The falling tree and the value of an independent advisor
I recently had a falling tree knocking out power of the whole neighborhood. I was puzzled, as it occurred in the middle of a sunny, windless day, but even more so, as I have had an Arborist from a well-known firm checking all our trees just a few months earlier. How was that accident possible? I turned to another tree expert, recommended by a friend. This independent advisor used to work for our previous advisor and shed some light on the mystery. “They are not paid for taking down trees but for maintaining and fertilizing them”, he explained. I realized, they were interested in selling me a recurring service and had no incentive to point out risks elsewhere. Luckily, nobody got harmed this time, the financial damage was limited and along the way I found my trusted advisor.
Outside of our domain we rely on the advice of dedicated experts. Our ability to assess the quality of the advice, however, is limited and we take a leap of faith. Without trust however, any advice is meaningless. So, how do we identify conflicts of interests and how do we find an advisor we can trust?
Who pays your Advisor?
There is overwhelming evidence that compensation influence us and research provides us with a wealth of examples on how manipulating payment structure alters employees’ behavior. The basic question therefore must be, how are my advisors compensated?
A true fiduciary draws 100% of his compensation directly from the client with no other sources of income that could translate into sources of conflicts. Whilst post-Madoff and financial crisis there has been a shift towards more transparency, a significant majority of financial advisors are still conflicted. There is typically no clear link between what the investor pays and what the advisor receives. The problem becomes accentuated as success is not measured in quality of advice, but amount of commissions earned and products sold.
Banker, Broker, Asset Manager or Investment Advisor?
Private Banking advisors typically earn a fixed salary complemented by a variable bonus that is tied to specific objectives and/or to their relative performance within the organization. The variable compensation is a function of how the assets managed have evolved and how profitable the “client book” is. Advice largely remains “free” and profitability is managed by selling products. Internal sales campaigns try to guide assets towards higher-margin products and solutions, preferably from their inhouse asset management.
Brokers (Broker-Dealers in the US) operate commission-based and their compensation is a share of the revenues they generate. Lacking recurring sources of income, their focus is often not the long-term investment success of an investor but rather on frequently soliciting short-term transactions, preferably triggering high commissions by distributing expensive “front-loaded retail share classes” of mutual funds and annuities.
How about seeking advice from Asset Managers? After all they are investment experts with an audited track record? Whilst their value proposition is often appealing, they are paid for managing assets and hence they will hardly advise to fire themselves when not delivering the promised results.
What about “fee-only” Investment Advisors (Registered Investment Advisors or RIA in the US)? In the purest form, their compensation is directly tied to the assets managed and they are only paid by the investors, therefore aligning with the client’s long-term interest. In the US, for instance, RIAs are subject to a “fiduciary” standard, meaning their advice must be in the best interest of the investor, whereas broker-dealers are held to a minimal “suitability” standard, which requires investment recommendations only to be suitable.
Moreover, lacking the element of sales, investment advisory is less lucrative than for instance banking and brokerage and it should give investors some comfort that a fee-only advisor actively chose to accept a smaller compensation. However, regulation typically leaves room for other sources of income, and even when they are disclosed, they may still affect the behavior of the advisor. In the US for instance, more than 60% of advisors are registered as Broker-dealers AND Investment advisor, leaving ample room for conflicts. Here, like everywhere else, careful due diligence is necessary.
Regulators around the world try to address the various conflicts of interest with new rules and enforced disclosure. Unfortunately, disclosures are not the antidote, as they are often very wordy and written in a language that is not easily understood by investors (keyword “small print”) and ultimately allow conflicted advisors to meet fiduciary standards.
How to identify a true fiduciary?
Overall beware of advisor’s tendencies to take shortcuts. The investment industry has large investment budgets at hand and as Daniel Kahneman put it “familiarity is not easily distinguished from truth. Authoritarian institutions and marketers have always known this fact”.
The following three questions shall guide you:
First, as discussed above, understanding your advisor’s compensation is key. Is somebody else paying your advisor, i.e. is there an incentive to prefer certain products over others?
Second, we believe independence is an important attribute. Public companies for instance are under pressure to deliver value to shareholders and thus are more likely to find alternative ways to protect their margins. Even in private organizations outside parties can exert pressure and add ulterior motives. Inquire who else has a financial interest in your business, especially outside of the advisor’s organization.
Third, barriers of entry are relatively low in the investment world. What are the qualifications of your advisors? What fiduciary standards are employed?
I ultimately found my trusted advisor for the trees in my backyard. However, with regards to managing our liquid wealth, stakes are much higher. The time invested on finding a true fiduciary and advisor is probably one of the best investments in the first place.
 Edward P. Lazear, Compensation and Incentives in the Workplace, Journal of Economic Perspectives, Volume 32, Number 3, Summer 2018
 Daniel Kahneman: Thinking, Fast and Slow