JOHN A. HASLEM is professor emeritus of finance in the Robert H. Smith School of Business at the University of Maryland in College Park. jhaslem@rhsmith.umd.edu. The New Reality of Financial Advisors and Investors John A. Haslem It is a truism that crisis calls for change. Arthur B. Laby [2010]. This study assesses the engagement of financial advisors by individual investors following the financial crisis. It is important to remember that financial advisors and broker/dealers differ in their regulation, and that there is much confusion among investors in differentiating the two. Beginning in the 1980s and more so in the 1990s, confusion has increased as broker/dealers have increasing looked, acted, and advertised as financial advisors, the investor s trusted advisor. Haslem Electronic copy available at: http://ssrn.com/abstract=1536029
[2008] discusses investors who use financial advisors, empirical studies of financial advisors, and investor behavioral issues. Selected Legal Issues The lines of confusion between financial advisors and broker/dealers have not been clarified sufficiently since the Investment Advisers Act. Investors must therefore depend primarily on the Act s basic distinctions. An investment adviser is... any person who, for compensation, engages in the business of advising others either directly or through publications or writings, as to the value of securities or to the advisability of investing in, purchasing, or selling securities. Under the Investment Advisers Act, services provided by broker/dealers are excluded as long as any advice given is solely incidental to brokerage services and for which the broker/dealer does not receive any special compensation. Over the years, however, these exclusions have been broadened and conditions relaxed. 2 Electronic copy available at: http://ssrn.com/abstract=1536029
Legal scholar Tamar Frankel [2010] writes that under the Investment Advisers Act financial advisors are... viewed and regulated as fiduciaries. Broker/dealers are... viewed and regulated as securities salespersons, and the SEC imposed on them a duty of fairness in their contacts with their customers.... The SEC has also determined that broker/dealers must follow a high ethical contract standard and deal fairly with customers. Frankel [2010] analyzes financial advisor and broker/dealer practices, fiduciary duties, and proposes changes in law. In addition, many state courts have found that financial advisors have a position of trust and confidence to their investors. Court applications of common law dictate that advisors owe broad fiduciary duties to their client investors, in spite of how they may be regulated. Fiduciary Duties 3
Fiduciary duties may appear to be a difficult term to apply in practice, but less so if its elements are revealed and followed. The overlapping fiduciary duties of financial advisors to investor clients may be outlined as followed: (1) always place client interests first and foremost, (2) always act with utmost good faith, (3) always provide full and fair disclosure of all material information, (4) never mislead clients, and, very importantly, (5) disclose all conflicts of interest, both large and small. The National Association of Personal Financial Advisors (NAPFA) [2008] requires a Fiduciary Oath of its members to provide additional protection to investor clients. The oath s elements include (1) exercise of best efforts to act in good faith in the best interests of clients, (2) provision of written disclosure to the client prior to and during engagement of any conflicts of interest, (3) advisor does not receive any remuneration contingent upon a client s purchase or sale of a 4
financial product, and (4) advisor does not receive any third party compensation based on client referral or client business. Further, the NAPFA Code of Ethics defines issues of (1) objectivity, (2) confidentiality, (3) competence, (4) fairness and suitability, (5) integrity and honesty, (6) regulatory compliance, (7) full disclosure, and (8) professionalism. Certified Financial Planner (CFP) Alan Roth [2009] reveals that not all financial advisors take their fiduciary mandates to heart. He notes that CFPs are bound to apply the duty of care of a fiduciary, which means... anyone acting in such a capacity should be putting the client s interests first. An actual CFP has a customer with an investment horizon of one year tells Roth the money will be invested in a money market fund. Roth recalls that this fund returns 0.2%, and the customer pays the financial planner a 1.0% fee. Roth states the financial planner should invest the client s money in bank CDs paying 1.55% with 5
no planner fees. So much for the financial planner practicing his fiduciary duty. The importance of identifying financial advisors who follow the precept of fiduciary duty is magnified by the large percentage of households that engage financial advisors. The Investment Company Institute [2008] reports 49% of household mutual fund assets are invested through financial advisors, but even more (55%) through full service brokers. The three largest financial advisor services used by households are (1) regular portfolio review and investment recommendations 85%; (2) planning to achieve specific goals, such as college and retirement---75%; and (3) comprehensive financial planning--- 75%. Banjo [2009], Kim [2009], Pilon [2009], Tergesen and Kim [2009b], and Roth [2009] discuss the choice of financial advisors. Financial Markets Crisis 6
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select a financial advisor who implements portfolios that truly hedge risk. In a 2009 study with a unique German data set, the first analysis finds client investor accounts managed by the bank s financial advisor outperform accounts invested with its broker. The second analysis compares the characteristics of client investors with financial advisor accounts relative to those with broker accounts. The third analysis uses client investors with the same characteristics in both the financial advisor and broker accounts. These more properly formulated results find broker accounts outperform financial advisor accounts across all performance measures. We know direct sold mutual funds outperform broker sold funds, and here it appears that broker accounts outperform financial advisor accounts, adjusted for investor characteristics. Such an adjustment has not been feasible in former studies. 30
Behavioral finance argues it is plausible to understand financial market events that include investors who are less than fully rational, and it is based on two tenets: limits to arbitrage that make it difficult to undue asset price dislocations caused by trades of less than fully rational investors, and results from psychology that find and define the biases of less than fully rational investors. Under these conditions, asset prices deviate from efficient market prices are right, but there still remains no free lunch. References Banjo, Shelly. Seven Questions to Ask When Picking a Financial Adviser. Wall Street Journal (http://online.wsj.com/article), April 13, 2009. Barberis, Nicholas, and Richard Thaler. A Survey of Behavioral Finance. Working Paper Series, SSRN, October 25, 2002 (ssrn.com/abstract=327880). Bell, Heather. Is Buy-and-Hold Dead? Journal of Indexes, Vol. 13, No. 1 (January/February 2010), pp. 34-39, 62. 31
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Statman, Meir. The Mistakes We Make---and Why We Make Them. Wall Street Journal (http://online.wsj.com/article), August 23, 2009. Swedroe, Larry E. The Only Guide to a Winning Investment Strategy You ll Ever Need. New York: St. Martin s Press, 2005. Taleb, Nassim N. Ten Principles for a Black-Swan Proof World. FT.com, April 7, 2009. Tergesen, Anne, and Jane J. Kim. Advisers Ditch Buy and Hold for New Tactics. Wall Street Journal, April 29, 2009a, pp. D9-D10. Tergesen, Anne, and Jane N. Kim. Wary Investors Are Seeking Out Objective Voices. Wall Street Journal (http://online.wsj.com/article), July 29, 2009b. Zweig, Jason. Inefficient Markets Are Still Hard to Beat. Wall Street Journal (http://online.wsj.com/article), January 9, 2010. 34