Brent Sheather: Mystery shopping not so good for financial advisory

Advisors in a US mystery shopper survey did not dissuade investors from trying to chase performance. Photo / AP

The NZ public has long been fascinated by the idea of the mystery shopping model whereby an organisation, often staffed by individuals with delusions of grandeur, surreptitiously seeks a good or service from a provider, secretly records and analyses the performance of the vendor and then publishes the results.

As far as I know this process was pioneered by Consumer magazine, most popularly with the financial advisory sector, even if they didn't always analyse the results intelligently. Now there is even a TV programme devoted to mystery shopping, Target on TV3. They say that any publicity is good publicity but it has to be said that mystery shopping has not been good news for the financial advisory sector although their performance is miles ahead of the practices apparently typical in the local carpet cleaning industry.

Apart from that notorious Target episode, one of the most recent scandalous local mystery shopping exercises occurred a few years back and put an end to the tenure of several financial advisors on the Code Committee. This episode was particularly humorous because the function of the Code Committee was to determine a Code of Professional Conduct for authorised financial advisors including minimum standard of competence, knowledge and skill along with requirements for continuing education and training.

The advisors charged with accomplishing this important task were ostensibly the best in NZ but a few of the organisations they owned were mystery shopped by Consumer and their financial advice was rated poorly. This episode would have been more humorous had it not been for the fact that the Code Committee didn't do its job all that well and as a result the financial planning/stockbroking sector today is probably almost as vulnerable to a bad mystery shopping outcome as it was back then.

The difference is that now the bad advice will be "documented". Today as then the big problem with going to a financial adviser is that he or she may pick investments with his/her interests in mind rather than those of the customer so the efforts of the Code Committee, while doing some good, were much like putting new wallpaper up in Christchurch's Forsyth Barr building after the earthquake despite a glossy outside the foundations upon which financial advice is given is often unbalanced.

There are two reasons however to be a bit optimistic firstly the FMA who inherited the original Code Committee are refreshing it with sensible non conflicted experts. Secondly, there are an increasing number of advisers who have seen the light and adopted a fee based model.

But the fun of mystery shopping is not confined to NZ, it's catching on in the USA as well. In February of this year the US National Bureau of Economic Research (NBER) based in Cambridge Massachusetts mystery shopped 248 unsuspecting Boston based financial advisors . The NBER staff came from the Economics Department of Harvard University, the MIT Sloan School of Management and the University of Hamburg so we can conclude they know what they were doing.

The paper describing the study starts by explaining that research suggests that individual investors frequently make poor financial decisions if left to their own devices. Common mistakes include over confidence, buying things that go up, using naive rules of thumb and trading excessively. The authors conclude that the net effect of all this silliness is to produce significantly lower returns than would be achieved if one bought an index fund and then went to the beach.

The study noted the above weaknesses of retail investors and sought to answer the question whether, given that 73 per cent of all individuals in the US consult a financial adviser before investing, these financial advisors corrected the weakness identified in retail investor decision making and gave them good advice. The authors "define good advice as advice that moves the investor towards a low cost, diversified, index fund approach", which many text book analyses on investment suggest.

The alternate hypothesis and one which this column has much sympathy with is that because some advisors are paid with incentives that encourage them to direct money to specific investments and generate high fees, advisors tend to exploit the biases of retail investors in order to maximize their own interests.

The authors also sought to determine whether individuals were able to differentiate between good advisors and bad. Before we get to the bad news it is important to note that the NBER study focused mainly on advisors whose target market was under US$500,000 for whom remuneration consisted mainly of commission rather than the fee based advisors more commonly targeting high net worth individuals.

Unfortunately the results of the NBER study confirm that the situation in the US is not too different from that locally. There was no lurid secret camera video but not much in the way of good advice either.

The major findings were as follows: advisors did not dissuade investors from trying to chase performance.

The NBER organisers had one group of mystery shoppers tell the advisor they had previously bought an energy orientated specialist exchange traded fund, had made money on the transaction and wanted to investigate the possibility of making more similar, undiversified, short term trades. Because advisors can make money from churning portfolios they didn't advise that this activity was silly.

The study also found that more than half of the advisors encouraged people to invest in actively managed funds with only 7.5 per cent encouraging investment in an index fund. That's bad enough but when the mystery shoppers who held a properly diversified portfolio made up of low cost index funds asked for advice most advisors recommended they switch to higher cost actively managed funds. When advisors mentioned fees "they did so in a way that downplayed fees without lying". Sound familiar?

The National Bureau of Economic Research authors concluded that not only does the market for financial advice not serve to deter retail investors from the previously highlighted bad behaviour but "in fact exaggerates biases that are in the advisors financial interest while leaning against those which do not generate fees". There is a lot more in the NBER paper should readers want to get more details.

One other important conclusion that we can draw from the NBER study, if we already didn't know it, is that the best approach to investing is the "low cost, diversified, index fund approach". This is the view of the NBER and their staff from Harvard, the Massachusetts Institute of Technology (MIT) and Hamburg University. These people don't own fund managers, don't get commission from clients and don't get trips overseas paid for by the financial services industry etc etc so can probably be regarded as reasonably independent. We should therefore take note of their views!

It also highlights to me how ridiculous much of the Continuing Professional Development promulgated in this country is. Some of it is provided by and subsidised by high cost, specialist, active managers whose products are completely at variance with a "low cost, diversified, index fund" approach.

Anecdotal evidence suggests that a good proportion the CPD available in NZ thus makes advisors worse at their jobs rather than better not to mention wasting their time and their money. The cost of financial advice both in terms of the advisor fee and the fee paid to fund managers is far too high relative to returns.

CPD advocating high cost, niche managers contributes to the investor biases identified by the NBER earlier, raises costs, raises risk and lowers returns. The Code Committee strikes again and in the absence of another Consumer study the FMA needs to continue to refresh it.