Is Your Advisor a Part-Time Fiduciary?

When you visit a doctor, you probably assume that he/she must do what is in your best interests and not what maximizes that doctor’s income. And you would be correct. Unfortunately, the same cannot be said with financial advisors. Being a fiduciary means that an advisor must legally put the client’s interests first, ahead of the interests of the advisor. This seems pretty basic to us at Greenspring – we have been following the fiduciary standard 100% of the time for 100% of our clients since our founding over 12 years ago.

However, the majority of advisors are not fiduciaries 100% of the time. There are several methods and loopholes to avoid being a fiduciary. You may have recently seen in the news that President Trump has ordered a review of a rule that was going to require the fiduciary standard with certain retirement accounts. Even if this rule does end up going into effect, it still only impacts those retirement accounts, not all accounts or investment products pitched by advisors. In addition, advisors are allowed to register with the government in a few ways, which lets them be a fiduciary when it comes to some activities but not a fiduciary when it comes to others.

Due to these complexities, our recommendation is to utilize a fee-only advisor such as one found at www.napfa.org (an association of fee-only advisors). Fee-only advisors are already subject to the fiduciary standard in all situations for all clients.

So the next time you see a financial advisor, ask them – Are you a fiduciary 100% of the time, or only when the government requires you to be? You might be surprised at the answer.

The Worse The Product The Higher The Commission

If there was still any doubt that brokers have been selling clients products that aren't in their best interest, this should put it to bed.  An article in Financial Advisor magazine reported the following:

Through August, sales of non-traded REITs were $3.15 billion, down 55 percent from the same period a year ago, according to the Robert A. Stanger & Co., which tracks the industry.

Sales of BDCs through August were $1.07 billion, down 62 percent.

Non-traded REITs, the bigger category, should reach around $5 billion this year — about half of last year — said Keith Allaire, managing director at Stanger.

What are non-traded REITs and BDC's you ask?  These are products with high commissions and fees (sometimes over 15%) with countless examples of massive blowups.  In this day and age with Google, it is hard to believe they still exist in their current form.  Just google "non-traded REIT scam" you'll find over 17,000 hits with the first few links being stern warnings from the SEC and FINRA.  The old adage that these products are "never bought but sold" is entirely correct.  You almost exclusively see these products sold by brokers.  So, what is the reason for the massive drop-off in sales?  The article states it pretty clearly:

"That's primarily due to the change from full front-load structure, to a trail commission structure," he said. "It's a matter of getting new products in the pipeline, and at B-Ds trying to figure what structure they want on the platform."

Translation:  cut out the big commissions and brokers won't sell it anymore.  This goes to show you that little concern was given to the quality of the product (anyone looking closely at these things knew that a long time ago) or the client.  The appeal of these products was always about the huge upfront commissions.  With the advent of the Fiduciary rule, requiring all brokers advising retirement accounts act in the client's best interest, it seems like some of these horrible products are seeing asset flows dwindle.  That's a great thing for consumers.

If you are in the market for an advisor, I urge you to find one that always acts in your best interest (not just for retirement accounts) so you can avoid situations like this.  The best way to find one is through the National Association of Personal Financial Advisors (www.napfa.org).  While you aren't guaranteed to find a great advisor (you still need to vet them further), at least you will know that advisor is not incented by selling you products (NAPFA members cannot accept commissions or kickbacks in any form).

Full disclosure- Greenspring is a member of NAPFA.

More Conflicts At Big Brokerage Firms

Did you ever wonder how a financial advisor makes their investment recommendations?  There are thousands of mutual funds on the market today.  How does he/she pick one over the other?  If your advisor works for a big brokerage firm like Morgan Stanley or Merrill Lynch, some of the decision making is taken out of his/her hands.  There is a little known practice that happens in which funds pay for "shelf space".  In order for a fund to be offered on a large brokerage firm's platform, they must pay hefty fees.  Some fund companies are happy to do this in order to gain distribution, while others refuse.  Here is Jason Zweig of the WSJ discussing some of the nuances:

The financial industry calls these fees “payment for shelf space,” and they can add up. At Edward Jones, revenue-sharing fees from fund companies topped $153 million in 2014, or just under 20% of the the St. Louis-based brokerage and advisory firm’s total net income that year.

At Merrill Lynch, fund companies pay up to 0.25% of sales and 0.10% of assets annually for “marketing services and support,” according to a 2015 disclosure. Morgan Stanley collects $750,000 per year from each of 28 fund companies it has designated “global partners” and $350,000 annually from each of another 11 “emerging partners,” according to the firm’s latest available disclosure.

The disclosure statements warn that revenue sharing can be an ethical minefield. Edward Jones says the payments create “an additional financial incentive and financial benefit” to the firm and its advisers. Merrill Lynch points out that funds that don’t enter into such arrangements “are generally not offered to clients.” Morgan Stanley says the firm may “promote and recommend” funds that pay higher revenue sharing.

Do you think there is a conflict here?  You bet.  Let me give you a real life example.  Before I founded Greenspring, I was employed by one of these large institutions.  After doing some of my own research I found a fantastic real estate fund that I thought would make sense to own in client portfolios.  But since this fund company was not willing to pay a portion of their revenue to my firm I was not able to offer it to clients.  As an advisor, when you can't recommend products that are in your client's best interest, there is a conflict.  One other thing you have to realize…the only way for the economics on this type of arrangement to work is by using high fee funds.  If you are offering your products on Merrill Lynch's platform, you can't pay Merrill Lynch 0.35% in the first year if your expense ratio is 0.2%.  Why do you think you can't buy a Vanguard mutual fund at these firms (which by the way is probably one of the best fund companies on the planet)?  Because Vanguard only charges 0.1%-0.2% for many of their fund expenses.  They don't charge enough to share fees.

Many investors think that a fee-based relationship is the same whether it is at Merrill Lynch, Morgan Stanley or an independent firm.  It's not.  While you may be paying similar fees to your advisor in each of these scenarios, what you don't see is that independent firms don't charge for shelf space, and therefore are free to recommend any product they think is best for their client.  The big firms only recommend funds that have paid them for shelf space.  This can have a major impact on fund selection and portfolio performance.

Conflicts Abound At Large Brokerage Firms

If you ever are interested in learning about the conflicts your advisor at a big firm might have when advising you, just go read their compensation plans.  They are complex and incentivize behaviors that may not be in your best interest.  Many of us at Greenspring started our careers at these firms so we weren't surprised to see that not much has changed.  I was particularly interested in a recent article that outlines the new compensation plans offered to advisors at Merrill Lynch and Morgan Stanley, the two largest brokerage firms in the world.  Here is an excerpt from the article about Morgan Stanley:

As for Morgan Stanley's lending award, it remains unchanged from last year at the advisor level: A maximum of $202,500 will be received for those showing growth in securities-based lending, tailored lending and home mortgages. Support staffers, though, can earn as much as $10,000 for their support of lending activities, up from $2,000 in 2015.

The president of the wealth management division stated in the article, "We continue to make private banking services our top strategic priority in support of [our] holistic advice."  Translation:  lets sell a boat load of banking products to our clients this year!  The fact that an advisor can earn over $200,000 if he sells enough lending products is sickening to me.  With that kind of money on the line, advisors are incented to push clients into loans.  Not only loans, but margin loans.  For the vast majority of investors this is a terrible idea.  Ask anyone who has heavily invested on margin how it worked out.

Merrill Lynch isn't any better.  Here is an excerpt:

Advisors who had fees and commissions of about $400,000 to $600,000 and received cash payouts of 40% in 2015, for instance, will need to produce $450,000 to $650,000 in 2016 to maintain the same payout level. Thus, a $400,000 producing FA who couldn't make the jump to $450,000 in production would make 5% less cash in 2016 — $152,000 vs. $160,000 in 2015.

Merrill's 2016 grid includes cash payouts of 34% of production to those reps bringing in yearly fees and commissions of under $250,000; 35% for those producing between $250,000 and $350,000; 38% for the $350,000–$450,000 range; 40% for $450,000–$650,000; 41% for $650,000-$850,000, 42% for $850,000-$1.05 million, and 43% for $1.05 million-$1.5 million.

So, lets say you are an advisor and its December 15th.  You've produced $425,000 in revenue for the year.  You know if you don't get to $450,000 in total revenue your payout (% of revenue you take home) is going to drop costing you thousands of dollars.  Do you think there is any incentive to push products that may not be in your clients best interest?  And this isn't just some small percentage of advisors that have to wrestle with this.  It is all of them.  When you look at the ranges, every advisor is going to be close to bumping up to a new payout.  Again, this is more incentive to sell products that the clients may not need.

Am I being harsh?  Don't advisors have a moral and ethical dilemma when they sell clients products that benefit the advisor more than them?  Maybe, but I have seen too much that leads me to believe it is happening frequently.  Dan Ariely, a professor of behavior economics at Duke puts it best:

Dishonesty is all about the small acts we can take and then think, no, this not real cheating. So if you think that the main mechanism is rationalization, then what you come up with, and that’s what we find, is that we’re basically trying to balance feeling good about ourselves. On the one hand we get some satisfaction, some utility from thinking of ourselves as honest, moral, wonderful people. On the other hand we try to benefit from cheating.

So rationalization is what we allows you to live with some cheating and not pay a cost in terms of your own view of yourself.

We all have biases and conflicts.  Advisors, like all of us, are prone to using rationalization to live with the products they are selling clients.  They have plenty of money, they'll be alright.  The performance has been great on this fund.  They have to bank somewhere.

Rationalizations are everywhere.  Our industry has to stop relying on an advisor's moral code and disclosure to clients (none of which work) and focus on setting up firms that avoid these conflicts altogether.  Greenspring has thought a lot about this.  That is why all of our revenue comes from our clients.  We don't want to be influenced by outside forces (earning a commission to sell a product, sales incentives, higher payout figures, etc) when we are advising clients.  We hope to see the industry follow this same path as the clients will be the real winners.

Non-Traded REITs- Just Say No

Real estate has been a great diversifier over time.  For investors not wanting to invest directly in properties, real estate investment trusts (REITs) offer an ideal vehicle to gain exposure to real estate through the public equity markets.  Unfortunately, over the past several decades a new product has found its way on the market.  The non-traded private REIT has exploded in the retail investor market, primarily sold by stock brokers and financial advisors.  Here is typically the key points of the sales pitch:

  • No price fluctuation
  • 6% yield
  • Diversification through ownership of commercial real estate properties

What's not to like?  Having heard this sales pitch from the product vendors myself, at first blush they can be compelling.  Unfortunately, that is not the entire story.  Let me point out some of the downsides of these products:

  • Huge upfront costs- typically only 85-90% of an investor's principal actually gets invested
  • No liquidity
  • Big commissions to the broker
  • Historical underperformance

Recently, a study was released that seems to back up our thoughts that these products have no place in client portfolios.  The study found that over $116 billion has been invested in these products over the last 25 years.  Their study also found that these investors are at least $45 billion worse off than had they just invested in publicly traded REIT's over the same period.  Returns of publicly traded REITs have been 11.3% per year while non-traded REITs have averaged 4% over that same period.  Here are some of the return statistics:

REIT

You may be asking yourself, "if these products are so bad, why do they still exist?"  The simple answer is money.  These products pay huge commissions and fees to the brokers selling them and the providers of the funds themselves.  If you have ever purchased one of these products, I would seriously question the advice you are getting from your advisor. The next time someone pitches one of these products to you, please reference this study and ask why this investment is appropriate.

 

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.