Making an investment is seldom as straightforward as purchasing a hammer or a basketball – products that can be touched, tested and evaluated against a known price. Investing sometimes means buying a product from a commissioned salesperson motivated by a sales quota, or buying a product with hidden risks, high expenses or excessive fees. Worse yet, it can mean buying a complicated product based on marketing hype rather than an understanding of how it works.
When the Sarbanes-Oxley Act (SOX) was passed in 2002, it was hailed as a big step forward for corporate transparency. The law mandated that publicly-held companies provide more accurate, timely, clear and consistent information to shareholders, analysts, and media.
This information helps investors make better-informed decisions about the current and future value of a company’s stock. However, if we think of investing as a long and complex supply chain of many parties that provide guidance, information, and services, the narrow scope of SOX is apparent. The legislation, focusing solely on public companies, had no direct impact on brokers, money managers, custodians, mutual fund managers, 401(k) sponsors, and others who may influence the investment results that individuals achieve.
Transparency, it seems, has a long way to go, and some aspects of investing seem to be intentionally opaque.
Transparency can mean many things (the term is not even explicitly defined in Sarbanes-Oxley), but a good functional definition might be simply this: knowing-and-getting-what-you-pay-for, or KAGWYPF.
The notion that you should get what you pay for when investing your life savings seems beyond self-evident, but it remains an elusive goal in many cases. Even just knowing what you are buying can present real challenges.
Transparency can be a challenge in cases like these:
- A broker/dealer may recommend private label mutual funds or “preferred” fund families for which he or she earns commissions or other compensation.
- Mutual funds and ETFs may carry high expense ratios – the cost the salary of the fund manager, research staff, and other items related to choosing and trading securities – that directly reduce the performance of the funds.
- Mutual funds may deduct 12b-1 fees from fund assets to cover marketing and other expenses. Again, these costs reduce return to shareholders.
- Broker/dealers may charge markups on bonds without disclosing the extra cost to investors.
- 401k plans administrators may only offer proprietary mutual funds that carry higher than necessary fees or expenses.
- A money manager or actively managed mutual fund may, without warning, drift toward a different style.
- Broker/dealers may make recommendations based on their own financial interests, not those of the client.
With whom are you working?
This last item above presents a special transparency challenge as very different standards of accountability apply to broker/dealers versus registered investment advisors. Stockbrokers are required to meet a “suitability” standard when making recommendations to clients. This is a loose standard that recommended investments should match the level of sophistication and risk tolerance of the investor.
The suitability standard is meant to catch the most egregious cases of imprudent advice. For instance, an exotic strategy involving hedge funds, derivatives, selling short, and buying on margin would not be suitable for a novice investor.
But the broker can still meet the suitability rule while recommending investments that are not in the best interest of the client. A mutual fund with big up-front sales charges or needlessly high expenses will generally meet the suitability standard, even if it will cost far more than other similar funds. The broker is under no obligation to search out or recommend similar investments with lower sales loads or expenses, nor reveal the fact that he or she earns higher commissions when certain in-house or preferred fund families are utilized.
In contrast, a registered investment advisor is held to a much higher standard – fiduciary duty. As a fiduciary, the advisor must act in the best interests of clients at all times. Investments must not be just suitable; they must be in the best interest of the investor. The registered advisor cannot put his or her own profits ahead of the client’s interests and must reveal any and all potential conflicts of interest that might work against the client.
Because of fiduciary duty, a registered investment advisor operates at a much higher level of transparency. This higher standard of transparency is not just an ethical pledge, it is a matter of law.
How far can you see?
The Department of Labor recently released disclosure standards (effective July 2011) to which 401(k) service providers must adhere regarding disclosure of fees and expenses. It is another positive step toward transparency, but like SOX it is limited in scope. The rules affect only the information that plan sponsors (employers) receive from service providers, and does not apply to, among other things, church plans, government plans, IRAs and SEPs.
If 401(k) disclosure and every other element of the investment supply chain is represented by a pane of glass, some are clear, some are various shades of cloudy, and in an extreme case like the Madoff scandal, a few may be purely opaque. The question for investors is: How far can you see through your stack of glass panes? Do you understand what you own and the fees and expenses that come with it? Do you understand the motivations of your advisor? Are you working with an advisor bound by fiduciary duty, or a broker held only to the suitability rule?
While Congress and various regulatory agencies may help to clean some of these window panes over time, inevitably it is the investor’s burden to ask questions of their investment advisors, financial planners, wealth managers, and brokers to assure they know and get what they pay for.
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