Is Your Stock Broker Acting in Your Best Interest?

The OSC is considering imposing a ‘best interest’ duty on stock brokers. Their industry body is resisting.

OSC considers imposing best interest duty on stock brokers. Their industry body is resisting.

Is Your Stock Broker Acting in Your Best Interest?

How do stock brokers choose investments for their clients? Most investors assume that stock brokers (who call themselves investment advisors,) assess their client’s risk tolerance and investment objectives and select investments that best match them. Indeed, stock brokers are legally required to select investments that are ‘suitable’ for their clients. Unfortunately, ‘suitable’ is a very broad term–learn more here>>

Have a look at your investment account statements. Ask yourself the following question: how did my broker choose the investments that I currently hold?

Mutual Funds

There are over 5,000 mutual funds are available in Canada. They’re classified into more than 30 categories: bond funds, equity funds, sector funds, specialty funds, regional funds, diversified funds, balanced funds, index funds, etc. Stock brokers like mutual funds because they are paid sales commissions and ongoing trailer fees that are invisible to their clients. Did your broker choose a fund that meets your risk tolerance and investment objectives, or the one that pays him the most? How many funds are enough? Learn more about why mutual funds are still popular despite high fees and poor performance here>>

Stocks

There are thousands of stocks available on Canadian, US and international equity markets. One of the pitches that stock brokers make to prospective clients is, “as a client you will have access to our analysts’ propriety research.”  Brokerage businesses earn large fees by raising capital for publicly traded companies (known as IPO’s or initial public offerings,) and from mergers and acquisitions advice, (M&A’s). Studies show that the vast majority of analyst reports are buy recommendations, rather than hold or sell recommendations.

Exchange Traded Funds

Why have Exchange Traded Funds (ETFs) become so popular? Low cost diversification and low management fees are the main benefits touted by the industry. ETF fees are in the 0.5% range, compared with 2% to 3% for many large Canadian mutual funds. However, in many cases, investors are switching to ETF’s without fully understanding what they are buying. You can read more about the risks associated with ETFs here>>

While ETF’s may offer low fees, stock brokers often charge clients a management fee to select funds on their behalf.  Holding a large number of ETFs can lead to over-diversified and potentially inappropriate portfolio diversification in relation to clients’ risk tolerance.

Alternative Asset Classes

Over the past few years, there has been growing interest in ‘alternative assets’ such as hedge funds and private equity funds. These funds often promise higher returns than public equity markets and paradoxically, lower risk. Not surprisingly, many have failed to deliver either.

Hedge and Private Equity fund managers typically charge clients based on a ‘2 and 20’ fee structure: an annual management fee of 2% of assets, plus 20% of profits above a pre-set threshold. This means managers have a big incentive to take on more risk. They also share those fees with stock brokers who sell their funds.

How can you protect yourself from the many conflicts of interest inherent in the brokerage business?

In each of these cases, there is a potential conflict of interest between the clients’ best interest and stock brokers’ incentives to earn higher fees. The OSC is reviewing the potential benefits of imposing a fiduciary, or ‘best interest’ duty on stock brokers.  Not surprising, their self-regulating body, the Investment Industry Association of Canada (IIAC) is resisting this initiative. Learn more here>>

At Sprung Investment Management, we are discretionary investment managers, not stock brokers. We are independent of any bank or broker and our only source of revenue comes directly from our clients. We do not receive any kind of commissions or trailer fees from stock brokers or fund managers. We are committed to meeting a fiduciary duty. A fiduciary duty or best interest standard (already the norm for lawyers, accountants and some other professionals) is a legal requirement that we put the client’s interests first. Our investments are made in your best interest.

At Sprung, our investment management approach is based on the value investing principles developed by Benjamin Graham.  Graham explained that “the essence of investment management is the management of risks, not the management of returns.” Learn more here>>

The management of risk begins when a new client joins us. You will meet directly with Michael Sprung and other members of our team. We take the time to get to know you in order to understand your investment objectives and risk tolerance.

Based on that understanding, we begin to build a portfolio that includes high quality stocks and investment grade bonds. Whereas mutual funds often hold a large number of stocks, our client portfolios typically hold 20 to 30. If you hold more, gains in any single stock will hardly affect the total value of your portfolio. If you hold fewer, losses in any single stock can have an adverse effect on your portfolio.

On the fixed-income side, we hold good quality investment grade bonds. We manage the duration of your holdings to reflect our view of the existing interest rate environment.

In summary, the benefits of portfolio management include:

  • A personal relationship with the person who is actually making investment decisions on your behalf;
  • Holding a well-diversified portfolio that properly reflects your risk tolerance and investment objectives;
  • Avoiding the conflicts of interest inherent in the broker/ fund manager relationship;
  • Transparency—no hidden fees or commissions;
  • Lower cost.

Does your portfolio properly match your risk tolerance and investment objectives? Sprung Investment Management Is Pleased To Offer Qualified Investors A Free Portfolio Review—Without Cost or Obligation. Learn more here>>

UPDATE March 27, 2014: Barry Critchley of the Financial Post interviewed Michael on the topic of a best interest standard. You can read the complete article here>>

 

Mutual Funds vs Portfolio Management

Mutual Funds why are they still popular despite high fees and poor performance?

Many Canadians still hold their investment assets in mutual funds. This, in spite of a decade of lacklustre performance and high fees. Even the emergence of exchange traded funds (ETF’s) has failed to put much of a dent in the mutual fund industry. As of November 2013, mutual fund assets in Canada were $986 billion; Canadian investors held only $62 billion in ETF’s.

Brokers mutual funds sales commissions trailer fees invisible clients

Brokers like mutual funds because they are paid sales commissions and ongoing trailer fees that are invisible to their clients.

Before describing how portfolio managers work with their clients, let’s take a quick look at how mutual funds function. A mutual fund is an investment vehicle that is made up of funds collected from many investors. The manager invests those funds in securities such as stocks, bonds, money market instruments and other similar assets. Individual investors own units in the funds in proportion to the amount they have invested.

While the first mutual funds were founded in the 1930’s, they grew in popularity beginning in the 1960’s. In an era of high trading commissions, their main benefits were that they gave small investors access to professional management and diversification at low cost. With the advent of discount brokerage in the 1980’s and ETF’s in the past 10 years, mutual funds are no longer a low cost option. With many large Canadian mutual funds still charging fees in the 2% to 3% range, they are now an expensive way to invest.

Why have many mutual funds performed poorly? High fees are certainly one reason. Another is that mutual funds tend to be over-diversified. Larger funds have so many assets (i.e. so much cash to invest) that they have to hold hundreds of stocks. This can make it difficult for funds to outperform market indices.

Despite this difficulty, brokers and fund managers feel that clients expect them to out-perform the market. To do that they are forced to take on more risk. However, if a fund out-performs in a rising market, it will likely under-perform in a declining market. That is exactly what many Canadian investors experienced in 2008: while the TSX Composite Index declined by just over 30%, many supposedly ‘conservative’ large-cap equity funds declined by 40% or more.

Given the poor performance of many large Canadian mutual funds, why do so many investors continue hold them? Brokers like mutual funds because they are paid sales commissions and ongoing trailer fees that are invisible to their clients. It is also worth noting that there is growing evidence suggesting that the sort of people most likely to go into the lucrative financial service sales roles are precisely those least suited to judging risk. Read more here>>

What’s the difference between a portfolio manager and a broker?

It is a source of pride for us that we are discretionary investment managers, not brokers. We are independent of any bank or broker and our only source of revenue comes directly from our clients. We do not receive any kind of commissions or trailer fees. Sprung Investment Management is committed to meeting a fiduciary duty. A fiduciary duty or best interest standard (already the norm for doctors, lawyers and some other professionals) is a legal requirement that an adviser must put the client’s interests first. That includes avoiding all conflicts of interest and making the best recommendations for the client even if it means lower compensation.

Canadian securities regulators are reviewing the potential benefits of introducing a fiduciary standard for brokers. Their industry body, the Investment Industry Association of Canada (IIAC) is fighting against this proposal. Learn more here>>

At Sprung, our investment management approach is based on the value investing principles developed by Ben Graham.  Graham explained that “the essence of investment management is the management of risks, not the management of returns.” Learn more here>>  The management of risk begins when a new client joins us. Clients meet directly with Michael Sprung and other members of our team. We take the time to get to know our clients in order to understand their investment objectives and risk tolerance.

Based on that understanding, we begin to build a portfolio that includes high quality dividend-paying stocks and Canadian government bonds. Whereas mutual funds often hold hundreds of stocks, our client portfolios typically hold 20 to 25. We believe this is a sweet spot for diversification. If you hold more, gains in any single stock will hardly affect the total value of your portfolio. If you hold fewer, losses in any stock can have an adverse effect on your portfolio.

In summary, the benefits of portfolio management include:

  • A personal relationship with the person who is actually making investment decisions on your behalf;
  • Holding a well-diversified portfolio that properly reflects your risk tolerance and investment objectives;
  • Avoiding the conflicts of interest inherent in the broker/ fund manager model;
  • Transparency—no hidden fees or commissions;
  • Lower cost.

OSC Reviews Relationship Between Advisors and Clients

OSC – CSA Consultation Paper 33-403 Proposes to Impose a Fiduciary or Best Interest Standard on All Advisors

In response to this proposal we have made the following submission to the OSC

The CSA is reviewing the potential benefits of introducing a statutory fiduciary, or ‘best interest’, standard for securities advisors when they provide advice to retail clients.

OSC roundtable best interest duty investments advisors

The OSC held a roundtable last summer to discuss imposing a ‘best interest’ duty on investments advisors.

The recent report by Laura Paglia of Torys LLP, written at the request of the Investment Funds Institute of Canada (IFIC) and the Investment Industry Association of Canada (IIAC) concludes, “there is no gap in Canada that need be or could be filled by imposing further statutory obligations on investment advisors and dealers.”

In our view, the discussion surrounding investment advisors and their clients has largely ignored the role that capital markets play in enhancing the well-being of the economy.  This role has several objectives, some of which may be in conflict with the objectives of many investors but are nonetheless necessary to allow capital formation and capital allocation to be directed in an efficient manner.

One of the most important roles of the capital markets is to provide a primary market that allows companies to form, raise capital to invest in productive resources.  This function of Initial Public Offerings provides a mechanism that allows the economy to expand.  Companies tend to go public either at very early stages of development or at times when the highest valuation a company can garner in order to expand is available through the public market place.  Secondary issues are also brought to market when management deems that they can get the best value in this manner.  This function often presents a conflict of interest between investment dealers and investors. Investment dealers, which generally include a lead underwriter and multiple other underwriters (also referred to as the sell side firm and the lead “book runner”, with “co-managers”), can take a cut of 3% to 7% of the gross IPO proceeds to distribute shares to investors.  When an advisor calls a client regarding an IPO is she acting in the client’s best interest, the best interest of the company that will receive the funds, or of their employer?

Another role that capital markets play is to provide an efficient market place for investors to buy and sell securities.  In this function, investors have a multitude of objectives ranging from pure speculation to saving for the long term.  It is unfair to categorise investors as one homogeneous group.  Most investment advisors are paid for piece-work; that is, they are paid by the volume of trades that they perform.  Again, this places their interests in conflict with many, but not necessarily all, investors.  Investors have a choice of the type of advisor with whom they can choose to deal.  Many advisors work on commission, but others work on a fee only basis.  Advisor/dealers working on a fee basis may still be in conflict with investor objectives if they are employed by a dealer whose objectives are volume related.

Much of the confusion to the investing public revolves around the fact that many investment industry professionals call themselves advisors or portfolio managers.  The distinction between an advisor/portfolio manager who must sell “suitable” investments and advisor/portfolio managers who meet a fiduciary standard is at best, murky.

There is a set of advisors that through extensive training and examinations, have the ability to manage investor funds on a discretionary basis.  Surely, people acting in this capacity should and must be charged with a fiduciary standard.  They should not be allowed to place themselves in a potential conflict with clients without extensive disclosure requirements.

Current advisors without this extensive training may not always appreciate the nuances of the best interest standard.

In our opinion, a revised regulatory framework should:

  • Make a clear distinction between individuals who meet a fiduciary or best interest standard and those that sell “suitable” investment product;
  • Restrict terms such as ‘advisor’ and ‘portfolio manager’ to individuals with the training and experience to act in the best interest of clients;
  • Prohibit those individual from selling products that present real or potential conflicts of interest, unless very extensive disclosure is present;
  • Indicate that other industry players, including financial planners selling mutual fund products, are selling “suitable” products and are in fact salespersons;
  • Disclose to clients detailed information regarding the remuneration all financial intermediaries.

Financial markets are vital to capital formation and the continued growth of the Canadian economy. The regulatory framework governing financial intermediaries must balance that positive role with the need to protect Canadian investors.

Michael Sprung – Submission Re CSA Consultation Paper 33-403

 

Susan Cain Quiet – Does Your Advisor’s Personality Expose You to Risk?

Does your advisor’s personality expose you to risk? In the new book Quiet, Susan Cain suggests it may.

In 2008, in the wake of the credit crisis and the collapse of Lehman Brothers, the S&P/TSX Composite Index declined by over 30%.  Many Canadian investors were shocked to find that the values of their portfolios had shrunk by significantly more. This shock was compounded by the fact that many investors believed that their advisors had put them in conservative investments. Their expectation was that high quality, conservative investments would be less volatile—i.e. that in a downturn, they would go down less than the market.

susan cain quiet advisor risk

Does your advisor’s personality expose you to risk? In the new book Quiet, Susan Cain suggests it may.

How could this happen? There is a growing body of evidence suggesting that the sort of people most likely to go into the lucrative financial service sales roles are precisely those least suited to judging risk. In the recently published book Quiet, author Susan Cain cites a series of studies that suggest that extroverts tend to be attracted to the high-reward environments of investment deals and trading. More importantly, the studies conclude that these outgoing people also tend to be less effective at balancing opportunity and risk than some of their more introverted peers.

In their defence, investment advisors would likely explain that that their clients expect and even demand that they earn their keep by out-performing market indices. However, in order to do that, they are forced to take on more risk. If a fund out-performs in a rising market, it will likely under-perform in a declining market. Again, that is exactly what many Canadian investors experienced in 2008: while the TSX Composite Index declined by 33%, many supposedly ‘conservative’ large-cap equity funds declined by 40% or more.

Part of the problem is using the S&P/TSX Composite Index as a benchmark to judge the performance of your investments.  The TSX is not an ideal investment yardstick. It simply reflects  the nature of business in Canada. And for better or worse, we are still ‘hewers of wood and drawers of water.’ Resource companies (combining the energy and materials sectors,) comprise about 50% for the market capitalization of the TSX Composite Index. That concentration in the resource sector means that the S&P/TSX Composite Index is highly volatile. For example, as commodity prices rose in 2009, the TSX moved up sharply. When they declined in 2011, the TSX dropped sharply.

“The essence of investment management is the management of risks, not the management of returns.” – Ben Graham

So what should investors do to reduce risk and volatility in their portfolios? Firstly, one should set reasonable expectations for investment returns. Rather than demanding that your investments outperform the market, it is more reasonable to ask that they generate a modest real rate of return, after inflation and management fees. We also believe your best protection is to find an investment manager who meets a ‘fiduciary duty.’ A fiduciary duty is a legal requirement that a manager avoids all conflicts of interest and put the client’s interests first. Investment advisors employed by the big bank-owned brokerages only responsibility is to suggest investments that are ‘suitable’ for their clients—a much lower threshold than a fiduciary duty.  In addition, they are not required to disclose any fees or commissions that they will receive if you buy what they are recommending.

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Does your portfolio contain investments or speculative bets? We are pleased to offer qualified* investors our free portfolio review. It will help you to understand if your portfolio matches your personal risk tolerance. Ask us how>>

*Canadian residents with a minimum $500,000 portfolio.

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Market Outlook – What’s the difference between a portfolio manager and a broker?

Market Outlook – What’s the difference between a portfolio manager and a broker?

Many clients do not understand that investment advisors employed by the large bank-owned brokerage firms do not meet a fiduciary duty. This is because of the many conflicts of interest inherent in their business model. Advisors are legally required to call you prior to selling you an investment product. They present investment ideas, but ultimately you, the client, are making the decision. Their only responsibility is to suggest investments that are ‘suitable’—a very low threshold. Also, they are not required to disclose any fees or commissions that they or their employer will receive if you buy what they are recommending. Because this is how they are compensated, at a minimum it creates a potential bias toward products that generate higher fees and worst it can lead to conflicts of interest

It is a source of pride for us that we are discretionary investment managers, not brokers. We are independent of any bank or broker and our only source of revenue comes directly from our clients. We do not receive any kind of commissions or trailer fees. Sprung Investment Management is committed to meeting a fiduciary duty. A fiduciary duty (already the norm for doctors, lawyers and some other professionals) is a legal requirement that an adviser must put the client’s interests first. That includes avoiding all conflicts of interest and making the best recommendations for the client even if it means lower compensation for the adviser.

The Ontario Securities Commission is considering requiring brokers to meet a fiduciary duty. Read More >>