Mutual Funds and Boca Brokers: Harmful to Your Wealth? – Part II

Probably the worst surprise an investor can experience is news that his investment adviser, money manager, or any other person handling his money is unethical––think Bernie Madoff, or some of the “brokers of Boca” as described in last month’s article. Of course there are other types of surprises in life that are also unpleasant, one of which happened to a very wealthy investment adviser who had enticed a young model, recently arrived from Italy, to become his mistress.

One night, during one of their rendezvous, she confided that she was pregnant, and he was the father. Not wanting to ruin his reputation or his marriage, he offered to pay her a large sum of money if she would go to Italy to have the child. He also suggested that if she stayed in Italy, he would provide child support until the child turned 18. She agreed, but wondered how he would know when the baby was born. To keep it discrete, he told her to mail him a post card, and write “Spaghetti” on the back. He would then arrange for child support.

About 9 months later, he came home to his confused wife. “Honey,” she said, “you received a very strange post card today.” “Really, let me see it”, he said. His wife watched as her husband read the card. He suddenly turned white, passed out, and had all the signs of a heart attack. His wife immediately called the paramedics, and when they arrived described to them what had happened. She showed them the post card and said, “I don’t understand this. It seems like perhaps a restaurant in Italy sent this card, but why? And why would it cause a heart attack?” The medics also puzzled over the card that read, “Spaghetti, Spaghetti, Spaghetti. Two with sausage and meatballs, one plain.” That’s what might be called a “3 course” surprise.

The element of surprise in the process of investing is in itself not surprising. In fact, any enterprise that exists where the future is unknown, or at least uncertain, carries with it the probability of surprise. When it comes to investing, the goal of the investor is to limit the influence of the surprise factor. Few investors would think they could be faced with the surprise that their broker is anything but totally honest, and works hard to achieve desired goals. However, the choice of a brokerage, and/or a broker is significantly more important than choosing individual stocks or bonds. The possibility of a case of rogue broker surprise can be significantly reduced with a minimum of research.

If you believe fraud can’t happen to you. Here is what a FINRA report determined:

“The ubiquity of fraud solicitations, coupled with the inability of many people to recognize the red flags of fraud, place a large number of Americans at risk of losing money to scams—with older Americans at greatest risk.   Financial fraud solicitations are commonplace. A new survey by the FINRA Investor Education Foundation found that more than 8 in 10 respondents were solicited to participate in a potentially fraudulent offer. And 11% of all respondents lost a significant amount of money after engaging with an offer.”

Incidentally, if you are a habitué of the “free lunch” seminars, the following subject is listed under the frauds and scams section of FINRA’s website under the headline: “Free Lunch” Investment Seminars—Avoiding the Heartburn of a Hard Sell.” It explains, “Investors frequently get invited to free seminars that promise to educate them about investing strategies or managing money in retirement—often with an expensive meal provided at no cost. But just because someone buys you breakfast, lunch or dinner doesn't mean you have to buy what they are saying—or selling.” It then goes on to warn, “We are issuing this Alert because, in many cases, free-meal investment seminars are not solely about education. Their ultimate goals are to recruit new clients and sell products—and while some pitches can be easy to swallow, the consequences can be hard to bear.”

Would you feel comfortable dealing with a brokerage or broker who had sanctions, or penalties, or any disciplinary action in his or her background? Is it worth two or three minutes of your time to find out? Go to FINRA Broker Check and type in the name of the brokerage house and the individual broker to determine whether there are any associated suspicious actions involved.

There is one serious flaw with Broker Check however. This following piece of information is not revealed in the majority of news reports extolling FINRA’s benefits, nor does FINRA mention it. In 96% of cases that were settled in the process of arbitration, the information regarding the complaint and the broker was expunged from the FINFA website. Remember, FINRA is an industry association, apparently interested, to some degree, in covering up inappropriate activity by its members. In July of this year, the SEC intervened, forcing FINRA to discontinue this activity. As a result, only the most egregious pre-July actions will be listed.

One of the many advantages of hiring a Registered Investment Advisor instead of a Registered Representative such as a stockbroker is that the former is monitored by the Security Exchange Commission, or by a similar state organization, not by FINRA. Each member must make available what is termed an ADV form that is updated annually. Form ADV is the uniform record used by investment advisers to register with both the Securities and Exchange Commission (SEC) or state securities authorities. The form consists of two parts. Part 1 requires information about the investment adviser’s business, ownership, clients, employees, business practices, affiliations, and any disciplinary events of the adviser or its employees. Going to adviserinfo.sec.gov can access that information.

Part 2 requires investment advisers to prepare narrative brochures written in plain English that contain information such as the types of advisory services offered, the adviser’s fee schedule, disciplinary information, conflicts of interest, and the educational and business background of management and key advisory personnel of the adviser. This report should be offered to the client.

If you are dealing with a Registered Investment Advisor, you have the right to ask to see his ADV form. It’s obvious that very little could be hidden from an investor smart enough to ask to see this report. However, one of the real advantages of this report compared to the FINRA statement, deals with the subject of conflict of interest. Covered in Part 1 of this series, brokerage houses and their employees (stock brokers) are only required to recommend investments that are “suitable” to meet the investor’s goals. If this results in the endorsement of an inferior product that provides higher personal compensation compared to another far superior product, this is legally acceptable as long as it is “suitable.”

This weakness should encourage investors to determine if their broker or financial advisor can pass a simple test. The May 2012 issue of Viewpointe covered the subject in an article in which the headline asked, “A Fiduciary––Do You Have One?” I wrote then, ”Definitions rarely make a case for exciting reading, but they are, nevertheless, particularly important if you wish to discover whether the person providing you with investment advice is truly working solely on your behalf, or if his/her loyalties lie elsewhere.”

There is a simple way to know whether your money is being handled by a “fiduciary.” Unless your adviser is considered a Registered Investment Adviser, you can be assured he or she does not adhere to fiduciary standards. No brokerage house would allow their employees to agree to do so. In fact, when I wrote about the rule in 2012, I mentioned that since 2010 the federal government was considering a ruling that would mandate that standard to apply to all money managers.

Now, after this five year delay, and numerous hearings including vehement objections from the brokerage industry (including Morgan Stanley and Fidelity), it appears that three (all Democrats) out of five members of the Department of Labor (DOL) will vote that the fiduciary rule, which the DOL is now calling the “Conflict of Interest Rule,” would redefine the term fiduciary to more broadly include anyone giving investment advice to individual investors, IRA owners and retirement plans, as early as the beginning of 2015. If this happens (don’t count on it since most Republicans in Congress object), you could feel more confident that your money adviser is providing totally honest advice.

If it doesn't pass, unless you are naïve enough to believe in the complete honesty of your money manager and the brokerage house he is compelled to obey in all matters, I would consider using the famous (or is it infamous) Donald Trump epithet when next confronting your broker ––“You’re fired”––and seek out a Registered Investment Adviser instead.

Your wealth and you will be healthier for it.

Next month: Investor faith in mutual funds continues to collapse.