Alignment, Not Disclosure

By Edwin Lee

31 July 2017

On 14th April this year, The Straits Times ran an article “S’pore, HK Wealth managers may have to disclose fund fees”. It highlighted the conflicts of interests inherent in the sale of mutual funds or unit trusts by wealth managers in the region. As a colleague and I discussed this with our client who is a doctor, she shared that there is a parallel in her field, where drug companies would pass a rebate on to the clinics based on the sales volume of the various drugs. Conflicts of interests show up across various businesses and industries.

But when we are in the business of STEWARDSHIP, one cannot help but feel as if the weight of guarding against conflicts of interests are truly ours to bear.

Last year, we know that the issue was highlighted in the banks’ in the sale of oil and gas bonds. We wrote a reflection about that in our website and stated that its really “Nothing new under the sun” – the GFC, Subprime collateralized debt obligations, etc. These are the very same conflicts that plague our industry.

When it comes to the sale of unit trusts, one needs to ask, “how are banks and bankers paid?” The obvious bill is the upfront sales charge which could range from 1%-2% depending on the size of the investment, the type of fund, size of the overall relationship and even the sophistication of the client. And then there’s the ongoing trailer fees that’s built in and deducted from the value of the fund on an ongoing basis. Investors do not actually open their wallets to pay for it, but ‘passively pay’ for it via a deduction to the Net Asset Value of the fund they are invested in. This fee might be 1.45% for the ‘private client class’ of a diversified bond fund run by one of the leading bond managers. This would be a class that is usually sold by banks dealing with private investors. In contrast, the institutional class that the university endowment fund would buy would have a management fee of 0.55%. Why the 0.9% difference? That is the trailer fee. The fee that is paid to the distributor – the bank and the banker for selling the fund.

Is there anything wrong in that? Everyone needs to get paid, right?

Well, yes, but here’s where the conflicts can develop. Some funds pay a larger trailer, some pay less. Some banks are so big, they know they have muscle to negotiate hard with the funds. They will squeeze the various fund managers and sometimes promote the fund house that pay the levels of trailers they are looking for.

Are the banks and the wealth managers really recommending the fund to investors because of its merits or because of the fees the firm will receive?

We need to come back to first principles – what is the role of the wealth manager? To be a steward of our client’s assets.

One part of that role is to select investments – should we buy a stock, use an Exchange Traded Fund, or invest in an active fund like a unit trust? One has a higher management fee than the other. If there are active fund managers that can outperform the index, then which one should we choose?

The article continues:

“The increased transparency will give investors much clearer visibility of how much money investment advisers make from fund managers for distributing their products, and investors might think more carefully before buying a fund.”

Last year after the Oil and Gas turmoil, banks started to disclose the fees that they are paid for selling new issue bonds. So how’s an investor supposed to interpret this? The banks are paid more for some bond issues and less for others. If I see that the bank is getting paid more for a particular issue does it mean that I had better stay away because it is riskier?

We know that there’s more that goes into the equation and things are not that simple.

My point is – “Alignment, Not Disclosure” is needed.

Private banks and wealth managers must restructure themselves to incentivise staff to work primarily for the interests of their clients. Because we are dealing with money, fear and greed driving the participants, it takes conviction to be able to live this out.

It takes 2 hands to clap, and advisors and clients both have a part to play in this relationship.

Over the years, some investment professionals have lost the trust of their clients. Yet we need to recognise that advisors are often caught in between clients squeezing for lower fees and management pushing for higher revenues. Consequently, higher than necessary leverage is deployed, less transparent fee structures and more complex products seem like an attractive way out of this squeeze.

So as an industry, how can we be better aligned with our investors?

Financial compensation drive behaviour, so we need to start at the root of the problem.

Have our investors as our paymasters. Stay vigilant in the fight against potential conflicts of interests that will continue to surface.

An example of this is the transactional versus the fee based model. If an advisor is paid per trade, what incentive does he have to ask you to hold on to a stock over multiple years?

But even in the fee based model, things could go wrong. The client could be charged a fee on the portfolio and since the advisor is being paid whether he works on the portfolio or not, the portfolio could be neglected! The fancy term for this is – ‘Reverse Churn’.

As a firm, the lion’s share of our revenue is paid by our clients – not by fund managers, banks, service providers, so with the client as our paymaster, we are better aligned.

Zooming out beyond Singapore, in countries the United Kingdom, front end loads and trailers can’t be collected anymore. They can only charge annual portfolio fees.

Why wait for regulators to force us to do the best thing for our clients when we can adopt it now?
Back to Perspectives

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