I’ve had a long career in the financial industry. Starting on the investment product manufacturing and distribution side, then advising clients, I’ve had first-hand experience with a range of business models. I’ve served as a chief investment officer for the better part of two decades now. This overall experience has given me a deep understanding of the motivations and objectives that drive most financial firms’ “representatives,” whether they are called brokers, client advisors, financial advisors, trust officers or something else.
Regardless of title, most of these folks are sales people for their institutions. While they may have the best of intentions, the investment philosophies and processes their firms employ put them in a conflicted position because they are designed with the primary purpose of selling something to investors. Their focus is on generating revenue for their firms and themselves, driven by financial incentives that are opaque to their clients. Clients experience mediocre to poor investment performance and often intuitively sense that something’s not right but lack the expertise and guidance to figure out why that is.
Actually, it’s not that hard to figure out if you understand “the game.” Like most businesses, investment firms seek to generate maximum revenue. Fair enough. However, for me, the problem is with how they seek to do it.
Based on my experience, investors are exploited with three main common industry practices:
1. INFORMATION EDGE: First, firms use their “information edge” over clients (and their own representatives) to push higher margin products. Investment information is often complex and firms deliberately keep it that way to sell product — whether that is a proprietary fund or a “third party” fund — which make it onto a firm’s “investment platform” in the first place because the firm believes they can help generate revenue.
2. OVER DIVERSIFICATION: Second, firms use diversification theory as a justification for investing in an unnecessarily broad array of funds. In some cases, this allows them to use more products with different share classes while keeping investments small enough so that they don’t breach fee breaks (i.e. amounts where product fees begin to drop). They also market diversification as a means to closely track relative performance against an index (usually a “blended benchmark” created by the firm), in a way that ensures reported performance is in line with or close to the index. Remember, firms generate their greatest revenue by distributing product and moving money from one investment to another. With close to benchmark performance, firms can get clients to “keep going” (i.e. remain hopeful) and replace the bad performers with good performers, thereby earning more fees. This leads to #3.
3. YESTERDAY’S SUCCESS: Firms often market investments that have already worked because that’s the easiest sale. They get clients out of the poor investment performer that “brought down” their overall performance and put them into the “best performers.” A chart with the line sloping up from left to right is always compelling and easy to sell. Unfortunately, this practice feeds into investors’ most common mistake, to buy high and sell low. Investing in something solely because it’s had a good run is usually not the best thing for a client.
While these practices are typically “disclosed” in some form or fashion, there are very few clients who can decipher such disclosures or understand the practices to which those disclosures apply. The only fool proof way for a client to get to the bottom line of this game is to demand to know exactly how much revenue the firm they work with generates (across all business lines and departments) by having them as a client — a dollar amount. No caveats or disclosures. If they can’t answer the question, in writing, then beware.
So, go ask your advisor: how much revenue does your firm generate by having me as a client?