possible new fiduciary laws
Legislative proposals have been floating around Congress for a while that would create national standards for the conduct of financial fiduciaries toward their clients, as well as mandate that financial planners and brokers must act as fiduciaries when dealing with individuals. This seems to me to be in reaction to the Madoff and Stanford ponzi schemes, where financial advisors seem to have been much more zeroed in on the large fees they were collecting for recommending the schemes than on the welfare of their customers.
After Goldman Sachs’ recent grilling by the Senate’s Permanent Subcommittee on Investigations, during which questioning senators quoted liberally from the conclusions of a similar committee looking into the causes of the 1929 stock market collapse, the idea has made it into a Senate bill that brokers should be fiduciaries in their dealings with institutional investors as well (or at least any government-related entities).
what a fiduciary is
To step back a minute, what is a fiduciary anyway?
In one sense, we’ll find out if this legislation passes, since it has to spell out in detail what a fiduciary is and does. In general terms, though, a fiduciary is:
–a trusted advisor who
–has a certain level of technical competence in the area where he is taking up fiduciary duties and who
–acts for the benefit of his client, with no thought for his own personal gain.
Doctors, lawyers and court-appointed trustees are all examples of fiduciaries.
a financial fiduciary
A financial fiduciary has to have a certain level of technical competence and must look out for the financial welfare of his client. To do the latter, however, it seems to me the fiduciary must have a deep knowledge of the client’s financial situation–including life goals, risk tolerances and investment objectives, as well as the size and disposition of the financial assets he possesses. How else will he be able to judge whether an investment is appropriate for a client?
retail brokers are not fiduciaries, by and large–but I think they should be
There’s no national fiduciary standard for brokers or financial planners. This means that at the moment, except where local laws require it, retail brokers and financial planners are not fiduciaries. They must do things that are good for their clients, but they need not do what is best for their clients. That’s an important distinction.
An example: A broker finds two mutual funds that meet the client’s risk/return profile.
#1 is expected to net the client 9% per year. The fund company pays the broker’s firm 40 basis points a year in fees. This sale will qualify the broker to attend for free a fund company-sponsored “information meeting” in Hawaii.
#2 has consistently outperformed #1 in the past. It is expected to return 10% a year. Fees to the broker’s firm are 30 basis points. No free trip.
Litigation has established (remember, however, I’m an investor, not a lawyer) that the broker can recommend #1 instead of #2 to the client. Why? The client will be better off with #1 than without it. Since the broker is not a fiduciary, he has no obligation to show #2 to the client or to highlight either the differences or the extra benefits of #2 to the broker.
Personally, I’m all for retail investment advisors becoming fiduciaries. The most highly skilled advisors probably are as well. I think there would be lots of fallout for traditional “load” mutual fund companies from this change. But that’s not what I want to write about today.
the institutional world is different
In order to act as a fiduciary when executing a trade, a broker has to understand a client’s current investment position and his intentions.
As an institutional investor, my investment plans and my current portfolio positioning are my competitive advantage. They are valuable intellectual property, my stock in trade, my equivalent of copyrights and patents. I’m certainly not going to disclose this information to the brokerage intermediaries I chose to trade for me. In fact, I may do everything in my power to disguise my intentions from him.
As an institutional investor, I’m invariably acting in the interests of clients. In assessing the suitability of any investment, a fiduciary probably should know who the ultimate owner will be and what his investment plans are. Again, my client list is also valuable intellectual property. I’m certainly not going to reveal that. I may also have clients who have specifically required that I not reveal their identities (usually because they don’t want to appear to be endorsing my management services).
In addition, although the broker has different information from mine–he sees what a wide variety of clients are trading–it may not be better information. In the equity world, his analysts may have more industry knowledge than mine. But because their livelihood is so closely linked to the health of the industry they follow, they may find it hard to see anything negative. And mine certainly know more about the individual companies we own than they do. And mine know more about related fields, which may be important, too.
To sum up, as an institutional investor I don’t need or want the broker to be a fiduciary. I want him to be an intermediary in trading who guards my anonymity, thus protecting my intellectual property. I may listen to his input, delivered, not from the trading desk but from his research department to my analysts, but it will be one of many factors I take into consideration.
In fact, if I’m a value investor, it’s music to my ears if a broker hates a particular stock. Part of my modus operandi is to buy companies that have performed badly but where I judge other investors have already acted out all their negative feelings by selling. My biggest worry is that my buy order will tip him off to the stock’s potential. The last thing I want is for him to come to think that this is a good idea. Yet, if he’s got to be a fiduciary, how else can he act on my behalf?
Washington doesn’t seem to understand this
The morning after the SEC announced it was suing Goldman for fraud, the Wall Street Journal ran an editorial in which it surmised that the SEC fundamentally misunderstood what the financial instrument that formed the basis for the suit is. Nowadays, I automatically discount what the WSJ says as being partisan support for Rupert Murdoch’s political allies. But I’ve come to think that, in this case at least, the comment is accurate.
An Op-ed column in yesterday’s Financial Times raises this point again. It also talks about the oddity that while in its suit the SEC is defending the interests of two European banks against an American company, Americans are suing one of the two banks for fraud and the SEC hasn’t stepped in to help.
I also found it striking in the Senate hearings about Goldman that the senators didn’t seem to appreciate that the rise of large multinational corporations after WWII and the emergence of large “buy side” institutions after passage of ERISA pension legislation in the Seventies have profoundly changed the landscape for institutional investing. Many of the functions the senators seem to think are performed solely by investment banks have decades ago shifted to their clients–either the finance departments of industrial companies or to giant investment management firms.
It seems to me the Goldman witnesses did themselves no favors by somehow giving their questioners the impression they had something to hide. They certainly didn’t get the point across that there’s a difference between an investment advisor and a trader. Then again, reflection, self-awareness and self-deprecation are probably not high on the list of attributes a trading firm like Goldman looks for in its employees. They were probably also scared, because Washington has a lot of power and wants to be seen as doing something.
Maybe I’m just getting old, but I find this all kind of scary, too.