Last month the FMA released a guidance note for financial services providers entitled "A Guide to the FMA's View of Conduct". This document was designed to "give guidance on what we will focus on when examining how financial services providers demonstrate good conduct".
Readers will likely be impressed with the FMA's rhetoric, especially that the requirement to put a client's interest first is being extended across all FMA licensed financial services providers. FMA Chief Executive, Rob Everett, was quoted as saying that "he has no patience for people who think the requirement to put clients' interest first is difficult or inappropriate".
Full marks there. But what does "putting a client's interest first" actually mean? Indeed can the experience that the typical retail investor has with the finance sector reasonably be described as having their interests put first?
More about that later but, for a start, the average man in the street is likely to have a problem with one fundamental position taken by the FMA and that is, apparently, that although financial advisers are required to put client's interests first what that means for a sales person at a bank that only sells a limited range of products (which are almost always higher cost products) is much less rigorous than for an adviser who works for a firm which is able to choose from a wide range of products.
Everett was quoted on the Good Returns website as saying "it means different things for different people in different circumstances. What it means for an AFA holding themselves out as a non-aligned individual is different to someone offering ASB products for example". I would describe this position as an "its ok to sell high cost products if that's all you have got" regime. It thus seems that all clients' interests will be put first but, borrowing from George Orwell's Animal Farm, "some clients interests will be put less first than others".
The FMA's view is that clients' expectations are different when they deal with a vertically integrated provider.
Vertically integrated firms like banks don't sell shonky products which are inappropriate for the consumer, but the conduct guide applies to all FMA licensed providers so local fx platforms, binary option providers and unlisted property managers will be required, under the FMA's view of conduct, to put clients' interests first (non-regulated firms offshore are a particular problem).
Perhaps the key issue here for local providers of esoteric solutions will be ensuring that the product is suitable for the individuals they sell to.
We must remember however that the buyers of those esoteric products are a minority - by far the most amount of business sees retail investors buying good products - many of which are burdened with high fees. The difference between what institutional investors consider good products and what is "bad" in terms of fees is wide.
For example the average management expense ratio on a local equity fund, even excluding the typical unfair performance fees, ranges from between 1.0% to 1.5% whereas low cost products are available offering broad equity exposure for 0.05%.
How is that relevant? Most academics reckon when choosing between similar investment products low cost ones are by far the best. The SEC website shows that each 1% in annual fees reduces the terminal sum over a 20 year saving period by 18%. So the impact of the 2%-3% annual fee typical of most wealth management solutions is huge.
Most retired New Zealanders will know of someone who has invested in a high cost superannuation product or managed fund which has, because of high fees, not fulfilled their investment needs. Indeed Herald columnist, Mary Holm, got a letter the other day from a reader who had this sort of bad product.
Their story was all too familiar - they invested in October 1997 in a high risk portfolio and 18 years later achieved a return of less than 2% per year after paying annual fees of more than 1.3% pa to their advisor. It's fair to say that, apart from getting the asset allocation right and maximising diversification, minimising cost is one of the most important jobs for a financial adviser.
So what is the FMA's approach to this problem? The FMA advised in an email that "if the fees charged inherently make the products sold one that does not perform for the customers' need that is clearly a problem and we would respond accordingly". The FMA encourages investors and providers to discuss fees to ensure they are reasonable.
(Putting the clients first) means different things for different people in different circumstances. What it means for an AFA holding themselves out as a non-aligned individual is different to someone offering ASB products for example.
The bottom line however is that the FMA doesn't have a remit to set fee levels of financial advice and fund management and until it does issues with fees are likely to be ongoing.
To the lay person the product that was purchased by Mary Holm's reader sounds like a product "that is inherently designed in such a way that it doesn't perform".
The FMA's latest view of conduct document frequently talks about the need for costs to be fair. So what is fair? We obviously need to consider returns. At the risk of boring readers most uncompromised experts reckon that international shares will outperform long bonds in the long run by 3% pa to give a total return of around 6% pa which is also consistent with the forecast return as per the Gordon Growth model.
Local high quality bonds yield 3% so that is a weighted average total return before tax and fees of around 5%. So is the 2-3% pa total fee implicit in a typical investment plan made up of a 1.5% pa management fee, a 1% pa advisors fee, a 0.3% pa platform fee and maybe 0.5% pa in other transaction costs fair? None of those costs look fair individually let alone in total, relative to the 0.05% annual fee of the Vanguard S&P 500 Fund.
It doesn't really look like putting client's interests first either or, dare I say it, good conduct. To put those numbers further in perspective the Government Super Fund which invests in a diversified portfolio and, presumably which the FMA executives are members of, paid an average management fee of 0.6 percent in the 2015 year according to the annual report and that document records that a major objective of that fund is to minimise fees. George Orwell's work springs to mind again.
On Radio NZ a spokeswoman for the Bankers' Association and indeed Mr Everett tried to differentiate bank advice to high net wealth individuals by an AFA employed at the bank versus advice to individuals with smaller sums like KiwiSavers.
But even if that were right why should a bank customer dealing with a sales person at a bank with a modest sum to invest get worse advice than someone with a large sum. Indeed commonsense suggests that those with modest sums are even more in need of a low cost solution than multi-millionaires.
However it is pretty clear to anyone in the industry that this is incorrect. I regularly see investment plans prepared by AFA's working at banks for high net worth individuals and the product selection is dominated by bank originated products which have relatively high fees. This is not surprising, you don't need an MBA degree to realise that a bank can make more money managing Mum and Dad's assets for a high fee than it can by sub-contracting out the business to a low cost provider.
A recent real life example illustrates - an individual went to the bank with just under $4 million to invest and the investment plan recommended by the bank's AFA included two of the banks own managed funds which comprised 72% of his portfolio, excluding cash. The cash was of course all with the bank too. Was this client's interests put first? The private banker opted for the bank's products and ignored other products with annual fees less than one-tenth of the bank's products.
Most retired New Zealanders will know of someone who has invested in a high cost superannuation product or managed fund which has, because of high fees, not fulfilled their investment needs.
I asked the Hon Paul Goldsmith, Minister of Commerce and Consumer Affairs and who has responsibility for the FMA, the following question:
Is an advisor who sells only high cost products putting clients' interests first if, apart from the high fees, those products are appropriate for the client?
By email he said "In some circumstances no, but that will be for the Financial Markets Authority to determine in each circumstance, based on the new code of conduct. A further requirement is that advisers and agents must ensure that consumers are aware of the limitations of their advice, such as that it only covers a limited range of products."
So Goldsmith has bounced the question as regards whether high cost biased advice is fair back to the FMA. He may also not appreciate that most vertically integrated organisations don't tell potential clients how much higher their fees are than low cost alternatives and the fact that high fees frequently mean investment objectives will not be met.
The bottom line however is no matter which way you spin it it is simply not right to describe an adviser who is constrained from choosing the best products for his/her client as putting their interests first.
Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.