Over the next two years the government and its agents will be reviewing the Financial Advisors Act 2008 (FAA). The FAA's main objective is to improve outcomes for retail investors dealing with intermediaries including ensuring the sound and efficient delivery of advice.
The government's decision to clean up the advice business was motivated to a large extent by the huge losses incurred by Mums and Dads who bought finance company debentures. The government's pointman in these endeavours, the FMA, reckon that things are looking better because advisors are now educated, licensed, have to abide by a code of ethics and, of course, have the FMA on the lookout for bad behaviour.
Things are obviously much better than those dark days when finance company debentures were popular but the way the changes have been undertaken means that progress has been mixed with equal measures of frustration and angst occasionally punctuated by instances of irony and farce.
Intermediaries like financial advisors, stockbrokers etc, have had to undertake education some of which was, to be charitable, pathetic, abide by a Code of Conduct part of which, as we will see, isn't at all realistic and endure some irrational determinations from the Financial Advisors Disciplinary Committee.
Humorous moments have included seeing key members of the Code Committee resign in disgrace after they failed a mystery shopping exercise by Consumer. Whilst many of these deprivations are well deserved the key question before the panel today is around what changes to the FAA are appropriate.
First up let's look at what is probably the key determination within the FAA as to how advisers should treat clients: Code Standard 1 says that "an authorised financial adviser has to put clients' interests first" and it adds "these obligations are paramount". Whilst this is a nice sentiment the reality in NZ is that financial advisers actually don't have to put their clients' interests first, whatever that may mean.
A genuine effort to put clients interest first would mean dramatically lower profitability for the finance sector and that really isn't an option. For this reason the government and its financial police have backed away from many material issues including banning commission payments.
Commission payments involve the advisor purporting to work for the client but in fact being paid for by the institution selling the service thus introducing a huge conflict of interest. This conflict is one reason Code Standard 1 is not achievable. Instead what financial advisors have to do to meet their legal obligations is simply to disclose their fees which in many cases means disclosing that they haven't put their clients' interests first.
For example in the real world some advisers put their clients into high cost managed or KiwiSaver funds simply because they pay commissions to the advisor when a better alternative would be a low cost fund which doesn't pay commission.
Recall the academic (independent) research which says that low costs are the best indicator there is of future outperformance so clearly favouring a high cost fund just because it pays commission over a low cost fund which does not is not putting your clients' interests first. But the rules are if you disclose the commission then it's all good, ie as this column has discussed before "if you disclose then anything goes".
Similarly if you go to a bank it will recommend its KiwiSaver fund without considering any other competing funds. Hardly doing the right thing is it? Putting your clients' interests first, as expressed in the Code of Conduct really are "weasel words" and more a public relations exercise than anything else.
Another glaring example of the duplicity involved in the preposterous "put clients first" proposition can be seen when we look at the nature of the investment banking business in NZ where a stockbroking firm acts for the promoters selling an IPO and at the same time advises mum and dad to buy the IPO.
There are two clients involved here with opposing objectives so inevitably the interests of one of them are going to be put "further first" than the other! If anyone genuinely wanted to clean up the industry a good start would be to stop this "client's interests are being put first" charade and be realistic.
The legislators weak strategy on commission reflects a wider problem: the emphasis of the law is on managing conflicts of interest whereas it should be to eliminate them. The disparity between the financial advisory sectors view on conflicts of interest versus that of professions was highlighted recently when the Law Society President expressed the view that "it is rightly expected lawyers act for their clients without conflict of interest or any form of bias".
Contrast this with what passes for good behaviour in the retail financial advisory sector - David Greenslade of Strategi Consultants neatly summed up the sad state of affairs here when he said "conflicts of interest are not wrong in themselves but they should be properly identified and effectively and transparently managed".
That this strategy is inappropriate was highlighted by a comment from a senior executive at ASIC (the Australian equivalent of the FMA), last week as follows: "Professionals have a fiduciary duty to the client and where's there is conflict that interferes with your capacity, is not a question of managing them, it's a question of getting rid of those conflicts".
Next let's look at education because education is frequently touted as a saviour for the industry. It may not be. The objective of education should be to make advisors aware of what best practice looks like so the test should be whether, after the education, advisors are better equipped to devise portfolios approximating best practice. This is not the case at present and two examples will illustrate.
Firstly, a number of CPD offerings are subsidised by small fund managers with highly specialised, esoteric investment strategies. Presently AFA's can attend these courses which promote the idea of investing in these specialist strategies when a lower cost, more broad based exposure to equities/bonds/property is lower risk, lower cost and consistent with best practice.
Other equally inappropriate CPD offerings are orientated to growing the advisors business as they emphasise selling techniques. In addition CPD for retail advisors is frequently confused with CPD for fund managers. This wouldn't be a problem if the basics were being taught properly. That might not be the case.
I discussed what strategy was appropriate for constructing a bond portfolio with a person who teaches Chartered Financial Planner (CFP) courses and that person wasn't aware how institutions manage duration risk.
However there is a more important systemic problem with education and training - even high quality education and training is frequently a waste of time because the investment industry can make more money by ignoring best practice. So whilst top management "talk the talk" they don't "walk the walk" and any new employee with the theory fresh in his or her mind quickly learns to keep quiet.
For example, diversification is acknowledged by academics as essential and the only "free lunch" available yet many financial advisory firms and private banks instead eschew the theory and recommend individual stocks in NZ, Australia, and even internationally simply because shuffling the deck periodically generates more fees than buying an index fund and fosters the illusion of "expert advice".
The sad reality of the investment advice industry as opposed to other professions like medicine and accounting is that proper training, academic theory and best practice is a clear and present threat to profitability and thus generally ignored.
The regulators, the Code Committee and the MBIE might like to reflect on how these mistakes were possible. One angle they could consider is that they have occurred because industry has largely captured the process and this has been able to happen because few people drafting the law actually were aware of what best practice looks like.
That this might be an issue was evidenced recently when a lawyer, an expert on the FAA, said that it was important that any modifications to the FAA include regulations so that advisors could offer advice on crowdfunding.
We know that the least risky portfolio is the "market portfolio" and advisors are supposed to do the best thing for their client which presumably includes minimising risk. It is a pretty fair bet that the equity and debt to be raised via crowdfunding is likely to never exceed .0000001 per cent of the investment universe. So it is clear that crowdfunding should comprise no part whatsoever of the average retail investors portfolio. Not trendy, not good for business but it's the right thing to do.