Investors Group Best Interests submission: best interests, subjectivity and the product outcome…

If I made my return from selling products and made those who sold my products dependent on what i gave them, I would want this consultation knocked out of the ballpark right now!

Reading through the Investors Group submission I focussed on their interpretation of best interests, or rather an apocalyptical interpretation that would raise the retail industry to its foundations.

“Although the term “best interest” of the client can sound altruistically positive it can have a technical meaning that overreaches any intended result.  If best interest is defined by the ultimate performance of the instrument, the determination of this will always be made in the future by looking back.  The approach simply cannot work since performance is affected by many factors over which the advisor has no control, including many client decisions both initially and throughout the life of the investment holdings in conjunction with co-incident market movements.”

The hindsight test – the hindsight test would never be applied to determine a best interests decision, but the impact of a negative outcome may well be used to assess the liabilities of a “not in your best interests decision”.  

The fact that an advisor has no control over the many factors that affect performance is not really the issue here.  There are many other objective tests that can assess a best interests decision, some of which are noted below. 

Asset allocation and the impact of costs

The advisor clearly has no influence over economic growth or how the market will value individual investments, or how each company will perform, but there are certain physical rules (objective constraints) that impact the relative performance of individual investments and that are known at the time of the investment.  Costs are one of them, and mutual funds with high fees are well known underperformers of their benchmarks.

Take my analysis in the in “Low returns and high MERs are just going to kill you”.   It takes a truly astounding level of outperformance on the active component of a mutual fund to recover its fees and just equal the benchmark performance.  This does not mean that active funds should not be used, just that you need a fairly significantly different style yield, growth, market and or sector cap differential from available and investible benchmarks, to justify selecting an active fund where fees and costs are high.  

Investors Group are quite correct in being concerned about the impact of best interests standards on the mutual fund industry, because a great many funds have little valid rationale.  You may say, well part of the costs are the costs of advice, in particular the trailer fees.   But fees paid to advisors need to add value, and if all the advisor is doing is reaping the trailer fees then you have to ask, in whose interests are the transaction.   Adding value requires providing services of greater sophistication and advice, which implies greater discretion and responsibility, which implies a greater need for best interests standards.

The industry does not want investors to focus on performance, that is why actual proper benchmarking of returns have not been seen in either the Point of Sale Documentation or the CSA client reporting proposals.  To tell you the truth, if regulators do not want to hold advisors and product providers accountable, then why are they embarking on a best interests standard?

Structure and impact

The more complex the product (irrespective of its bells and whistles) the greater the likely impact of a significant allocation to this product.  Anything which impacts the yield of a portfolio, the liquidity, the duration, the balance, without any of the impacts being addressed within a recommendation has the potential to be against the client’s best interests.   For example, a significant allocation to principal protected notes with no yield but a principal guarantee would impact a) the overall yield of the portfolio, thereby increasing capital depletion for a given yield requirement, b) and reduce the overall available liquidity in a portfolio.  Failure to address the impact of a product or a security on a portfolio is likely to have a potential best interests liability. 

And of course you have the downright crazy products like Corporate class equity mutual funds with 8% withdrawal rates which are effectively market risk suicide missions. 

Likewise leverage is also a product in portfolio terms given the way significantly impacts the risk/return equation.   I fail to see how common garden variety leverage (the non managed type we see being used) could form a part of any risk management focussed portfolio option. 

Failure to address significant risks to returns in construction and planning

Higher expected returns on risky assets, irrespective of the volatility, allow you to increase your allocation to risky assets.  The use of overly optimistic assumptions in the construction and planning phase of a portfolio may result in recommendations that are not in the client’s best interests.  As advisors, your central allocation benchmarks should also be your core risk management benchmarks.

Indeed, the more you represent your skills, your expertise and the ability of you and your firm to navigate the depths of markets, the more you are saying that you are acting in your clients best interests, and the more attention to detail you will need to bring to bear to your research, your selections, your processes and systems etc, etc, etc.

Best Interest can be interpreted anywhere from the advisor being responsible for the success of an investment in the nature of a guarantor…to a standard that is close to that which applies currently (acting fairly, honestly, and in good faith) on the other. 

Incorrect: best interests can only be interpreted as a guarantee if it is part of the contract.  And, “acting fairly, honestly and in good faith”, if we define this by referencing the limitations of the current suitability process with its accepted remuneration conflicts, is not a best interests standard.

“The difficulty with the consultation paper begins with its supposition that the concept of best interest has a precise meaning, when it does not.  The issue is made worse where by the implication that investments are a kind of commodity, interchangeable one with the other, where a set of objective requirements can identify a single solution….securities are intangibles where the choice is dependent on a range of subjective factors, which for most people require the assistance of an advisor to determine which alternative is best”.

Best interests standards should be grounded in well structured models.  There are many components of a model that lead to and help define the best interests outcome.  Many of the inputs (assumptions) and decision rules (how you react within the model to certain inputs) may well be subjective, but even then, these subjective inputs should be objectively measurable.  Portfolios are not just a matter of taste and preference, and whatever your taste and preference, your points of reference should be similar, even though your position relative to any given benchmark may differ.   

In other words, a best interests model will have its own precision, in that it will recommend a specific set of outputs, whose objectivity can be related back to the model and its components.   In this sense of the word, it is easy to assess at outset whether a product or security is in the client’s best interests, given the clients detailed parameters, your structures and disciplines and the process in which client risk aversions and preferences are related to your model’s outputs

Leave a Reply