Conflicted Advisors

Dishonest advisors may not be easy to catch, but, once we identify them, we know they’ve acted illegally and we have a legal infrastructure in place to punish them. Similarly, inept advisors also eventually reveal themselves and, once again, their poor records speak for themselves: We know they are inept when they continue to provide advice and services that destroy value.

Conflicted advisors (non-fiduciaries whose motives are not well aligned with those of the small investor) are harder to spot, because they are in some ways in the gray areas of the game. Although they don’t have our best interests at heart, they are not acting illegally. Morally we may find their actions distasteful, but from a legal perspective, because they are non-fiduciaries, no sanctions can be applied.

Here are some examples. An advisor may suggest you rebalance your portfolio very frequently, sometimes convincing you such moves are necessary to adhere to some special investment strategy. This generates activity in your account and therefore more fees for the advisor, who is compensated for every transaction. When taken to an extreme you may be able to pursue legal action, but it will be harder to make your case when the advisor is not a fiduciary.

Another example involves an advisor who directs you to investments that make the most money for him through commissions and other fees, including potential payments from the originators of those investments. In such cases, the investments may appear reasonable, but they are not necessarily in your best interest. It is likely that very similar investments are available from another source with lower fees. This seemingly slight perversion of priorities can come with what appear to be small fees, but with dramatic cumulative effects for you in the long run.

The good news (yes, there is some good news) is that you can and should ask advisors whether they have a fiduciary duty. The blurring of the traditional advisor functions in recent years means that some service providers have a fiduciary duty to clients for certain services, but only a suitability requirement for other services they may provide. For example, a single advisor may charge you commissions on certain transactions (functioning effectively as a broker without fiduciary duty) while charging you fees for other assets under management (an investment advisor function that may carry fiduciary duty). Insurance company representatives may hold a variety of designations and may even claim to be fiduciaries when it comes to discussing retirement investments, but they may not be fiduciaries as salesmen of insurance products. Responsible advisors make it clear which services or offerings are fiduciary and which are not. Needless to say, this only makes it more difficult for the small investor to figure out where the conflicts are and how to tiptoe around them.

The recent financial debacle and high-profile shenanigans by various advisors (with and without fiduciary duties) have led to a serious deterioration in trust by consumers and small investors. The Cohn & Wolfe Financial Confidence Survey administered in January 2009 found that nearly a third of respondents (32 percent) described financial institutions as “greedy,” with only five percent selecting “ethical.”

According to a rasmussenreports.com article dated September 21, 2009, only 41 percent of Americans have a favorable opinion of stockbrokers and financial analysts. Compare this to 94 percent of Americans who view small business owners favorably.

Perhaps not surprisingly, my recommendation for the small investor is to steer clear of those providers who don’t have a fiduciary duty. I would go even further and insist on fiduciary duty and an explicit commitment to fee-only service, such as that offered by NAPFA-registered financial advisors. This ensures that the advisor is not influenced through compensation offered by market players other than you (for example, through payments from mutual fund companies).

Why on earth would you do anything else? If you can find people who have your best interests at heart, it makes sense to secure their services rather than taking your chances elsewhere.

But if I steer clear of brokers, you may ask, how do I execute my trades? The simple answer: Open a discount brokerage account, which allows you to bypass any contact with an advice-providing (non-fiduciary) broker. This is discussed further in the Passive Investor's Game Plan section of this site.

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