Nothing new under the sun!

By Edwin Lee

17 April 2017

The recent rout in the oil & gas space has once again surfaced long existing structural conflicts of interests that exist within certain pockets of our wealth management industry.

News of the defaults hitting the offshore oil and gas space has highlighted these conflicts, and various articles and comments have surfaced from stakeholders like bankers, bond issuers and investors. Yet many of the key issues remain ‘unspoken’ and the reader is left to ‘fill in the blanks’ over a worrisome coffee or a downright depressive whiskey.

As we review what has happened, we come to see that as wise old King Solomon said, there really is ‘nothing new under the sun’!

Many questions have been asked:

  1. How could the regulator have better prevented this from happening? Could they have afforded investors more protection? Is the Accredited Investor rule inadequate?
  2. Should it be a requirement that only bonds rated by credit ratings agencies like Moody’s and S&P be allowed to be marketed?
  3. If the ‘Know Your Client’ (KYC) and ‘Risk Profiling’ of the client was done by the bank, how did this happen?

Yet we think the more important question we should all be asking is this:

What is the key role of investment professionals in the wealth management space here? We are talking about the Private bankers, investment and portfolio counsellors and portfolio managers.

Relationship Management? Client Education? Prudent selection of investments? Ensuring risks taken are suitable for the client?

We would propose that the key word to sum it all up is simply – stewardship.

Investment professionals are called to be good stewards of client assets (when given the discretionary authority to manage assets) or are paid to help clients be better stewards of their assets (when the assets are under an advisory relationship).

(As we table some of the ‘inside-thoughts’ of our business, please know that we write this cognizant that we have many good friends who are investment professionals. This is an appeal knowing that there is a better way to perform our role as stewards, recognizing that it does come at a cost. )

We would venture to say that most of these bonds that have been hit are held by private investors in ‘advisory relationships’. This means that the bank does not have the discretionary authority to make investment decisions in these clients’ portfolios and the investments professionals have to ‘take the orders’ from the clients after sharing investment research with them. The fact that there are so little of these bonds in the banks’ discretionary portfolios as compared to advisory portfolios should already raise eyebrows.

In these advisory relationships, the clients do rely on the investment professionals to make the investment decisions.

So what went wrong? And what can continue to go wrong?

As mentioned, it’s the same story over again & this is just another reminder. From the GFC and subprime mortgages in the US to the spill over effects globally, there’s really ‘nothing new under the sun’. So here are the few issues at hand:

  1. Alignment of interest – who are the investment professionals working for? The institution or the clients?
  2. Conflicts of interest – how the different divisions of the banks have conflicting goals, and how that impacts the investor.
  3. Ongoing monitoring of investments and the incentives and resources to do so.
  4. Leverage, prudence, portfolio management and the role of the clients.
Alignment of interests

The reality is that we are all dealing with money here and as with many industries, the bottom line is important to the banks. As publicly listed firms, shareholder pressure, quarterly earnings are very real to senior management teams. And if the firm is a high performing entity, these pressures must be felt at the foot soldier levels. As the paymaster, there’s significant leverage firms can apply to its employees. (Think Wells Fargo for a recent case in point.) So is the employee working for the best interest of the bank, himself or herself, or the client? Or can it all be done well all at once?

What are pressures like for the foot soldiers? We already deal with many pressures on the day to day basis – client satisfaction, portfolio performance, volatile markets, administration and compliance paperwork. But if you ask any investment professional, the revenue & assets under management targets likely top the list of stressors.

What does it mean when it comes to the daily grind?

Let’s take the advisory ‘trade ideas’ as an example. The traditional model has it such that the investment professional is measured by the revenue generated by the account, which often translates to the commissions paid by the client on a trade, or in the case of some bond new issues, the ‘sales rebate’ that the investment bank pays to the professional. The Fixed Income and Equity sales desks would generate trade ideas weekly/daily, and these would be sent out to the bankers and investment counsellors, who will in turn then translate these ideas into trades with the clients. Simple enough.

The banker and the investment counsellor (the professionals who communicate with the clients) appropriately relies on the fixed income or equities desk of the bank to provide recommendations and advice. The banker and investment counsellor cannot be expected to do fundamental due diligence on each and every stock and bond in their clients’ portfolios – they wouldn’t have time to talk to you if they did that.

However, once the bond or stock is ‘sold’ to the client, the reality is that it is hard for the banker or investment counsellor to maintain due diligence on all the underlying companies. He or she is swamped by the plethora of work to do, and often looks to the Fixed Income and Equities desk for the next trade idea. Furthermore, it is not easy for the professional to handle 30-100+ client accounts each, depending on the tier. Remember that when a trade idea goes out to a client, the client might counter propose and ask the team ‘what about this other stock or bond that’s a competitor?’ So the teams end up doing more work on securities and we end up with a mixed bag of client accounts with many different securities. That’s the reality of the business, and to monitor each and every position in each client account is actually a mammoth task. Yes, with the right technology tools and the right team, it can be done – but it’s still a lot of work.

When the pressure’s held constant at 200PSI, it might be fine, but when its turned up to 1000PSI, we start seeing cracks and sometimes blow-outs!

Conflicts of interests

The spotlight thrown on the recent offshore bond defaults once again highlights the ‘typical textbook’ case of conflicts of interests so I’ll keep it brief.

The debt capital markets division of the bank is paid by the banks to raise capital for the companies, so in a sense, it is right that their loyalty lies with these companies – their goal is to raise funds via bond issues.

But what about the private wealth divisions of banks? Whose interests are they supposed to look after? We all know it’s the end clients or the investors. We wealth managers are paid to be the gatekeepers, trying our best to screen the universe of investments – sifting the chaff from the wheat.

Sometimes these 2 ends can meet symbiotically, but not all the time.

Ongoing monitoring of investments and the incentives to do so

As alluded to earlier, I would propose that the transactional advisory model, where professionals are paid commissions for each trade, is not the best incentive model to encourage a high level of due diligence on the investments currently held in the client portfolio.

Once the trade is done and the stock or bond is added to the clients’ portfolio, follow through research support and recommendations are often lacking.

In defence of investment professionals, I would highlight that the interaction between advisor and client also plays a big part in this.

Let me give you an example, again with the oil and gas or metals and mining space. Many firms continued to recommend oil and gas stocks three to four years back. We would have ‘sold’ these ideas proposing the stocks or bonds to the clients and if convinced, the client would have bought these for their portfolios. Say a year later, the research desk changes their view and highlights that oil prices would be headed even lower over the next year. These stocks and bonds would already have fallen somewhat and the investor would have lost money. The banker needs to come to the client, tell him, “Mr Client, our analysis now shows that we should be selling this position as it would likely fall further.” “What?! Your desk said it’s a good buy last year, and now you are telling me after it’s down 10% that we should cut? Let’s wait and see, maybe things will get better…”

It takes courage to face the client with this news and more courage to persuade the client to take action. (Loss aversion is the term used in behavioural finance to describe the reluctance of clients to cut losses. It’s very real. Even professional investors struggle with it.)

Whether there is a profit to be made or a loss to be taken, there is a lingering thought that the investor is asked to make a trade so that the firm generates commission revenues.

The fee based model has been proposed as a solution to this problem. The banker/firm is not paid on trades but mainly on a fee based on the value of the client portfolios. If the bankers are not getting paid on the trade commissions, the client does not have to second guess the motive of a trade recommendation. If the professional is paid on the value of the portfolio and she sees a high level of risk that would impact the portfolio value, she would definitely be putting in effort to urge the client to sell the position!

Leverage, prudence, portfolio management and the role of the clients.

Over the past months, clients and prospects have come to us asking us to review their portfolios currently managed at the private banks.

As we go through the portfolios, a few common issues are seen.

One of the basic concepts in portfolio management is that of diversification. Position size limits & sector limits are necessary – so that when we are wrong, and we will be wrong at times, the impact to the portfolios are limited.

Many of the portfolios have taken on inappropriate levels of concentration risks.

Why is this the case? Shouldn’t professionals know better? Once again, what sounds good in theory doesn’t always happen when the rubber meets the road.

Once again, let’s come back to our oil and gas bonds as the case in point. Usually once the fixed income desks send out the blast email informing the bankers that there is a new issue, the books close within the day so clients have to decide if they want to buy these bonds within a few hours. The banker has the day to call his or her clients to inform them of the new deal, give them time to consider the offer and then call them again to take the order.

Say it takes the banker half an hour to brief the client on the opportunity. The client comes to decide – ok, let’s go ahead. ‘How much should I buy?’ The banker can say $250,000 (the minimum piece for these bonds), $500,000 or $1,000,000. Either way, he’s taken 30 minutes. But he could be making 4 times the revenue if the client executed $1,000,000 instead of $250,000. For the same time taken.

Assuming the portfolio is worth $5,000,000. Taken to the extreme (it’s seldom this bad.), the difference could be 20 conversations on 20 bond issues or 5 conversations on 5 bond issues. All for the revenue.

Multiply these numbers by the number of clients being managed by each professional and add the ‘pressure factor’ and you get a clearer picture.

Clients actually have a part to play in this as well. Think of it, the investment professional is facing pressure on one side by his or her bosses to bring up revenues, and clients on the other side to bring down fees.

So you can understand why applying ‘leverage’ looks like a great solution. The client receives a higher return and the banker generates a higher revenue for the bank and takes home a bigger pay check. And they all live happily ever after…. Until the music suddenly stops.

So these are some of the very real issues and thoughts that go on in the professionals’ mind even as we reflect on what’s happened.

It’s not the first time and it won’t be the last time these issues come to the forefront. There are solutions to these.

The fee based model is one of them. But even then, the same problem can occur in the fee based model. The client could be charged a few on the portfolio and since the banker is being paid whether he calls the client or not, the portfolio could be neglected.

There’s even a fancy term for this – reverse churn.

For as long as greed and fear continue to be dominant emotions in wealth management, and the pressures continue to be high, there will truly be ‘nothing new under the sun’! For clients who have been hit, investment professionals could now play the tune for the times – fear. ‘Switch to high grade, investment grade bonds only’, because that’s what investors want to hear.

The wealth management process is a complex web of emotions and decisions where trust is paramount.

Clients, recognise that investor education is the best safeguard. Choose to work with investment professionals you can trust. Know that the culture of the firms is a big factor here.

Bankers, pressures from regulators, markets, clients & bosses will continue to mount. Write the word ‘Stewardship’ on a post-it and stick it on the monitor in front of you as an anchor to headwinds. It will serve you well when the storms blow, but better when the skies are clear.

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