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    July 2012
    M T W T F S S
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    Is Your Financial Advisor a Salesman?

    Alan Fustey

    By Alan A. Fustey

    When an advisor recommends that an investor purchase a financial product, there can be as many as five participants who have a financial interest in the transaction:

    • The investor
    • The financial advisor
    • The company that employs the financial advisor.
    • The company that manufacturers the product which is purchased.
    • A lender, if the financial advisor recommends that the investor borrow to invest.

    When the recommended investment is profitable, everyone on this list makes money. However, when the investment experiences a loss, the investor is likely the only one of the five participants that suffers. All of the other participants have either been compensated, are still being compensated or have not lost a cent.

    The financial advice industry is plagued by a principal-agent problem wherein individual investors (principals) rely on licensed representatives (agents) for advice. The information asymmetry that is present in this relationship (agents have information that the principals do not) can lead to numerous conflicts of interest.

    A conflict of interest is present any time a financial advisor is not thinking exclusively about what is in the best financial interest of the client they are advising. Conflicts can result from an outside influence that affects or biases their judgment.

    A commission-based compensation model forms the core of the sales culture that is present in many financial advisory firms. Advisors are required to sell products as part of the process for providing financial advice, since the advisor’s pay is linked directly to these transactions.

    Many investors are not aware of the potential conflicts or the abuse that can bias the advice they receive. Scrutiny of compensation models as they currently exist in the financial advice industry is increasing; with the result that commission-based models are now being more generally viewed with a jaded eye.

    Canadian Securities Regulators are now pushing for increased disclosure of financial advisor compensation through implementation of their Client Relationship Model initiative. Once fully implemented, this model will increase investor awareness of advisor compensation and how potential conflicts and biases may occur. However, it does not provide any new information about the abilities, skills or ethics of a financial advisor.

    In my opinion, the ongoing debate about compensation disclosure misses a key point: What is the duty that is owed by the financial advisor to the individual investor receiving the advice?

    A fiduciary is someone who has undertaken to act for and on behalf of another individual in circumstances that give rise to a relationship of trust and confidence. A fiduciary duty requires a legal and ethical relationship of confidence regarding the management of money between the fiduciary and a principal. The fiduciary must not put his personal interests before the duty.

    Most individual investors in Canada are unaware that there are different standards of care placed upon financial advisors depending on how they act on behalf of clients. Financial advisors who act on a discretionary basis when managing investment assets, as well as individuals who have achieved the Chartered Financial Analyst designation, are viewed as owing a fiduciary duty to their clients. Financial advisors who make recommendations to clients that require authorization from the client prior to executing the recommendation are not held to a fiduciary standard. Rather, they owe only a duty of suitability.

    If financial advisors who are compensated by commissions believe that they should hold themselves out to the investing public as anything other than salespeople, then they should also be accountable under a higher standard of care to their clients. Current regulations may not require this fiduciary standard of care; however, there is nothing that prevents them from using it as a guiding ethical principal in how they interact with the individual investors they advise.

    When an advisor’s method and amount of compensation is transparent to an investor, it removes the suspicion regarding whose interests are being served when investment recommendations are provided. However, when advisors also rise to a fiduciary standard, they further enhance the relationship with their clients through shared mutual interests and heightened trust.



    Alan A. Fustey is a Portfolio Manager and Author. This article is based upon an excerpt from his book Risk Financial Markets & You: Your Guide to Making Better Investment Decisions.

    The MONEY® Network