From the July 2015 issue of Research Magazine • Subscribe!

What Transparency Should Look Like

Recently in these pages I argued that the nature and impact of digital technology in our world has made the idea of secrecy largely obsolete and, further, that this new and radical transparency will dramatically change contemporary culture and (especially) the financial services industry.

I argued: “Instead of trying to maintain the self-serving secrecy that has dominated our industry for so long, especially because such secrets will keep getting exposed sooner and sooner, the key to our longer-term survival will be to remake who we are and what we do to serve clients in a transparent future.”

This month I want to consider what a truly transparent future might look like in a bit more detail. These ideas must be offered tentatively of course, as good science demands. As Nobel laureate and physicist Steven Weinberg notes in a similar context via his outstanding new history of science “To Explain the World”: “Philosophers have tried to prescribe rules for scientific research. It never works.” Or, to quote a Danish proverb (often attributed to another great physicist and Nobel laureate, the Dane Niels Bohr): “It's difficult to make predictions, especially about the future.”

Yet even if we can't know with any degree of precision how the future will look, we can with reasonable confidence predict the general trends that we expect to continue and the areas where change will almost surely occur.

As a starting point, it should be clear (pardon the pun) that if transparency means anything, full disclosure will be a key part of our future. The Internet and everyone's instant access to it militates against secrecy everywhere all the time. If nothing can be expected to remain secret, it's silly to try to hide things.

I don't mean full disclosure in the sense of lots of fine print that nobody reads and nobody wants you to read. Instead, within financial services, I mean full disclosure in the sense of conveying real understanding about what is being offered and why, about what can go wrong and the likelihood of something going wrong, and about what one's goals are and ought to be along with a clear statement of what success will look like or cannot look like. Full disclosure will mean real clarity and no more complexity for its own sake (so as to justify a higher fee).

True transparency will also focus on fees. No more ducking and avoiding the subject. No more hidden rewards. Every client deserves to know how much the services purchased really cost and how much the advisor is being paid (as well as by whom).

Fiduciaries Needed

Full disclosure should also mean true fiduciary status for all financial advisors. My own experience as well as the available research have shown that individual investors don't know who is a fiduciary or what a fiduciary actually is.

The vast majority of advisors are trying to do the right thing, but financial incentives are insidious. The confirmation bias we all suffer means that we as advisors will truly come to believe that the investment option that pays us more is better than the lower cost option. That tendency plays right into the hands of the suitability standard that currently governs broker and insurance agent activity. And since fees are the best indicator we have of investment success over time, the impact is significant.

The suitability standard gives advisors a remarkable amount of wiggle room (not that you could tell from the big firms’ television ads). It merely requires that the investments brokers recommend and sell must fit clients’ investing objectives, time horizon and experience. Thus the sale of a proprietary small cap mutual fund may be suitable even if there is a better and cheaper one available. Moreover, in such a situation the broker is not obligated to advise clients of the better option nor the existing conflict of interest (that the fund being recommended provides more compensation).

There is also little (if any) ongoing duty to monitor the client's investments and financial situation or even to have any further contact without fiduciary obligations. It should be obvious that a “one-call close” is great for the salesman—who is hardly an “advisor”—but dreadful for the purchaser (who is hardly a “client”).

In my view, there is no good reason for financial advisors ever to be the exception to the rule that requires one's professional advisors to act in one's best interest, with full transparency and without conflicts of interest. I expect it from my doctor, my accountant and my attorney. I even expect it from my plumber and my pool guy. One's financial advisor should be on the same footing. Under the suitability standard, what is alleged to be the financial planning process can begin and end in a single meeting. For fiduciaries, that first meeting only begins the advisor's obligations and commitments to clients and to their financial planning needs.

The fiduciary standard is a controversial matter, as indicated by the SEC's recalcitrance over doing what the Investor Protection Act of 2009 mandated and the debate over the Department of Labor's proposed fiduciary rule with respect to retirement accounts. And I don't deny that there are some difficult and complex issues involved. But the essential outcome shouldn't be in dispute and objections offered simply to be obstructive should be dismissed out of hand.

Finally, true transparency will mean that the financial plans we create, the investment portfolios we manage and the solutions we recommend must be supported by good, evidence-based reasons for thinking they can succeed. The great Charley Ellis, longtime chair of the Yale Endowment and founder of Greenwich Associates, has laid out the investment management problem clearly and succinctly.

Ellis wrote in Financial Analysts Journal: “Extensive and readily available data show that in a random 12-month period, about 60% of mutual fund managers underperform; lengthen the period to 10 years and the proportion of managers who underperform rises to about 70%. Although the data are not robust for 20-year periods, the proportion of managers who fall behind the market for this longer period is about 80%. At least as concerning, equity managers who underperform do so by roughly twice as much as the ‘outperforming’ funds beat their chosen benchmarks, and so the underperformers’ ‘slugging average’ is doubly daunting. New research on the performance of institutional portfolios shows that after risk adjustment, 24% of funds fall significantly short of their chosen market benchmark and have negative alpha, 75% of funds roughly match the market and have zero alpha, and well under 1% achieve superior results after costs—a number not statistically significantly different from zero.”

Somehow I suspect that if this reality were fully disclosed and explained to clients, the asset allocations proposed might look a bit different, even among those advisors who make a compelling case for some form of active management.

To this point, our industry has been willing—even eager—to pretend that the financial world is different than it is. Full transparency means that those days are numbered. For those advisors who are willing to embrace reality with both hands and respond accordingly, that will be a very good thing. But for those who insist on trying to maintain the fantasy-based status quo, reality is going to bite and bite hard, perhaps sooner rather than later.

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