The Wall Street Journal article below highlights the conflict of interest(s) inherent when your financial advisor is held to the Suitability Standard not the Fiduciary Standard. This is especially prevalent with large broker-dealers. While the article highlights fees there is also the undercurrent that investment choice is limited; as an investor you may not be shown the full landscape. As a metaphor, you are only allowed to shop at Safeway and not the other stores in your town. The author ends with some good questions and it is just another example why the independent, Registered Investment Advisor is different than traditional broker-dealer approach. The full contents of the cited article is reprinted below.
Have I Got a Fund For You! Why Brokers Push Some Investments
If only, in turbulent markets like these, you could know your financial adviser will always act in your best interest.
In mid-December, Securities and Exchange Commission Chairman Jay Clayton told the U.S. Senate Banking Committee that investors don’t want brokers or financial advisers to have “hidden incentives or incentives that are clearly inconsistent with making a recommendation that is in the interests of their clients.”
A rule the SEC proposed last year would help bring some of those hidden incentives into the light, although big Wall Street firms are lobbying to water it down.
What about the incentives Mr. Clayton spoke about that aren’t even hidden?
You can spot them in the disclosure brochures that investment-advisory firms file with the SEC, known as Form ADV Part 2. (You should be able to find them for your adviser here.)
Many major brokers, banks and financial advisers take revenue-sharing payments—legal kickbacks that mutual-fund companies pay to reward sales of particular funds. Such payments vary from 0.01% to about 0.15% of the amount invested.
That gives firms an incentive to favor the funds that share the biggest revenue payments with them.
In one disclosure, Morgan Stanley points out that funds with higher management fees make greater revenue-sharing payments: “This fact presents a conflict of interest for us to promote and recommend funds that have higher management fees.”
Morgan Stanley and other firms say they mitigate such conflicts by ensuring their brokers don’t receive incentive compensation based on how much revenue sharing their sales generate. On advisory accounts, Morgan Stanley rebates such fees to clients.
How much the firm’s investment professionals earn, says a spokeswoman, “is not impacted by whether the fund family participates in these programs or not.”
Even so, the firms themselves get the extra revenue. Perhaps that’s why Morgan Stanley and other brokerages no longer offer low-cost mutual funds from Vanguard Group, which doesn’t make revenue-sharing payments.
When Morgan Stanley trimmed its menu of funds, “having consistent economic arrangements with our asset-management partners” was a criterion, says a spokeswoman.
Some firms swear they put your interests first, but constrain your choices.
“The adviser generally limits its selection to JPMorgan affiliated funds,” says a filing from an investment-management unit of JPMorgan Chase & Co. “With limited exceptions, the adviser does not consider or canvass the universe of unaffiliated funds available, even though there may be unaffiliated funds that may be more appropriate for the client accounts or…have superior historical returns.”
JPMorgan officials weren’t available to comment.
Bank of America Corp.’s Merrill Lynch discloses that it makes more money on alternative-investment funds affiliated with the firm than on similar ones from outsiders. Therefore, says Merrill, “we may have a conflict of interest” when selecting such funds. The firm seeks to mitigate that by, among other things, not considering those extra fees when paying its advisers, “although such policies and procedures do not eliminate such conflicts of interest.”
A spokesman says Merrill’s advisers “are paid a portion of the asset-based fee paid by clients, which does not vary by product type or asset class.”
Several firms, including units of UBS AG and Citigroup Inc., disclose they may sometimes scrutinize their internal portfolio managers differently than they do outsiders.
“Affiliated investment managers are not required to meet the same standards as unaffiliated investment managers,” says a Citigroup disclosure, “and, in some cases, affiliated investment managers will not be subject to any formal review process of any kind”—including analysis of their performance or financial condition.
“Not only is that a conflict, they don’t even give a reason why the affiliated managers aren’t subject to the same due diligence,” says Nicole Boyson, a finance professor at Northeastern University who studies such disclosures. “They just give them a free pass.” Citigroup declined to comment beyond its disclosures.
“Although disclosures are critically important,” a UBS spokesman said in a statement, “we also have firm-wide policies and training that help employees identify such issues and ensure they are managed appropriately.”
Several firms admit they have an incentive to prod clients into leveraging up their portfolios with borrowed money. Such margin debt amplifies investors’ exposure to the markets, raising the total amount upon which the firms can charge fees.
The borrowings also magnify the risk investors may lose money. In a sudden market drop, the broker can sell the related investments for whatever they will fetch to pay off the debt.
An investment-advisory affiliate of Citigroup clearly spells out that it may recommend investments “with a greater potential for higher returns, and a corresponding higher potential for volatility and risk of loss,” than it would in an unleveraged account.
The disclosure also says the firm could act in ways that “may be adverse” to its clients’ best interests if it has to collect on any margin debt.
Regulators might never clean up such conflicts. That leaves you holding the shovel. Always ask your adviser: Does anybody else pay you to give me advice? Will you itemize all your fees and expenses in writing?
Source: Wall Street Journal
The opinions expressed in the reprinted article are those of the author, and do not purport to reflect the opinions or views of CPWM, LLC, its affiliates, or any of their respective employees.
This information does not constitute and is not intended to be a substitute for specific individualized legal or estate-planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified advisor, CPA, estate planner or attorney. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers are obtained from what are considered reliable sources. However, their accuracy, completeness or reliability cannot be guaranteed.