Financial services industry forced to bury its mistakes
The financial services industry is a somewhat unique one in that it combines both a traditional advice role with a traditional sales role. The overlap of these two pursuits (which might often be mutually exclusive) is neatly captured by the self-regulatory terms of reference given by provincial legislation such as the Ontario Law Society Act, which encourages members of the Law Society of Upper Canada to engage in "balanced commercialism".
Of course, a term like "balanced commercialism" could be interpreted differently by some elements of society. Many people think professionals charge too much for their services. The question of fair payment, as it exists for financial advisors, is further complicated by the frequency and appropriateness of product placement. The other element of what advisors do is their fiduciary responsibility to make recommendations based on their clients' best interests.
Given that this is the case, the Efficient Market Hypothesis (EMH) poses a significant legal threat to financial advisors and product manufacturers alike. Nearly 40 years ago, a graduate student named Eugene Fama at the University of Chicago put forward this hypothesis in his Ph. D. thesis. It has stood as the reigning null hypothesis explaining capital market behaviour ever since. The basic thesis is this: markets work. Stated a little less cryptically, it means that no one can "beat the market" because market prices for securities reflect all current information all the time. Since there are literally thousands of bright, hard working people trying to out-smart one another when it comes to securities valuation, the price is always sufficiently right that no one could be expected to "add value" by exploiting any mis-pricings. In short, EMH suggests that markets are "efficient" and there isn't any one of us smarter than all of us.
Since 1965, the whole world has been trying to prove Fama wrong, but no one has been able to do it. Given that so many people have been unsuccessful for so long, isn't it about time that Bay Street, Wall Street, and everyone who works there acknowledged that Fama might be right? Of course, this presents a huge moral quandary for a number of stakeholders in the financial services industry. Most of them make their money through the promise (either explicit or inferred) that they can "beat the market." To date, no one has ever produced reliable, statistically significant evidence that anyone can beat the market. The financial services industry, like some physicians, has been forced to "bury its mistakes."
If stock picking - either through individual security selection or through the use of mutual funds - does not typically add value at all, what's a fair (commercially balanced) price to pay? Stated differently, how much should consumers expect to pay for a product or service that likely only subtracts value over time? Remember that there are two parties that have liability issues here - financial advisors and mutual fund companies. Sort of like cigarette manufacturers and physicians. One makes the damaging product and the other is a primary gatekeeper regarding the product's usage. Asking a financial advisor when to use active management in 2004 is like asking a doctor about the best age to take up smoking in 1964. The only responsible answer in both cases is an emphatic "never!"
Not all active management is harmful, of course, but it's just so darned difficult to identify those that seem to add value. Similarly, purposeful asset allocation and a belief in market efficiency are not mutually exclusive. Still, impure mutual funds often make things even more difficult for strategic asset allocators by muddying their own investment mandates.
We believe that reams of class action lawsuits will be filed once consumers realize (as we did only very recently) that we've all been duped. Advisors will have to account for why they never even offered their clients passive investment options. Mutual fund companies will have to explain why they never disclosed the risks associated with their actively managed products. When the lawsuits came in the tobacco industry, it was the cigarette companies that got sued rather than the doctors. For a long while, doctors claimed ignorance. Besides, the cigarette companies were much easier targets - and they had the added bonus of having substantially deeper pockets.
When the day of reckoning came, society decided that it was the product manufacturers who had to be held accountable rather than the intermediaries. We're not saying that's right or wrong, it's just how the chips fell. Maybe it'll be the same with actively managed mutual funds; maybe not. All we know is that we have already sent our clients a letter telling them that we believe they should switch to an all passive portfolio immediately in the hope that they don't hold us responsible for any harm that may have come to them financially. We warned them as soon as we realized how bad it really was. Now that everyone else knows how bad it is, we wonder how many financial advisors will follow suit. We use the word "suit" deliberately.
John J. De Goey, CFP is a Senior Financial Advisor with Burgeonvest Securities Limited (BSL) and author of The Professional Financial Advisor II. The views expressed are not necessarily shared by BSL. www.burgeonvest.com www.johndegoey.com
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