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Conflicts of Interest and Mutual Fund Advice

If you're a mutual fund investor, chances are pretty good that at some point along the line you would benefit from some good financial advice. From the lackluster returns that fund investors earn, to their paltry savings rates, to their modest balances, there's no lack of evidence that the typical fund investor could use some help as they attempt to fund their long-term goals.

The good news is that there's a veritable army of self-anointed financial experts standing ready to provide their services. The bad news is that an investor trying to find a financial advisor has to navigate a veritable minefield in trying to find good, solid advice that is in his or her best interest.

The problem that plagues the financial advice industry is the same one that is the source of so many of the mutual fund industry's problems: conflicting interests.

Financial advisors fall into two broad categories: those who are subject to a "suitability standard," who are permitted to recommend one fund over another simply because they get paid more to do so; and those who are subject to a "fiduciary standard," whose recommendations are supposed to be based solely on what's in the client's best interest.

But no matter the standard under which they operate, financial advisors -- and the firms that employ them -- are much like all of us: they want to increase their own revenue. The problem is that every dollar they earn comes directly out of their clients' pockets. (An old industry chestnut makes the point nicely: A young broker asks a veteran partner at his firm what his proudest accomplishment is. His response? "Over the years I've gradually transferred my clients' assets to myself.")

These conflicts are most evident in the brokerage world with its suitability standard. Just last week, Investment News published an article that described how many Merrill Lynch brokers were complaining about the pressure they were getting from their managers to push the banking services of their parent firm, Bank of America.
Distasteful? Yes. Shocking? Hardly. When Bank of America acquired Merrill Lynch two years ago, they weren't doing so out of the kindness of their hearts; they recognized it as an opportunity to harness Merrill's large sales force to expand their banking reach.

What you or I might call a conflict of interest, corporate America calls "synergy."

In many firms, this conflict is codified in "revenue sharing" arrangements, in which mutual fund managers agree to pay a firm in return for being included on their list of recommended funds. What are the odds that one of these advisors would recommend a fund from a manager that doesn't participate in revenue sharing? Slim and none. Remember, to a man with a hammer, everything looks like a nail.

This doesn't mean that advisors who are held to the stricter fiduciary standard don't have to wrestle with their own conflicts of interest. Some two years ago, a number of CFP-credentialed Fidelity brokers -- who were subject to the fiduciary standard -- claimed that they were being pressured to sell their clients "high-margin money management and insurance products."
The conflicts of interest advisors face aren't limited to investment selection. For instance, if you're paying your advisor a percentage of assets under management, and ask him if it makes sense to pay off your mortgage, you can be sure that he's doing a bit of mental arithmetic to determine how his fee will be impacted if you take a slug of your assets out from under his purview. Ideally his recommendation won't be impacted by this reality, but it's possible it will.

Finally, there's the issue of fees. Many advisors are adopting the fee structure described above, paid a percentage of the assets they manage. While such an advisor might provide sound advice utilizing low-cost index funds or ETFs, the value of that advice might be completely eroded by high fees.

What's too high? Typically, anything above one percent is considered costly, and even fees of one percent can be dear, consuming -- in many years -- any equity premium your portfolio might earn. But here's a good test. If in defending his fees, your advisor claims an ability to produce superior returns via market timing or fund selection, say thanks but no thanks. Because the value a good advisor provides lies not in their ability to improve performance, but rather in their ability to keep you from making costly mistakes.

Which leads me to another story. A client called up his advisor, wanting to know what he should do in reaction to the plummeting market. "Nothing," said the advisor. The next year, he called again, wanting to know what he should do in response to the soaring price of gold. "Nothing," was the advisor's response. In year three the client called again, wanting to know what he should do to take advantage of the soaring bull market. "Nothing," said the advisor again. "Excuse me," said the client, "but every time I ask your advice, you tell me to do nothing. Remind me again what I'm paying you for." "You're paying me," said the advisor, "to keep you from doing something."

And therein lies the true value of advice.

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