The Future of Finance

Putting Investors First. That was the motivation behind the work that went into this book. The 2008 financial crisis did nothing to improve the already poor reputation of the financial services industry, even though the popular narrative of gambling bankers needing a government bailout is a gross distortion of the causes. While there were certainly bad actors and subsequent penalties that by 2013 had already exceeded $100 billion (Campbell, 2013), the everyday self-seeking advice that is provided to so many individual investors is what really caught our attention. This was happening before the crisis and continued afterward. It's why financial services companies and banks consistently receive low ratings on trust in surveys of public opinion (Harper, 2013).

My own epiphany around this issue occurred during the summer of 2013. After 23 years at JPMorgan spent dealing with institutional clients who generally have the resources to sort good advice from bad, I had set up my own investment firm and began managing money for wealthy individuals as well as institutions. As I reviewed the non-traded REIT investment held by Penelope (described in Chapter 1), growing incredulity came over me as the prospectus revealed just how abusive the product was. I imagined the guilty laughter of the brokers selling such products after each successful sale drew in another unsuspecting client with little understanding of just how badly their trust was being abused. Frankly, it made me angry. When I was growing up, my grandfather was a bank manager. He ran a local branch of National Provincial Bank (many mergers later, now part of Royal Bank of Scotland). He made loans and took deposits in our suburban community just outside London. It was a very respectable job, and long before computers revolutionized banking it was a respected industry as well. Of course, within financial services there are dozens of very different and specialized subindustries, but most of them ultimately simplify down to providing advice and services around other people's money. The trust clients place in the finance professionals with whom they deal ought to be returned in kind every time. It is not.

The JPMorgan and predecessor firms I worked for operated with integrity, which was manifested in the people who ran them. Well-known names such as Jamie Dimon, Bill Harrison, Walter Shipley, and John McGillicuddy are all current and former CEOs of the lineage from Manufacturers Hanover Trust to Chemical Bank, Chase Manhattan, and JPMorgan. They defined the culture that was built on simply doing the right thing. But the values were propagated throughout the firm by terrific senior managers such as Don Layton. Don is currently CEO of Freddie Mac, one of the two government agencies that underwrite mortgages. America is fortunate to have such an intelligent and highly skilled banker now running a firm whose previous woeful management helped cause the financial crisis. I spent most of my career at JPMorgan working for Don. One of the hallmarks of great management is predictability; if you know how the guy at the top thinks and what questions he would ask if he was in the meeting, the right decision is far more likely to be made without him even being involved. This was the culture that Don Layton instilled. You could hear the questions he'd likely ask and anticipate the expected responses to resolve an issue the way you'd like it to appear on the front page of the New York Times (a test that few sales of the products listed in this book could comfortably pass). If the right values are present throughout an organization, the senior manager doesn't need to be everywhere because he is, in effect, everywhere already.

I guess I took it for granted that this was the operating protocol in most of financial services. Penelope's experience with non-traded REITs revealed just how far that was from the truth.

As I compared Penelope's experience with those of other new clients, a troubling pattern began to emerge. Moreover, discussions with friends of mine running investment businesses similar to mine began to convince me that these weren't just isolated incidents. We'd all had similar experiences of reviewing past advice and investment products sold that most definitely failed to put the investor first.

It's not that investment recommendations all have to be profitable. Of course it would be nice were it so, but as soon as you move beyond riskless US Treasury bills, the possibility of a higher return naturally comes with the chance of doing worse. The problem is overly expensive, overly complex investment products that render the odds of a successful outcome so poor. And you know what? This is my industry, too. I have spent my professional life in financial services and it will remain my career for the rest of my life. A living made at the expense of clients by selling them inappropriate, expensive products is not a living worth making. The quicker such salespeople switch careers, the better for everyone else. If this book prompts an ethically challenged financial salesperson to move on, or a client to ask more searching questions before committing capital, then we'll have achieved something worthwhile. As long as there are questionable individuals dragging down the reputation of our business, we'll be shining a light in those dark places.

If you strike up a casual conversation with an investment professional and guide the conversation over to non-traded REITs, invariably the response is along the lines of they're an accident waiting to happen, a security that ought not to even exist. I once met someone who worked at the firm that had sold Penelope the non-traded REIT in Chapter 1. He had recently joined the training program and hadn't been involved in selling them, at least to that point. I asked him what people inside the firm were saying about American Realty, the REIT in question. He chuckled; commissions had been the driving force behind the recommendation of these and other similar securities to so many clients. With as much as 15% of the investor's money up for grabs through fees, many brokers were able to convince themselves and their clients that even with 85% of your money (i.e., what's left after fees) working for you it was still a good deal.

Understand Who Your Advisor Works For

This and many of the other examples highlight the challenge for the client of identifying the right kind of advisor. As we've discussed, the investment business broadly consists of two types of firm: broker-dealers (B-Ds) and investment advisors (IAs). Confusingly, both employ people calling themselves financial advisors, even though the financial advisors at B-Ds operate differently from those at IAs. It comes down to what is the responsibility of the people you're talking to, or where their loyalties and obligations lie. Investment advisors and the registered people who work for them (called investment advisor representatives, or IARs) have a fiduciary obligation to put the client's interests first. It is required by law, with no exceptions. If you're talking to a financial advisor who works for an IA, he is going to offer advice that is in your best interests or risk losing his license or further sanction. He typically gets paid a fee based on the size of your account, and certainly doesn't share in any transaction fees incurred investing your money. If your financial advisor works for a B-D, he's called a registered representative (RR). He'll still provide you advice, but his fiduciary obligation may be to his employer. He owes his clients a lesser standard of care, that of suitability and disclosure. An important exception to this is the Certified Financial Planner^® (CFP), who also owes clients a fiduciary obligation, as John Burke clearly showed in Chapter 8.

It is a confusing structure, and it's unreasonable to expect non–finance people to appreciate the subtle differences, especially when everyone they meet smiles and appears to have only the best of intentions. Think of it like this: an IAR, or a CFP, with their legally binding fiduciary obligation to put your interests first, is sitting at the table alongside of you, contemplating investment choices out there with you. The RR, representing the B-D, is sitting across the table from you. He likely earns his money from transactions, usually commissions on trades but also from mark-up on bond trades he might recommend to you or underwriting fees on newly issued securities (such as non-traded REITs or structured notes). For all of these transactions and indeed, for the advice he offers, he doesn't need to have your best interests at heart. He merely needs to make recommendations that are suitable and properly disclosed.

Recently, there's been attention focused on whether the same fiduciary standard should apply to both types of financial advisor. The Dodd–Frank Wall Street Reform and Consumer Protection Act (known simply as Dodd–Frank) directed the SEC to consider whether everybody advising investors should be a fiduciary. The B-D industry was adamantly opposed. Although such a standard would clearly impede their ability to make money the way they currently do, they argued instead that it would hurt smaller investors, coverage of whom would no longer be profitable and therefore less available. The CFA Institute and others argued in favor of a uniform standard as being in the best interests of clients, reasoning that having some people called financial advisors operating under a different standard than others was confusing. It is confusing, and for a while I agreed with the CFA Institute's position. But on reflection, I've come to agree with the B-D industry.

First of all, many financial advisors, or RRs at B-Ds, do offer genuinely good advice. Just because an unscrupulous minority is not acting in the way they should doesn't seem sufficient reason to change how the rest of them work. As long as the nature of the relationship is disclosed, I can't see much wrong with the current setup. I think of the B-D model as similar to a Mercedes dealership. You know when you enter that the friendly salesperson wants to sell you a Mercedes, and will not make any money unless you buy a car. The salesperson is sitting across the table from you, desiring to make a transaction with you. Many people buy cars from Mercedes quite happily in this way. Nobody employs an agent to represent them in negotiating with the car dealer, and even though the sales process emphasizes all the positives of the anticipated purchase while batting away any perceived negatives, it works. Of course, the salesperson genuinely wants you to be happy with your purchase, and probably believes more than anything that this particular Mercedes is the best purchase you can make with your money. However, even if the salesperson doesn't believe all that, you still get the same information, and it doesn't matter. You understand the relationship. You know who represents the car company.

Financial advisors at B-Ds are the equivalent of the Mercedes salesperson in this example. They are generally better educated and the sales process is more sophisticated, but they are nonetheless across the table from you. This works for many clients and crucially, as long as they understand they're not dealing with someone who has a fiduciary obligation to them, I see nothing wrong with this.

Incidentally, some financial advisors at B-Ds will claim they have a fiduciary obligation to their clients at certain times. It depends on the transaction, though, so sometimes they do and sometimes they don't. I would personally dismiss this entirely. You can't have a relationship whose defining quality changes, depending on what is being discussed. You're either a fiduciary 100% of the time or none of the time. There should be no part-time pregnancy in investing when it comes to dealing with clients.

Financial advisors with IAs are more akin to doctors or lawyers, people whose advice is provided with a legal obligation to put your best interests first. This is not to say that doctors and lawyers are flawless, merely to note that the model under which they operate requires them to represent their patient/client wholeheartedly. Conflicts of interest are meant to be disclosed, and if meaningful, the client will be directed to a different professional. To return to the analogy of the table, the financial advisor at an IA is sitting on your side, with you.

As we've seen, both models work, and I don't think the people who work for a B-D should be vilified or forced to overhaul the way they operate. This is one of those issues for which full disclosure can be a sufficient solution. Just as the financial advisor at an IA will inform the client of his obligation to act as a fiduciary, the advisor at a B-D should similarly state that he is not a fiduciary. Sometimes a Realtor will ask you to sign a form acknowledging that the Realtor is bound to put the interests of the seller first, so that if you're a potential buyer you understand the context in which the selling broker's opinions are offered.

I personally think the IA model with its fiduciary obligation is superior, but plenty of people feel differently. The market can decide once accurate information is provided to clients in a plain, easily understood form. I suspect that if every conversation with a broker opened with the admission that the financial advisor is not the type who's a fiduciary, many of them would be clamoring to adopt the same fiduciary standard used by the other half of the industry. Therefore, as long as clients receive accurate information, there's little need to engage in more dramatic change.

This distinction between the two types of financial advisor does raise an interesting point though. If your compensation comes largely through commissions, mark-ups and underwriting fees you are more likely to recommend investments that are laden with those. To use the non-traded REIT example, a careful reading of a prospectus reveals that the fees can reach up to 15% of the investor's capital, leaving only 85% of it to be invested. At the same time, the abuses appear at least anecdotally to be far more prevalent on the B-D side than the IA side. This is because it's virtually impossible for a fiduciary to recommend an investment that results in only 85% of your capital being put to work. It would require the adoption of some fairly heroic and ultimately implausible assumptions on the subsequent return for such a recommendation to really be in the client's best interests. By contrast, the advisor at a B-D isn't burdened by the requirement to put the client's interests first, only by the lesser standard of disclosure and suitability. The clear conflict of interest, in that the advisor stands to benefit from the enormous fees generated by the client's acceptance of the recommended non-traded REIT, need not play a role. They're disclosed and visible to the careful reader. But non-traded REITs are such a poorly designed product that it wouldn't be a bad idea for a new client to inquire of the new advisor whether the advisor had ever sold such a product to a client. It might disqualify the advisor from further consideration by the client, but even if it didn't the knowledge would represent useful information about how that particular individual had balanced his responsibility to clients with his commercial objectives in the past.

Really Understand the Fees

In fact, a common trend at work through many of the chapters concerning investments you should avoid is that they are more frequently recommended by the nonfiduciary type of advisor. It's not a coincidence. It's a bit like hedge funds, in that although the vast majority of hedge fund managers are honest, crooks are attracted to the traditional hedge fund structure because its relative opacity makes it easier to defraud clients than if you're running, say, a mutual fund. To take just one recent example, in January 2015 Magnus Peterson, founder of Weavering Capital, a London-based hedge fund, was sentenced by a London court to 13 years in prison for defrauding his hedge fund investors (Binham, 2015). Weavering had hidden trading losses by executing fictitious derivatives trades between his hedge fund and another entity he controlled. Hedge funds are just easier places in which to engage in such shenanigans. It doesn't mean hedge funds are full of crooks; simply that dishonest financiers find much to like about running hedge funds. Similarly, while the vast majority of advisors at B-Ds are honest, the advantage of the B-D structure for an unscrupulous advisor is that it makes it easier to profit at your client's expense. The absence of a fiduciary standard for B-D advisors is the reason.

The good news is that attention is being focused on the areas we've covered in the book, and daylight is often the best disinfectant. In casual conversations with industry colleagues, the topic of non-traded REITs would typically elicit responses such as, “They're an accident waiting to happen,” and similar opinions. In fact, I'd venture that most investment professionals regard these securities quite rightly as overpriced and inappropriate in the vast majority of cases. Their fee structures keep them alive. It's a sorry indictment on the minority who do sell them, and a pity that there aren't more outspoken observers willing to say what they think.

Closed-end funds can be an interesting place to invest. The initial public offerings (IPOs) are generally a bad deal for investors, but there are plenty of smart people who find value for their clients among secondary offerings. A friend of mine, John Cole Scott at CEF Advisors, is someone that can be relied on to navigate the market intelligently on behalf of clients. There are many inefficiencies that clients can exploit; just don't get drawn into participating in IPOs. Most CEF specialists knowingly agree. But once you get beyond that, the discrepancies that occur between net asset value and market price can be worth going after. There just isn't that much liquidity, so although a handful of firms specialize in this area, it requires patience and institutional-sized accounts will need to look elsewhere.

Structured notes are increasingly the target of scrutiny from the regulators. The SEC has an investor alert page that lays out many of the concerns they have about the growth of retail investing in such products. They warn about pricing, poor liquidity, and other impediments to earning an attractive return (SEC, 2015). Jason Zweig is a well-respected writer for the Wall Street Journal who has weighed in on the topic. He noted that structured notes, “…are sometimes marketed by less-scrupulous financial advisors” and noted another regulatory warning, from FINRA (FINRA, 2011). At least the regulators are trying to prevent unwitting investors from choosing expensive, poorly constructed products. Generally, the SEC isn't allowed to forbid the sale of an investment just on its merits, and of course, structured notes are compliant with relevant laws and regulations. You can draw your own conclusions as far as what to think of brokers who persist in marketing securities about which regulatory warnings exist. Clearly though, they are highly profitable or firms wouldn't be willing to take the risk. Naturally enough, the brokers that originate and sell structured notes think they're great products. As is often the case, they can point to volumes as proof that they're meeting client demand. Just ask yourself why the buyers are overwhelmingly individuals advised by a salesman rather than institutions who will have greater access to the tools and knowledge with which to figure out how expensive they are.

The hedge fund debate is pretty much over. Today's investors are largely pension funds, reliant on consultants who make money both recommending a chunky hedge fund allocation and then helpfully sourcing individual funds with which to implement it. The smartest people in the business run hedge funds and would never recommend a diversified portfolio. Today's public pension trustees rely on consultants in order to limit their exposure under the Employee Retirement Security Act (ERISA), which governs their activities as well as because many of them don't have sufficient expertise for the role they have. Recommending hedge funds with all their complexity sounds more sophisticated than choosing index funds. Ultimately, the taxpayers who underwrite so many public-sector pension funds will be on the hook to meet the shortfall resulting from poor, self-serving advice provided by the consultants that have been hired.

Because of the economics surrounding how hedge funds are marketed, it's almost certain that if your financial advisor recommends a hedge fund investment he's receiving a lucrative payment if you accept his advice. There are some great hedge funds and happy clients. There always will be. However, the good ones rarely need to pay anyone to find them clients. The people I've met who are happiest with their hedge funds have very few (usually less than five) and often found them informally through a personal recommendation. The best way to use hedge funds is sparingly. You don't need any, but you may come across someone who strikes you as honest and exceptionally smart. Those people are out there, too. If you feel comfortable, go ahead and make a small investment. Don't rely on hedge funds to do much to your overall portfolio, but there are plenty of worthwhile managers, and you may be lucky enough to run into one of them.

The embedded inefficiencies in parts of finance represent a very difficult public policy challenge. The evidence suggests that in some lines of business, banks and brokers are extracting unreasonably high profits, in areas such as investment banking, debt and equity underwriting but also in some transaction areas such as bonds and other more complex products. The year 2008 represented a watershed event in that the government responded to a public outcry over irresponsible Wall Street and moved forward on two fronts: increased regulation and higher capital requirements. Having worked in finance my entire life, I can tell you it was never exactly underregulated. Public opinion demanded a public policy response against Wall Street, but it's not clear to me that lowering the cost of financial services represents a fundamental objective of these initiatives. In fact, the regulatory and capital changes both serve to increase costs as bank CEOs frequently point out. A friend of mine at JPMorgan recently told me that meetings routinely involve at least as many legal and compliance people as business people. It must be a stultifying environment for any business manager trying to navigate a new product through today's complex set of internal approvals and into the marketplace. Of course, financial innovation has only too rarely translated into better ultimate outcomes for clients. However, there have been useful new ideas apart from the ATM, no matter what Paul Volcker may believe. Securitization is one of them; the market for derivatives is another. But the most basic problem is that competition doesn't work as well as it should. The investment potholes described in this book wouldn't be separating nearly as many people from their money if the costs were clearly understood. What's needed is a simpler way of explaining in plain English just what's going on. Instead, financial transactions are documented with densely written prospectuses and contracts that meet the letter of the law in terms of disclosure but fail to explain much that is useful to the non-investment professional. Meaningfully increased transparency can surely only help.

Try Asking These Questions

When choosing your advisor, it can be helpful to have a list of questions ready. The answers will help you decide whether you're making the right choice.

1. Do you have a fiduciary obligation to me? If you care about the answer to this question, the only acceptable answer is, “Yes.” Nothing else works. “Usually but not in certain cases,” or “Sometimes,” or, “No but if I was I wouldn't be able to offer you some of our best deals,” should all count as a negative response. You can still pursue a relationship with this advisor, but understand that he's sitting across the table from you rather than alongside, and that his compensation will come in part if not entirely from the transactions you do.
2. How will we assess your performance? It ought to be such a simple task to figure out whether your advisor's advice has helped you. After all, investing lends itself to quantitative measures of results more than perhaps any other endeavor. If your advisor plans to rely on qualitative measures such as, “Better than expected,” or, “Quite good under the circumstances,” then beware. Nobody likes to be benchmarked. When I was investing in hedge funds, I'd often ask a manager how we'd agree after the fact whether he'd done a good job. Although you'd think that evaluating hedge fund performance should be straightforward because they do produce numerical results, every hedge fund manager I ever met insisted that this fund couldn't be compared with other similar-looking hedge funds. Although the manager might have sincerely believed that what he was doing was different than anybody else, the absence of a clear benchmark is invariably to the advantage of the one whose responsibility it is to generate the results. My question was receptive to a wide range of answers. The manager could suggest almost any measure of assessing results, as long as it was measurable. He could select comparison with an obscure hedge fund index I'd never heard of, or state a number, such as “at least 10%” (although we'd also have to agree on a risk measure, too, since without it a 10% return target is meaningless). But we had to agree on something that involved the use of numbers. I always found it vaguely amusing that people whose whole life involves analysis with numbers could be so unprepared to submit their own work to the same type of review.
3. How much will it cost? You may have to probe a bit on this question to make sure you get a complete answer. For example, in our business we charge a quarterly fee, which is a percentage of assets. When we do trades, the client typically pays a commission of $8.95 per trade to Charles Schwab, where we custody most of our assets. Of course, we don't get the commission and have no incentive to overtrade. Because we run investment strategies that only own equities, there are no other fees. If your advisor works for a B-D, there may be commissions, bond markups, and underwriting fees if you buy new issue securities. Bond markups can quickly add up, and you may be better off owning an ETF or mutual fund because their transactions costs in the bond market are far lower than those faced by individuals. We pointed this out in Chapter 2. The SEC has published a report identifying the high costs faced by individual bond investors. If your advisor plans to buy bonds for you, make sure you fully understand the transactions costs. Buying new issue securities is invariably expensive and in aggregate not worth the money. We talked about closed-end fund IPOs in Chapter 2 and explained why you should never buy a closed-end fund IPO. The same is true of non-traded REITs. Occasionally, there might be a good deal in the secondary market when some poor souls who inadvisedly bought into the IPO finally ditch the disappointing investment at a fire-sale price, but as an individual you're unlikely to see such a transaction and are certainly poorly placed to evaluate it unless you have expertise in the area. Conventional IPOs have in aggregate been shown to dramatically underperform the equity market (Ritter, 2013). Jay Ritter, from the University of Florida, found that the average three-year market adjusted return on IPOs from 1980–2011 was –19.8% (i.e., they underperformed the market by this amount). IPOs are priced to jump on the first day's trading, which is part of the marketing strategy to draw in new buyers. There is a big adverse selection process at work, though, in that you'll get more of the flops while the truly attractive ones are scooped up by the clients who pay the most commissions. You're also buying securities from true insiders who know far more than you possibly could about the company in question. They've selected the time and price at which to sell so as to maximize their own economics, not accommodate your desire for an attractive return. If you forswear all IPOs you'll miss many bad ones to compensate for the odd good one. Especially beware an advisor who claims he'll get you in the latest hot IPOs. One way or another, you'll probably be paying for it. You'll need to go through all of these costs to make sure you have the complete picture.
4. Do you invest in products that have been the subject of warnings from the regulators? This is a revealing question, because if the answer's yes, then an explanation has to follow. Indeed, what is an acceptable response to this question? Most likely, you'll be told that the regulators aren't really that smart, and that they don't appreciate some of the subtle sources of value to be found. Or that his firm only sells the most attractive type of the securities in question. Or maybe that he used to but has since recovered, as if from an addiction. But whatever the answer, you should think pretty carefully before proceeding to do business with someone who has seen fit to promote investments that have drawn such regulatory scrutiny. It's possible there's a good answer, but if you use this question to reject an advisor, you'll probably be better off.
5. What conflicts of interest do you have? You want an advisor who puts your interests first 100% of the time. If this isn't going to be the case, you need to understand when, and why, you won't be receiving completely unbiased guidance. The principal–agent problem is fundamental to many of the business relationships that exist in finance. Your advisor is your agent, and whether the advisor is a fiduciary or not, as the principal you need to be prepared to manage that relationship so you get the best possible advice and outcomes.

What Else Can Be Done?

The regulatory structure in the United States possesses Byzantine complexity. For example, trading markets are divided between the SEC (for securities) and futures (the CFTC). The fact that an ETF on the S&P 500 is regulated by the SEC while a futures contract on the S&P 500 falls under CFTC jurisdiction is a reflection of the way politicians have put their own interests first. The continued existence of the two regulators traces back to the Senate Committees, which oversee them: finance (for the SEC) and agriculture (for the CFTC, since futures were originally based mostly on agricultural commodities). Even during the overhaul of financial markets regulation that took place following the crisis of 2008, merging the SEC and CFTC was regarded (Vekshin, 2009) by policymakers as a nonstarter, because each committee's members enjoyed campaign contributions from their respective industries. Merging the CFTC into the SEC under the oversight of the Senate Finance Committee would remove an important source of campaign contributions for the members of the agricultural committee, and was regarded at the time by then-Treasury Secretary Tim Geithner as a fight not worth having. The GAO (US Government Accountability Office), a nonpartisan Congressional agency (U.S. GAO, 1995), long ago concluded that such a merger made sense.

Bankers routinely complain about the deadening effect of increasing regulation. JPMorgan's CEO Jamie Dimon notes in the company's 2014 annual report that nowadays when a bank does something wrong, there are multiple regulators, each levying fines that are often set independently of one another. It's not that banks shouldn't be punished when they break the rules, but when multiple regulators all pile on with their own individual punishments, it looks more like an alternative source of tax revenue than part of a carefully considered, investor-oriented regulatory regime.

It would be hard to argue that today's financial services industry is underregulated. Yet we've been able to write a book full of products that in many cases shouldn't be sold to clients in their current form. Although it's tempting to assert that even greater regulation is needed, we believe people in the industry need to take more responsibility for ensuring they do what's right. If the vast majority of the professionals who provide honest advice would speak out more when they see things that reflect poorly on the whole industry, we'd go some way toward restoring reputations and weakening the public policy drift of applying ever-increasing levels of regulation and oversight.

Many of the products we've written about, such as non-traded REITs, structured notes, and annuities, are the subject of investor alerts on FINRA's website. Most people would find it quite extraordinary that even though the agency that regulates broker-dealers provides warnings on certain investment products, some firms continue to sell them. Therefore, do the warnings mean anything? Are they unreasonably cautious, or just wrong? Are investors supposed to heed them and avoid such investments? And on the rare occasion when a client asks of a financial advisor how their firm reconciles its recommendation to buy a non-traded REIT with FINRA's admonitions, how exactly does the advisor respond?

In this respect, we look rather like the tobacco industry, where dangerous products are sold with warning labels. Is that really the limit of the standard to which we aspire? Shouldn't advisors be aiming just a little higher?

The Role of CFA Institute

CFA Institute is a great organization that is well positioned to have a voice on such issues. CFA^® charterholders (of which I am one) are required to pass three six-hour exams and conduct themselves in an ethical manner. Chartered Financial Analysts have demonstrated a solid understanding of how to analyze investments, and while continuous learning is a requirement of every charterholder, passing the exams does in my opinion reflect a substantial commitment to personal excellence in the field. CFA Institute doesn't sell anything beyond educational products and membership in its organization. Its Mission statement is:

“To lead the investment profession globally by promoting the highest standards of ethics, education, and professional excellence for the ultimate benefit of society.”

These are lofty goals and yet perfectly appropriate. In fact, the CFA Institute Professional Conduct Program and the Disciplinary Review Committee routinely sanction members it finds have failed in some meaningful way to live up to its Code of Conduct and Standards of Practice. Their names are published in the CFA Institute magazine and on the website along with a description of their misconduct, and applicable sanction which can include permanent revocation of their CFA^® charter. Out of the more than 130,000 members worldwide (CFA Institute, 2015), only a very small percentage find themselves subject to the disciplinary process. This is a reflection of the importance that each CFA charterholder places on embodying the Mission Statement. Having invested the typical 300 hours of study recommended to pass each of the three exams few are going to find the possible loss of their CFA^® charter a risk worth taking.

CFA Institute launched an initiative called The Future of Finance, part of a “Global effort to shape a trustworthy, forward-thinking financial industry that better serves society.” One area of focus is “Putting Investors First.” It includes a list of ten “investor rights” that any investor should expect from their financial services provider. Here is the CFA Institute Statement of Investor Rights:

1. Honest, competent, and ethical conduct that complies with applicable law;
2. Independent and objective advice and assistance based on informed analysis, prudent judgment, and diligent effort;
3. My financial interests taking precedence over those of the professional and the organization;
4. Fair treatment with respect to other clients;
5. Disclosure of any existing or potential conflicts of interest in providing products or services to me;
6. Understanding of my circumstances, so that any advice provided is suitable and based on my financial objectives and constraints;
7. Clear, accurate, complete and timely communications that use plain language and are presented in a format that conveys the information effectively;
8. An explanation of all fees and costs charged to me, and information showing these expenses to be fair and reasonable;
9. Confidentiality of my information;
10. Appropriate and complete records to support the work done on my behalf.

“Copyright 2013, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved.”

#7 in particular would go a long way towards helping clients better understand the investments they're buying. Current standards of disclosure result in documents that run to hundreds of pages being provided. While meeting a legal standard, it doesn't always promote understanding.

CFA Institute is currently finding its voice in this area. Given the preponderance of disadvantageous products still in existence, surely a part of Putting Investors First must include pointing out examples of those interests not being put first. CFA Institute represents much of what's right within the financial services arena. It's fair to say that if everybody in the industry, regardless of whether or not they're a CFA^® charterholder, conducted themselves on a daily basis in a way that's consistent with the Statement of Investor Rights listed above, the world would be a better place. Achieving that seems like a worthwhile goal.

CFA Institute also offers an “Integrity List,” consisting of 50 more detailed steps Finance professionals can take to promote a better industry. It's promoted as, “Fifty actions you can take to build trust and enhance your firm's reputation.” Because while this book is directed at clients, the people that advise them are ultimately the most important part of the solution. The list comprises six categories: committing personally to ethical and honest behavior; inspiring others to do the same; developing trustworthy relationships; transparent communication; continuing learning, and advocacy for a better system.

I won't include all 50 items on the Integrity List here. You can find it at: http://www.cfainstitute.org. Whereas the Statement of Investor Rights tells clients what they should expect, the Integrity List tells the individuals who make up the industry how they can conduct themselves for everybody's benefit. It includes committing to honest and ethical behavior, but also pointing out areas of abuse publicly. Naturally, this book has come about because the writers all believe that more needs to be done. It isn't that hard to provide objective criticism of some things that stand out. If all you know about non-traded REITs is that they charge clients 15% in up-front fees that ought to be enough for anyone striving to live with the Integrity List to disassociate themselves from the product. And it's therefore not hard to write publicly about what you see that's wrong. You don't have to write a book, it can be in your blog or investor letter.

Bigger Isn't Always Better

In finance, size brings with it conflicts of interest. Big firms will usually grab the headlines, but it's harder for big firms to promote all 50 items on the Integrity List. Endorsing ethical behavior is fine, but few large firms are going to tolerate employees practicing #2 on the list of 50, which is to “Name and shame unethical behavior.” Large size increases the odds that they'll offend someone who may be a client, and conflicts of interest are an inevitable part of size. Smaller firms with simpler business models are better able to pursue a single-minded focus on providing client-centered service. “Strive for a conflict-free business model” is #3 on the list, and while it's more aspirational than realistic for big firms, it's not an unreasonable objective for smaller ones.

While investing your money through a large firm can inspire confidence that it'll be safely handled, few large firms nowadays can point to an unblemished regulatory record. Often, the point of size is to find synergies across different business units and to exploit “cross-sell” opportunities. Growth demonstrates satisfied clients, but the more important question clients should ask themselves is whether that growth is good for the clients.

Size makes it harder to outperform the market as well. For example, an article in the New York Times found that most mutual funds run by large banks underperform the averages. It analyzed data from Morningstar on funds run by Goldman Sachs, Morgan Stanley, Wells Fargo, and my old firm JPMorgan to arrive at this conclusion. In the article (Popper, 2015), Larry Swedroe, director of research at Buckingham Asset Management, commented that, “It's a good business for them—but that doesn't mean it is a good investment.”

In this book we've set out to help investors and to provide constructively to the ongoing debate around Wall Street and whether it delivers what it should. The growth in financial services that's taken place over the past 30 years has not obviously coincided with improved economic outcomes. As we've shown, basic measures of the cost of financial intermediation have not changed in spite of the enormous investments in IT that have taken place. Median living standards adjusted for inflation are also roughly where they were at the beginning of the 30-year boom in Finance, as I showed in an earlier book, Bonds Are Not Forever. Although the financial sector continues to perform many vital tasks for the economy, the 2008 crisis showed that much was wrong. Investment banks were certainly woefully undercapitalized with as much as $30 of assets for each $1 of equity. Approving such wildly risky leverage was frankly stupid by all concerned. Among the many regulatory changes since then has been a steady increase in the levels of equity capital required by banks as well as the creation of the new designation of “Systemically Important Financial Institution,” or SIFI. Such companies are deemed “too big to fail,” and therefore since they have an implicit public sector guarantee they receive an additional level of regulatory scrutiny as well as heightened capital requirements. Although the patchwork of regulatory agencies in the US represents a great disservice and demonstrates a political inability to put America's interests first, bigger firms do deserve tougher rules. If size is a good thing in banking, it ought to generate a higher return on capital, so higher levels of capital need not be a problem. If it can't do that, it makes sense to shrink.

General Electric (GE) most dramatically demonstrated this in its recent decision to spin off most of GE Capital, their finance arm. There was a time when GE Capital represented almost half of the parent company's profits (Stewart, 2015), although the freezing up of financial markets in 2008 caused them funding problems and led to a steady reduction in GE's reliance on finance to drive its profits. The SIFI designation that GE's size drew was a factor in their decision, and shedding most of GE Capital was expected to free them from being a SIFI along with the increased cost of regulatory scrutiny and capital requirements this entails.

It's hard to see anything bad in this outcome. GE's financial assets will largely wind up in the hands of disparate other firms. GE itself probably becomes marginally less complicated and therefore less risky to the public sector in the event of another crisis. The services GE Capital provided will largely continue to be on offer, just with different owners.

Another consequence of the 2008 crisis has been to make working in financial services a generally more miserable experience. This is especially so in large firms who bear the brunt of the many changes driven by a strong public desire to avoid a repeat of the public bailouts. Anecdotally, anybody with friends at a large financial institution can recount weary complaints about the internal power of compliance and risk managers. A recent global survey of the industry revealed widespread dissatisfaction about compensation and “dull work” (McLannahan, 2015).

When I worked at JPMorgan, any new investment product had to pass through a rigorous new product approval process. It was necessary to obtain a sign-off from a wide variety of support units covering areas of risk such as market, legal, and reputational. Navigating through this was appropriate and tedious at the same time. Unsurprisingly, reports indicate that substantially more rigorous reviews are now the norm.

Much attention has focused on unreasonably high compensation. It will be obvious to the reader that the authors of this book all make their living in financial services, so one can easily dismiss any views on the topic as lacking objectivity. Any business requires labor and capital to operate. It always seemed to me that in the division of profits in finance between the providers of these two inputs, the providers of capital received the short end of the stick compared to the providers of labor (i.e., the employees). While bankers and brokers can't claim to be poorly paid, there is some evidence that the pendulum is shifting back toward capital; at a minimum, since the industry broadly requires more capital than it used to in order to operate under today's rules, more of the profits are earmarked to provide that capital an acceptable return. This also seems quite appropriate. To my mind, some of the criticism of Wall Street compensation can be traced back to the insufficient levels of capital at which the industry was allowed to operate. Fixing that alters the balance between the two, and while I don't believe there's any merit to a public policy that focuses on compensation in any private sector, compensation critics must at least be drawing some satisfaction from the direction things are moving.

Improved outcomes for clients of the financial services industry will require that the clients become more discerning. It takes homework and effort to find an advisor who will truly put your interests first. Because such things are important but rarely urgent, it's often easy to put off the analysis that will help you find a relationship that's best for you. This book is intended to provide information and tools to allow clients to take greater control of their finances.

There's little doubt that the providers of financial services need to change too, and this book is also addressed at them. Collectively, we need to raise our game. We need to ensure clients are put first, that investments are explained clearly, and that fees are fair. Our industry has been maligned because too many individuals are operating at odds with the CFA Institute's Integrity List or anything similar. The vast majority should take hold of the industry's reputation and ensure the trust so many people place in us is amply repaid.