Blind investment faith

By BRENT SHEATHER*

Investment analysts in the United States are copping the flak as investors look for someone to blame for their losses from the technology bust - and for compensation.

At the heart of the pending legal actions is the question of independence and whether - or, more accurately, to what extent - analysts' recommendations were compromised by their employers' investment banking aspirations.

Problems with independent financial advice are not limited to the US. The issue is a potential minefield for financial advisory and stockbroking companies in this country too, with all sorts of accidents waiting to happen. All it will take to blow up here is the right confluence of events.

With retail investment at low levels, underwriting new share or bond issues and selling them to clients is an important source of profit for local brokers and advisers.

But that sort of work brings a major conflict of interest; to get the job of selling a new share or bond issue in the first place, one must extol a positive opinion of the client company. And, when advising individual retail clients, it often means setting aside investing tenets like the need for diversification.

As an analyst, if you are silly enough to come up with a "sell" recommendation, before too long the chief executive of the impugned company will be ringing your boss and threatening to move their business and, by implication, your job, down the road. Similarly, when commenting on managed funds, a broker who criticises a manager's performance or fees faces the very real risk of losing that manager's institutional business.

Perhaps the only way of avoiding this sort of conflict is to separate ownership of the retail and institutional stockbroking functions. But this flies in the face of the conventional wisdom, in this country at least, which has seen institutional brokers acquire retail brokers.

The problems facing US brokers may make that strategy less attractive in future, depending on what the courts decide.

While all and sundry in the local retail investment advisory business like to trumpet their "independence", the harsh fact is that virtually no player is truly independent.

Indeed, in Australia, recent law changes specifically target the indiscriminate and misleading use of the word independent by financial advisers.

The law says: "Advisers will be prohibited from using the word 'independent' or similar words (such as 'impartial' or 'unbiased') where ownership links and means of remuneration would result in potential bias.

"Advisers may only use the terms 'independent', 'impartial', 'unbiased', or similar words if they:

* Avoid any commissions, trailing commissions, soft dollar arrangements and other benefits from product issuers which may tend to create a product bias.

* Operate free from any direct or indirect restrictions relating to the products they recommend.

* Operate without any conflict of interests created by ownership links to product issuers."

Australia's Financial Planning Association called on the Government to dilute the terms of the proposal because of its potential effect on the competitiveness of niche advisers.

This is a particularly interesting view given that the FPA also acknowledged that, even though many of its advisers charge customers a fee - rather than relying on up-front commissions from fund managers - around 99 per cent still receive trailing commissions from managers.

On the other side of the fence, the Australian Consumers' Association believes the level of disclosure is so poor that investors have no way of knowing what degree of conflict of interest is implicit in the advice they receive.

Where would this law leave most New Zealand financial planning firms? Up the creek, probably. Going through a list of this country's largest financial planning companies, most fail the independence test due to one or more of the issues flagged in the changes to the Australian law.

A recent review of investment advisers in Consumer magazine was instructive; of the 14 financial planning firms consulted, seven directed some or all of the client's funds into their own managed funds, four were paid by commission and directed the funds into commission-paying products, one gave inexplicable advice to invest in a boat, and two appeared to have chosen their investments free of bias, although this is impossible to confirm.

Many local firms regularly use words like "impartial" and "unbiased" in their advertising. This is despite a finding by the Advertising Standards Complaints Board in 1997 that a firm could not claim to be independent because a financial adviser received remuneration from the issuers of financial products in relation to the sale and servicing of those products. As the board said: "The receipt of any commission or fee removed independence."

In an ironic twist, the adviser's lawyer made the point that, if the complaint was upheld, "no investment adviser in NZ or Australia could fairly call themselves independent". Exactly!

Independence in the local investment advisory industry, if it ever existed, is diminishing as firms create proprietary products such as mastertrusts, and product providers scramble to lock in retail distribution channels for their products by buying shareholdings in advisers and stockbrokers.

For investors, the key is to find those firms that are least biased, and that is difficult because associations and affiliations can be tenuous and complicated given the globalisation of the industry.

For example, if you walk into one prominent financial planning firm, the odds are that the recommended vehicle for investing in New Zealand shares will be a fund whose manager is owned by the financial planner's parent. Don't expect independent advice from your local trustee organisation either; with changes of ownership and an eye on the bottom line, nowadays if you have money to invest it's more than likely you will be steered into its own in-house managed funds.

Insurance and investment manager Sovereign raised eyebrows last November when it announced it would pay a $1 million bonus to the adviser who wrote the most business. The scheme was dropped after criticism from within the industry.

The increasing incidence of previously independent firms recommending their own in-house products is a concern, particularly when more often than not the choice is not obvious on the basis of performance or cost.

Some of the local proponents of mastertrusts have argued that they are truly independent because they charge for investment advice on a fee basis and rebate any commissions received. This is quite ridiculous. A fee-based advisory service no more guarantees independence than does an advert declaring a firm to be unbiased.

This is partly because initial fees typically represent a diminishing part of an investment advisory firm's total remuneration.

The advent of mastertrusts has reinforced this trend. Consider the case of a fee-based advisory firm which sells a mastertrust: initial fees are 2-3 per cent, but the annual fees - assuming the client invests for 10 years - would total more than 30 per cent of the initial capital, more than half of which would go to the advisory firm.

The mastertrust includes only a selection of the unit trusts available in NZ - trusts with which the advisory firm may have arranged soft dollar commissions, such as help with research, travel expenses to conferences or volume bonuses. All this creates a huge potential for bias.

The area of research also introduces potential bias. Investors are often advised to make sure that they deal only with financial planning firms which have access to "independent" research. But many "independent" research firms research only unit trusts, superannuation funds and the like, rather than the lower-cost alternatives (including direct investment), so they are themselves "dependent" on providing a clean bill of health to the limited range of products they cover.

In Britain, too, the concept of independent financial advisers is increasingly viewed as something of a misnomer. In a recent article the Financial Times personal finance editor called on independent financial advisers to drop claims of independence. The ombudsman who regulates retail financial planners in Britain also argues that the word "independent" is inappropriate and says advisers who receive commissions should be labelled "salesmen", not advisers.

So how does the average NZ investor check for independence in the absence of a sensible legal framework? Next to researching the area yourself, it's probably best to ask your friends how they invest, look closely at any proposal and ask your adviser why this or that fund has been selected and how its annual fees compare.

The good news is that NZ appears to have a Securities Commission again at long last with a boss - Australian Jane Diplock - prepared to make her presence felt in the areas of dodgy advertising and contributory mortgages. Let's hope Ms Diplock resolves the independence issue soon in the same sensible way that the Australians have.

* Brent Sheather is a Whakatane investment adviser and sharebroker.