio construction , risk minimization ,the calculation of performance return , asset allocation, tax optimization, The relationship between risk and return, The Grass Isn’t Always Greener-Chasing Return in a Challenging Investment Environment , Structured products , Financial tools and calculators etc. should , with a few exceptions, be left to professional educators that are independent of both the industry and securities regulators.They have much greater leeway to be constructively critical of regulations, regulators, industry participants , industry sales practices and behaviours.

Of course , if investment advisors were professionals working to a Best interests standard , much of this Street proofing education would be redundant . There would be no need for CAVEAT EMPTOR

REFERENCES

 

     1. Investor Enquiries and Complaints Archive: Kenmar Associates

2. IOSCO REPORT ON INVESTOR EDUCATION INITIATIVES RELATING TO INVESTMENT SERVICES http://www.lautorite.qc.ca/files//pdf/education-financiere/IOSCOPD404.pdf
3. Improve consumer protection by SROs: C.D. Howe Institute research report
   http://www.investmentexecutive.com/-/improve-consumer-protection-by-sros-says-c-d-howe-institute
4. Improving financial literacy through behavioural economics http://www.oecd.org/daf/fin/financial-education/TrustFund2013_OECDImproving_Fin_Ed_effectiveness_through_Behavioural_Economics.pdf
5. Marketing of mutual funds (2005) Ken Kivenko http://venablepark.com/articles/analyze_fund_ads_for_clues.pdf
   
6. How to know when your advisor is behaving badly - The Globe and Mail http://www.theglobeandmail.com/globe-investor/investor-education/how-to-know-when-your-adviser-is-behaving-badly/article18593654/#dashboard/follows/
   

 

         

 

Advisor's Alpha :Good for your Practice and your Clients ( Vanguard 2013)

Outperforming the broad market has historically been very difficult, both in absolute terms and in tax- and risk-adjusted frameworks. Where adding value is the goal, advisors may be better served by changing their performance benchmark from the market’s return to the returns that investors might achieve on their own, without professional guidance. A financial advisor has a greater probability of adding value, or Alpha, through relationship  oriented services, such as providing cogent wealth management and financial planning strategies, discipline and guidance, rather than by attempting to outperform  the market.Read the Paper

d research May 2012

On the stability of Risk Tolerance

It is widely believed that (financial) risk tolerance is highly unstable and particularly subject to market conditions. However, through a series of independent studies there is now strong evidence that this view is incorrect. The most recent study clearly demonstrates the stability of risk tolerance across the 2003 to 2009 market rises and falls through detailed analysis of test/retest data, involving two tests of the same individuals, the first during the 2003-7 bull market and the second in the subsequent bear market. The study confirms the anecdotal evidence from FinaMetrica subscribers that clients' risk tolerance scores remained remarkably stable through the most turbulent market conditions in living memory. Many advisors and others involved in financial advisory services will now need to change their views about the nature of risk tolerance, how it should be assessed and its role in the financial advising process - all of which will be discussed under Consequences for Advice. However, before considering the consequences we should review the evidence for the stability of risk tolerance and before that we should examine why the contrary view is so widespread.Read the Research paper here

All you ever wanted to know about Disclosure...and MORE

A core tenet in contemporary securities regulation is that public disclosure will level the playing field by reducing information asymmetries. It's tempting to think that just by spelling out the features and risks on a piece of paper, let investors read it and everything's OK — the investor now can make an informed investment decision.. The reality is that the disclosure process is far more complex . Effective disclosure depends on how clearly written the disclosure is , the completeness of the disclosure, the investors' willingness to read it , the investor's understanding of the disclosure , the investor's financial and contractual literacy , the investor's vulnerability level, when the disclosure takes place and a number of other factors.Even the method of delivery ,font size and location can impact the effectiveness of disclosure.In the case of retail investors, we have concluded that disclosure is a necessary but insufficient tool for investor protection.In this blog we discuss a few key aspects of disclosure for the retail investor.

Take a look at our Comment letter on Point- Of- Sale disclosure to the Bank of International Settlements.It's a great primer on disclosure as it appies to investing. It's written in plain language so very easy to follow.http://www.bis.org/publ/joint32/kenmar.pdf

For over a decade, Kenmar Associates has advocated for the delivery of Fund Facts prior to the
decision to purchase mutual funds. For whatever reasons, such an obvious requirement has been
opposed by industry participants and lobbyists. This makes absolutely no sense if there is to be an
informed investment decision. It is inconceivable that an industry which constantly claims the value of investment advice should not insist that dealer representatives provide a copy of FF's to clients before the purchase decision is made. Providing FF two business days after the investment decision has been made is a nonsense disclosure . Here's what we told regulators http://www.osc.gov.on.ca/documents/en/Securities-Category8-Comments/com_20140411_81-101_kenmar-associates.pdf

Disclosure isn't just about product characteristics and features.One of the complaints often heard about the investment industry is lack of disclosure about compensation. It is up to clients to ask their financial advisor how they are compensated, and even then it might be difficult to verify if the advisor is telling the truth. Independent research has demonstrated that compensation has a huge impact on the investment recommendations by advisors ( non-fiduciaries). It would seem that more disclosure is the obvious answer, but according to one academic study it might not make much of a difference in the actions of clients and might make the advisors even more biased.George Loewenstein et al from Carnegie Mellon University wanted to evaluate the effects of conflict of interests disclosure from advisors, on the decision making of their clients. The study entitled “TheDirt On Coming Clean:Perverse Effects of Disclosing Conflicts of Interest“ had a surprising result .- disclosing the conflict- of- interest actually increased the bias even more.Lowenstein argues that “moral licensing” is one of the reasons this happens. Basically this theory says that an advisor with an undisclosed conflict- of-interest will feel guilty enough about it that they will try to “do the right thing” to some degree. By disclosing the conflict- of-interest, it allows the advisor to do whatever they want since they have admitted the conflict and therefore don’t have to feel guilty about it anymore. Be aware.

Regulators recognize that sales communications play an important role in the business of investment fund issuers, and as such,expect such communications to provide “clear, accurate and balanced messages, particularly when directed at retail investors.Such materials, if improperly written, can undo the positive intent of mandated disclosures.Sales communications should be in plain language and avoid the use of industry jargon, defined terms or acronyms and generally be easy to understand by retail investors. Information, including warnings, disclaimers and qualifications, must be given sufficient prominence in order to be consistent with the content of the document.Sales communications should not include statements that are vague or exaggerated or that cannot otherwise be verified. Regulators expect fund companies and dealers to include specific information in sales communication documentss if a distribution or yield is quantified in such document, including the basis of the calculation, the percentage of total distributions comprising reinvested units, how the yield was calculated, the time period covered by the distributions, the key assumptions and the impact changes to such key assumptions may have on the target distribution or yield. Lastly, They also expect that return of capital distributions should not be presented in a way to suggest that they represent investment returns.A lot of expectations but unfortunately little monitoring and regulatory enforcement.

It is all well and fine to disclose the MER of a mutual fund but unless the investor can assess the long-term impact on fees, the disclosure has limited value.Similarly ,if performance is provided without comparison to a benchmark , the average retail investor may derive little from the disclosure. Some disclosure documents are so complex and filled with elaborate terms and conditions that it should come as no surprise that retail investors find it difficult to make informed decisions.This is one reason why we have promoted the idea that investment advisors should be proficient and be required to act as fiduciaries.

We will soon be commenting on the fee and performance disclosures required by the Client Relationship Model part 2.Until CRM2 disclosure focussed on the prospectus and continuous disclosure obligations. With CRM2 ,regulators awoke to the fact that dealers had been able to promote a transaction business as an advice business but without the associated disclosures and standards. Once registered as salespersons, stockbrokers and salespersons  became dealer representatives and business titles changed to advisor and other misleading tiitles which calmed invesrors. .Hence the sudden need for the disclosure of fees , account performance , conflicts- of -interest and client relationships and an increrased regulatory scrutiny of  "advisor " titles and designations.

We have also commented in the past on " Free lunch" seminars, financial pornography , presentations at retirement homes, Fund company webinars , "advsor" use of social media and other " off book" disclosure mechanisms that are loosely covered by securities laws and rules.All of these sorts of  sales communications ( i.e. disclosures of information  designed to promote sales) can be hazardous to your financial wealth. Take a read about what one abused investor has to say about “un-disclosure ” .http://www.investoradvocates.ca/viewtopic.php?f=1&t=180&p=3786#p3786

Broker Incentives and Mutual Fund Market Segmentation

Broker Incentives and Mutual Fund Market Segmentation Diane Del Guercio, Jonathan Reuter, Paula A. Tkac NBER Working Paper No. 16312 Issued in August 2010 NBER Program(s):AP   IO 

We study the impact of investor heterogeneity on mutual fund market segmentation. To motivate our empirical analysis, we make two assumptions. First, some investors inherently value broker services. Second, because brokers are only compensated when they sell mutual funds, they have little incentive to recommend funds available at lower cost elsewhere. The need for mutual fund families to internalize broker incentives leads us to predict that the market for mutual funds will be highly segmented, with families targeting either do-it-yourself investors or investors who value broker services, but not both. Using novel distribution channel data, we find strong empirical support for this prediction; only 3.3% of families serve both market segments. We also predict and find strong evidence that mutual funds targeting performance-sensitive, do-it-yourself investors will invest more in portfolio management. Our findings have important implications for the expected relation between mutual fund fees and returns, tests of fund manager ability, and the puzzle of active management. Furthermore, they suggest that changing the way investors compensate brokers will change the nature of competition in the mutual fund industry. Read the paper 

The importance of Risk Profiling

The #1 cause of client complaints is unsuitable investments. The # cause of unsuitable investments is a poor risk assessment of the client risk profile.The article discusses the elements of risk and how to take risk into account when designing an investment portfolio.Read the article

IFIC funded study points the way to reform-our Observations

IFIC sponsored a Study by  The Conference Board of Canada (CB0C) Boosting Retirement Readiness and the Economy Through Financial Advice CBoC is recognized as a professional research house with the highest level of intellectual integrity.. CBoC openly acknowledge that “advisors” do not produce enough extra returns to cover their fees . CBoC argue that the real benefit of having an advisor may not be investment advice at all. It may have more to do with engendering beneficial savings behaviour among clients. They concluded that if more people used investment advisors, they would save more money, and the country would benefit over the long term .As is well known ,“advisors” seek out clients who already have significant investable savings and tend to drop clients who fail to invest enough money over time because these clients don’t generate enough fees .If one reads between the lines, CBoC is saying that account underperformance is significant and the main benefit of advice is an increase in savings rate i.e. a babysitting role. This implies that if lower cost products were recommended , better returns would be obtained AND even more savings would accrue. However, the current Canadian business model where “advisors” sell more expensive ,underperforming actively-managed mutual funds leads to high costs and minimal unbiased advice. This supports a reformed business model where investors pay advisors' separately for tailored advice rather than having the mutual fund company pay for the advice contingent on selling their product..This way ,investors can feel more assured that the recommendations made are in their best interests and if not, they can engage another advisor or become a DIYrs if they feel they are sufficiently competent to control their own financial destiny. This will lead to increasing the number of professional advisors and enhanced financial outcomes for over 10 million Canadians. IFIC deserve credit for engaging CBoC and letting the chips fall where they may.Read our Observations 

The Costs and Benefits of Financial Advice

The Costs and Benefits of Financial Advice

Abstract : We assess the value that financial advisors provide to clients using a unique panel dataset on the Canadian financial advisory industry. We find that advisors influence investors’ trading choices, but they do not add value through their investment recommendations when judged  relative to passive investment benchmarks. The value-weighted client portfolio lags passive benchmarks by more than 2.5% per year net of fees, and even the best performing advisors fail to produce returns that reliably cover their fees. We show that differences in clients’ financial knowledge cannot account for the cross-sectional variation in fees, which implies that lack of financial sophistication is not the driving force behind the high fees. Advisors do, however, influence client savings behavior, risky asset holdings, and trading activity, which suggests that benefits related to financial planning may account for investors’ willingness to accept high fees on investment advice.Paper by Stephen Foerster, Juhani Linnainmaa, Brian Melzer Alessandro Previtero ,March 8, 2014 Read the Research Paper

 

A Primer on preventing financial abuse and fraud against the elderly

This document is a handy self-protection reference for seniors and retirees who want to avoid financial assault or fraud . Read it here