What would we think of doctors who deliberately hurt patients by prescribing dangerous and unhealthful products in order to make more money? Fortunately, the medical profession is set up in such a way that such things virtually never happen. This is not so in the financial services industry, where hazardous products are routinely sold to unsuspecting consumers.
Why are there tens of thousands – perhaps hundreds of thousands – of financial advisors who deliberately harm their clients’ financial health in order to earn more money?
The doctor analogy arises repeatedly in a new book, “Wall Street Potholes: Insights from Top Money Managers on Avoiding Dangerous Products” by Simon Lack, the author of “The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True” (which I earlier reviewed).
Perhaps the most important use of the doctor analogy in the book is this one: “Suppose a minority of doctors was prescribing medication known to be harmful? Would the rest remain silent?”
Lack’s book is partly a campaign to call out those financial advisors and consultants who prescribe financial products known to be harmful. These are the “potholes” referred to in the title. Lack does not identify the culpable advisors by their individual or corporate names, but he and his coauthors do identify a few of the products. (Several of the chapters are written by others besides Lack.)
The hedge fund pothole
Wall Street is laden with potholes, but Lack and his coauthors cover only a few generic ones. One of the most astonishing – in keeping with Lack’s previous book – is the hedge fund pothole.
Most readers of financial news must have noticed something inexplicable. For years, average hedge fund returns have been abysmal. Lack notes that the average fund and the universe as a whole has underperformed a 60/40 stock/bond portfolio since 2002 not only over the whole time period, but in every single year.
And yet, over that time period, net flows into hedge funds have been huge. They have been growing even in recent years as their underperformance has been widely publicized (not least in Lack’s earlier book).
How can this be? Whether it is an advisable practice or not, investors’ money tends to move into market segments that have performed well and away from those segments that have performed poorly. Why hasn’t this happened with hedge funds?
I knew the reason before reading Lack’s book. But I did not know it with the up-close confirmation that he provides. The Economist magazine has also been on this case for a while, though seemingly with little practical effect.
Lack points out that prior to about 2002, hedge funds were a very small investment market segment. Their investors were mainly high-net-worth individuals and families. At that time they had performed quite well.
But then, institutional investors, such as pension funds and endowments, were enticed to become hedge fund investors. I saw this process in motion when I attended a conference on hedge funds in the spring of 2005. It took place at a posh hotel on the banks of Lake Geneva in Switzerland. I wrote about this in my 2007 book, The Big Investment Lie.
At this conference a number of institutional investors were in attendance, for example an administrator of a British pension fund who gave a talk. He said that he, like other institutional investors, was evaluating hedge fund investing and “dipping a toe into it gradually.” He expressed reluctance and caution. But it came off to me more as though he were saying, “Treat me to a few more posh conferences and expensive dinners, and talk to me in Greek letters so I can impress my bosses. Then we’ll see.”
Sure enough, institutional investors did start piling into hedge funds. And they kept piling.
In the present day, a large segment of the investment money in hedge funds comes not from high-net-worth individual investors but from United States public pension funds, the kind that promise benefits to retired firemen, police and other city and state government workers.
The Economist points out that these public pension funds – unlike private pension funds, which are increasingly an endangered species – use an unusual accounting procedure dictated by the Governmental Accounting Standards Board (GASB) rules. Instead of discounting future liabilities (future pension payments) at the rate of interest on a safe bond, they discount them using the pension fund’s investment portfolio’s expected return.
Most public pension funds hire a consultant, such as Towers Perrin, Cambridge Associates or one of several others. These consultants typically assume a 7% expected rate of return on hedge fund investments. (If you want to know where they get this number, read this 2010 Advisor Perspectives article, as well as this one; hint: those consultants may not reveal its source.)
As compared with, perhaps, a 2.5% to 3% realistic return assumption on today’s safe bonds, a 7% discount rate yields a very low present value of future pension benefits. It therefore implies a very low requirement for taxpayers to make contributions into the pension fund.
For the short-term goals of today’s politics, this is the desired solution. Republicans embrace it to keep taxes low; Democrats embrace it as a holding action against Republicans who they believe would otherwise argue that the promised public employee benefits are unaffordable and must be reduced.
Doing their clients’ dirty work for them – and benefitting from high incomes, incidentally, as a result of recommending investments in large hedge funds – are the pension fund investment consultants. They are playing the same role in fomenting the now and future public pension fund meltdown that ratings agencies played in fomenting the 2007-2009 financial crisis.
The hedge fund recommendation process gets worse
You would think this is bad enough, but it gets worse. What is the purpose of a hedge fund? The idea is that very smart investment managers, who can identify sometimes obscure market inefficiencies and opportunities, will have the flexibility at hedge funds – as opposed to the more rule-bound and sluggishly-large mutual funds – to leap in an agile fashion to take advantage of those opportunities.
So what do the consultants do? They recommend precisely those practices that make it nearly impossible for hedge funds to do that. First, they tend to recommend large hedge funds rather than small ones because the consultants’ business models produce higher profits for less cost and effort if they don’t have to research many small hedge funds. Larger hedge funds tend to perform more poorly than smaller ones, according to studies cited by Lack. And it stands to reason that niche market opportunities can be better exploited on a small scale than on a large one.
And the consultants then proceed to recommend that institutional investors in hedge funds monitor them for “style drift,” which is understood to be a bad thing, rather than a good thing. Style drift means the hedge fund changes its style of investing from what it was selected for in the first place. But if the hedge fund is to be smart, agile and opportunistic and to dart from a market opportunity that is either already fully exploited by the hedge fund itself or has been caught onto by other investors, it will inevitably exhibit “style drift.”
Everybody in this dismal chain is to be indicted for it: the pension fund administrators and trustees who cannot really be held responsible in some cases because, as Lack describes, they are often retired firefighters or steelworkers with no knowledge whatsoever of investing and are totally dependent on the consultants; the politicians who knowingly allow the unrealistic assumptions to be dictated to them because it is in their political interest to do so; the hedge fund managers who charge absurdly high fees on false pretenses; and, most of all, the consultants who are supposed to be, or at least are assumed to be, experts and honest brokers but in fact make recommendations, like the collateralized debt obligations (CDO) boom-era ratings agencies, solely to maximize their revenues. Who should not be indicted for it? The pensioners themselves, who are being exploited by all and sundry, and who will, in many if not most cases not be able to collect the pensions that were promised to them; they will instead, in effect, have donated a substantial portion of their pensions so that hedge fund managers and pension fund consultants can become filthy rich – or the taxpayers who will bail them out at the behest of the politicians who abetted the problem.
Did the pensioners at one time in the past negotiate their future pension benefits too well, extracting them from bureaucrats and politicians who were overly acquiescent because of the soaring investment returns of the 80s and 90s? Perhaps. But in all other areas in our contract law-revering society, a deal is a deal. Breaching the contract, while in the process making hedge fund managers and consultants who facilitate that breach extraordinarily wealthy, constitutes a very black mark on America’s vaunted capitalist society – a capitalism that is supposed to rest on the bedrock of respect for contracts.
It’s not that Lack believes that no investor should invest in hedge funds. On the contrary, he believes that large investment funds should make small investments – no more than 3% of their portfolios – in a small number of small hedge funds, which they have researched very well. It stands to reason that some market inefficiencies will always exist that can be exploited, but they can be exploited only by a small number of small and agile investment managers.
Potholes galore
Lack and his coauthors identify several other dangerous potholes, including non-traded REITs, annuities and structured notes. Non-traded REITs and many varieties of annuities are noteworthy in particular for their outrageous fees and illiquidity.
But one structured note cited and described by one of Lack’s colleagues, Kevin Brolley, serves as a good example and object lesson. It is an excellent instance of how an overly trusting investor can be taken advantage of by financial product designers and salespersons.
A structured note is usually an investment that guarantees some minimum return – thus guarding against excessive risk – while allowing the investor to participate in the upside if the stock market rises substantially. The simplest example of a structured note is either the combination of a Treasury strip held to maturity with an equity investment or equity market call option, or the combination of an equity market investment with a put option on that investment. The two combinations are functionally equivalent.
Like CDOs, structured notes are not necessarily bad. In fact, for certain purposes, and barring excessive fees, they can be well-suited.
But the example given by Brolley shows how bad these products can become at the hands of financial product designers and salespeople who can operate with confidence that the customer will trust them no matter how complex their product and their sales pitch, and no matter how detrimental to the customer’s finances that product actually is.
Here is the structured note from hell issued by Goldman Sachs:
Placement fees were 3.5%, and the estimated worth at the time of pricing was 92.70%. In addition to principal protection, the investor will receive a minimum payment of 6% at the final maturity. That is, for a $1,000 investment, the minimum the investor will receive at maturity is $1,060. Anything above that will be subject to the performance of the S&P index.
But it is not what you think. If the index rises 10% over the life of the note, it does not mean the note will pay 10%. If it rises 30%, 40% or even 50%, it does not mean the note will return that. Nor does this note pay some participation rate of the upside. Why not?
The payoff of the note is actually determined by the sum of the quarterly returns (not the compounded returns) over six years. But quarters with strong positive returns are capped at 4.5% while there is no floor on negative quarterly returns.
Brolley did a backtest and found that for 58 quarterly rolling six-year periods between 1994 and 2014, the note would have paid a six-year total of 6%, the minimum, in 48 of those periods. The average payout in the last 49 six-year cycles was 6.005%, an average return of less than 1% a year. For that, the investor paid a 3.5% placement fee.
Only an investor who believes the financial product seller has the investor’s best interest at heart – or one who is so befuddled by the options as to give up completely – would accept a product like that without adequate due diligence.
Many customers, as Lack notes, treat the relationship with their financial advisor the same as they would with a doctor. And he adds, “It ought to be that the professionals advising you on your financial health can be relied upon with the same confidence with which the medical profession is trusted to help you live gracefully to a ripe old age.” But of course, they can’t be so trusted.
What to do about this?
One of the problems, according to Lack, is that while “investment advisors” are, by law, supposed to have investors’ interests at heart, “financial advisors” – which is what brokers or “registered representatives” often call themselves to make it seem like they are performing a service to the customer the way an investment advisor does – are not required to have investors’ interests at heart.
Investment advisors are required to be fiduciaries while financial advisors are not. But – and this was news to me, because I didn’t know the numbers – Lack says there were 636,707 registered representatives in the United States at the end of 2014 while there were a total of only about half as many other designations of financial advisor, including financial planners, financial analysts and life insurance underwriters. A customer is much more likely to find herself with a “financial advisor” who is a broker and thus incented to sell a product for as high a profit as possible than with one who is truly serving the customer.
Many people believe the solution is for the law to require that brokers be fiduciaries too, but surprisingly, Lack does not favor that solution. He believes the division between financial product salespeople, who, like used-car salesmen sit across the table from the client and do not necessarily have the client’s best interest at heart, and true advisors who sit on the same side of the table and do have the client’s best interest at heart, is not an unnatural one. The problem is that clients don’t know the difference. “Financial advisors” -- brokers in particular -- try to obscure that difference rather than inform the client of it.
Lack believes that better disclosure is the solution. He says that realtors disclose to home buyers that they are bound to work on behalf of the seller, and therefore the buyer should beware. This disclosure is presumably required by law. (I was not aware of this, but I take Lack’s word for it.) A similar simple disclosure, he believes, should be required to be made by financial product salespeople – brokers, whether they call themselves financial advisors or not.
The larger problem is ethics
I don’t think any solution will work as long as the ethics of so much of the financial profession are this bad.
Lack says at one point, “A living made at the expense of clients by selling them inappropriate, expensive products is not a living worth making.”
How many doctors would agree that “a living made at the expense of patients by deliberately delivering services that make their health worse is not a living worth making”? The vast majority of doctors would surely agree with that statement. They might even be incredulous that such a question needs to be asked.
Not so, I’m afraid, for the vast majority of finance professionals. From a finance professional raking in the money from inventing or selling products like Goldman Sachs’s structured note mentioned above, one is more likely to hear that they plan to make as much money as possible as quickly as possible.
The ethics of the finance industry will improve only through a many-pincered campaign of shaming, indicting, prosecuting, outrage, protests and shunning (these are already happening), and yes, laws and regulation, preferably carefully applied. It was a long slog involving heavy-handed regulation as well as public information campaigns, some of it direct from government officials like the U.S. Surgeon General, before the tobacco industry was put in its rightful place. It was also a long slog before severe racial discrimination was thoroughly discredited; it also involved – and probably required – government intervention, even if some of it was misguided.
We are a long, long way from financial advising being a true profession in service to its clients and the public, as medical advice-giving is. It will require a long campaign to get it there.
Michael Edesess, a mathematician and economist, is a visiting fellow with the Centre for Systems Informatics Engineering at City University of Hong Kong, chief strategist of Compendium Finance and a research associate at EDHEC-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, was published by Berrett-Koehler in spring 2014.
Read more articles by Michael Edesess
