Wednesday, July 01, 2015

Greed: Getting Grimmer and Grimier

According to Bloomberg, “the CFA [Chartered Financial Analyst] designation is considered the gold standard of the investment management field, and those who have that credential are expected to have an in-depth knowledge of the investment industry, with many going on to careers as portfolio mangers or research analysts at hedge funds and private equity firms.”

In early January, the CFA Institute issued a report on a survey it conducted with its members on the state of the financial industry. The results are disappointing. For example: “It's clear that recent scandals and the regulatory reforms they provoked have not sufficiently changed how some participants in the financial industry conduct their business. As participants in that industry, we're doing the public – and ourselves – an injustice if we write the litany of scandals off as ‘just a few bad apples’ or even worse, as the price of doing business.”


The report then claimed, “We are making it too easy for the public to equate the finance industry with self-dealing, dishonesty and corruption. Trust, not cash, is the fuel that makes the financial system function, and when investors, big and small, start to regard the system as one rigged against them, the risk of collapse will never be far away.”


The survey also found, “The greatest area of concern for the health of the global economy however, remains the same as it has year after year: the lack of trust in the industry. Over half of our members (63 percent this year, up from 54 percent last year) blamed this on a lack of ethical cultures within financial firms, suggesting the problem stems more from flawed (unethical) internal firm culture than from poor government regulation and enforcement [Hello Gordon Gecko!]. Nor are members seeing any improvement in the level of integrity of global capital markets, with a majority expecting the state of integrity in 2015 to stay about the same as its level in 2014.”

The Fiduciary Standard

A lack of ethical culture within financial firms? Really? Remember, this evaluation comes from some of the most highly respected members (CFA’s) of the financial industry, each one legally (supposedly) committed to the “fiduciary standard.”–– To act in the best interests of the client. The ten biggest employers of this elite group are the large brokerages such as Bank of America; Merrill Lynch; Barclays; Citigroup Credit Suisse; Deutsche Bank; JP Morgan Chase; Morgan Stanley Smith Barney; RBC; UBS and Wells Fargo.

So if you are dealing with any of these institutions, and are “lucky” enough to have as your advisor a CFA, you have the best of both worlds…right? Maybe! Your contract is not with the individual CFA but with the broker-dealer, and with the exception of Vanguard, none of the brokerage houses that I know of––certainly not any of the above––observe the fiduciary standard. As a result, although the CFA might act solely on your behalf, according to his employer, he also could accept commission-based compensation, an inherent conflict of interest, unless he informs you under what circumstances he is doing so.

The Melody Lingers On

The comment about lack of trust in the industry “year after year” rang a bell. As implausible as it sounds, the first thing that came to mind when I read the above was the lyrics to a song that hit number one on the music charts 73 years ago in 1943. This was the “big band swing” era, and Helen O’Connell, with the Harry James orchestra, sang, “It seems to me I heard that song before. The lyrics said forever more, I know it well that melody.”

The “song” I heard before, and the “melody” I remembered was contained in a book that so impressed me, I wrote an article about it that appeared in Viewpointe in August 2002. The book, titled “The Four Pillars of Investing” published in 2000 (updated in 2010), is (still) one of the best basic textbooks on investing I have ever read.

The Four Pillars of Investing

The author, William Bernstein, was a practicing neurologist (and a Ph.D.) who became so successful as an investor that he retired from his practice and established a boutique investment-advisory firm called Efficient Frontier Advisors. That organization caters to clients with a minimum of $25 million. He has written a number of books, updating The Four Pillars of Investing in 2014.

Here is what I wrote in the Viewpointe article about the fourth “pillar” in the book, the piece that resonated so strongly when I read the CFA Institute report.

Investment Business
  • Investors tend to be touchingly naïve about stockbrokers and mutual fund companies: brokers are not your friends, and the interests of the fund companies are highly divergent from yours. You are in fact locked in a financial life-and-death struggle with the investment industry; losing that battle puts you at increased risk of running short of assets far sooner than you’d like.
  • The modern financial industry…exists almost exclusively for one purpose: the extraction of fees and commissions from the investing public, and that in fact, we are all locked in a constant zero sum battle with this behemoth.
  • [The financial industry] operates at a level of educational, moral, and ethical imperatives that would be inconceivable in any other profession. A small example: by law, bankers, lawyers, and accountants all have a fiduciary responsibility towards their clients. Not so stockbrokers.(Incredibly, Bernstein was astute enough to include this note on fiduciary responsibility 15 years ago.)
  • The primary business of most mutual fund companies is collecting assets, not managing money.
  • Ninety-nine percent of what you read about investing in magazines and newspapers and 100% of what you hear on television is worse than worthless.
This particular “pillar” was just one more factor that convinced me to maintain an investment code of conduct that has served me well over the 32 years that I have been investing. It can be summed up in two words –– skepticism and cynicism. That is the reason I never used a stock broker or investment advisor until six years ago when I finally discovered one I felt could trust–– a fiduciary naturally.

Remember the huge penalties imposed on a number of financial institutions that contributed to the “Great Recession” that began in December 2007 and ended in June 2009? It was hoped that the multi billion dollar settlement numbers, as well as new rules like those imposed by Dodd-Frank regulations would help to deter future infractions, and breaches of ethics. However, there are few indications that Wall Street has cleaned itself up. Instead there have been consistently strong suggestions that many of the lessons of the crisis still haven’t been learned. Apparently whatever disincentives have been implemented are insufficient.

Skepticism and Cynicism Further Validated

The minions that occupy positions in the financial industry require at least some semblance of honesty, reliability and trustworthiness––you would think. But if I needed another reason to exercise a skeptical attitude toward these so-called professionals, another survey issued just two months ago provided it. This new report paints a particularly disturbing picture since it is the most detailed and expansive of its kind. Its goal is to measure workplace ethics in the financial services industry. It also serves to prove that the term “ethics in the financial services industry” is an oxymoron.

Although the study was commissioned by a law firm (Lobaton Sucharow) that represents whistleblowers, the independence of the survey (consisting of more than 1,200 professionals working in the United States and the United Kingdom) was assured by the appointment of researchers from the University of Notre Dame to implement the project. Respondents represented a broad spectrum of the industry, from young professionals to senior executives, investment bankers, and investment managers, from San Francisco to Scotland. Here are some of the key findings––as the saying goes, “read ‘em and weep.”
  • 47 percent believe their competitors did something unethical or illegal to get ahead in the market (but of course “only” a still-high 23 percent believe people in their own companies did so).
  • Over a third (34 percent) of financial professionals “earning” $500,000 or more say they have “first hand knowledge” of wrong doing in the workplace.
  • 25 percent would illegally use inside trading information if they were guaranteed to make $10 million and not get caught.
  • Almost one in five believe people in the financial services industry need to “at least sometimes engage in illegal or unethical activity to be successful.”
  • Almost a third of financial professionals surveyed (32 percent) believe their pay and bonus structures encourage wrongdoing.
  • A third (33 percent) do not believe their industry has changed for the better since the crash of 2008.
  • 17 percent do not believe the top brass would report illegal activities to the authorities.
  • One out of 10 financial professionals surveyed said they have signed or were asked to sign a gag order that would ban them from whistleblowing. 16 percent report policies and confidentiality agreements that ban reporting illegal activities to the appropriate agencies.
  • 25 percent of those making $500,000 or more said they were asked to sign gag orders.
  • Alarmingly, more of those with fewer than 10 years of experience in the finance industry (13 percent compared with 7 percent of those with 21+ years) were asked to sign these gag orders.
  • 39 percent believe law enforcement and regulators are “ineffective” at “detecting, investigating, and prosecuting securities violations.”
It seems to me that even these results might not reflect the full degree of the problem since it is likely that participants would be reluctant to admit to the full ramifications within the industry in which they work.

The report then sums up as follows: “Many in the financial services industry appear to have lost their moral compass, and younger professionals pose the greatest threat to investors. Wall Street needs to take the first step toward recovery and admit that it has a corporate ethics problem, or Main Street should brace itself for more scandals.”

Grimmer and Grimier indeed!

Go Fiduciary!!!


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