Understanding How Broker Incentives Shape Financial Advice
Interactive Brokers recently posted a hilarious video, which highlights potential conflicts between advisers and investors.
We transcribed the video below:
[The scene: two men, shaking hands in a hallway.]
Investor: Thanks for the advice. I’ll think about it.
Wirehouse Broker: Here’s some info on the proprietary fund I recommended. And you should take this too.
[hands investor a giant block of salt.]
Investor: A giant grain of salt.
Wirehouse Broker: When you’re considering my advice, remember that I get paid based on how well I sell our bank’s expensive trading products.
Wirehouse Broker: And we’ll be selling your order to…whoever pays me the highest kickback.
Investor: That…should be illegal.
Wirehouse Broker: Yeah…probably!
This is a brilliant commercial, since it cuts right to the heart of what is wrong with the current Wall Street business model, which is fraught with conflicts of interests!
Let’s examine a few items from the video.
The Wirehouse Broker in the commercial, let’s call him Fred, works in the Asset Management or Financial Advisory unit of a large bank.
Let’s say Fred works at JP Morgan, but you could replace JP Morgan with any bank–CS, UBS, BofA, Goldman, MS, and so forth.
Fred is one of thousands of FAs, or Financial Advisors, at the bank. These FAs are not fiduciaries for their clients, they are brokers that need to ensure they recommend products that are “suitable” for their clients. It is important to highlight that Fred is NOT an RIA, or a registered investment advisor, which has a fiduciary obligation to their clients. It is also important to note that Fred isn’t necessarily a bad guy, he is simply being put in an impossible situation where he wants to help his client, but is paid based on how much he helps the bank.
The difference between fiduciary and suitability standards are outlined here.
Some interesting segments from the video highlight the conflicts of interest inherent in the broker-dealer model for financial advice.
First, note that the broker is recommending a proprietary fund. What does this mean?
As part of JP Morgan’s Asset Management business, the bank has developed a large mutual fund complex. That is, JP Morgan sponsors JP Morgan funds, and pays portfolio managers, who act as investment advisors for the funds. JP Morgan funds are thus “proprietary,” in that the JP Morgan FA is distributing the funds, which are ALSO managed by JP Morgan.
Now, Fred is a very important part of the distribution function for JP Morgan funds. But he also needs to meet the suitability standard for his clients. If you talk to the banks, what they will say is they are “open architecture,” meaning Fred can select from among proprietary funds and third-party, externally-managed funds. Yet from JP Morgan’s perspective, proprietary funds are an ideal product to sell, since they generate 1) management fees from the funds, and also 2) distribution fees from the FA, thus maximizing overall profits for the Asset Management business. From the bank’s perspective, other things being equal, they would prefer that the FA sell proprietary funds.
But are other things equal?
Does this arrangement create incentives for JP Morgan to encourage its FAs to push JP Morgan products, even when those products may be overpriced and inferior to those of other fund companies? This is why the Broker then hands the symbolic giant “grain of salt” to the investor in the Interactive Brokers commercial.
Second, note that the broker says he gets paid based on selling the banks “trading products.” What does this mean? Trading products can be all kinds of things, from structured investments to customized strategies. The sky is the limit.
Let’s say JP Morgan offers a particular trading product called a “Master of the Universe” portfolio. This portfolio contains a lot of – wait for it – JP Morgan funds.
Now the bank is even happier. It collects 1) a portfolio level fee, 2) fees on the trading of the underlying funds, and also 3) the FA clients feel “special.” A trifecta! Naturally, since this is such a good deal for the bank, the bank is highly motivated to get the FA to execute the trifecta. So perhaps the FA can get paid based on how well he sells the banks expensive trading products.
“Selling Order Flow”
Third, let’s say further that the FA’s client has a number of market orders to execute. Perhaps he is rebalancing his portfolio. What does the FA do?
Well, he has bunch of orders in hand. One option is to talk to various high frequency trading firms who may be able to execute the orders. The high frequency trading firms want this business. In fact, they want it so badly they will even pay for it. Let’s say one firm offers a larger payment for his orders than the others. Naturally, this is the firm who will execute the orders. Does this result in the best outcome for the client? Not necessarily. So the FA really can sell the client’s order flow to whichever firm pays him the highest kickback, and he has clear incentives to do so.
As the video highlights, “Isn’t this illegal?” Well, it probably should be, but that doesn’t prevent people from doing it.
What’s the Bottom Line?
Think through the incentives of people who give out advice. The Interactive Brokers commercial, in an in-your-face sort of way, highlights various conflicts of interest. We outline with some more detail how and why banks and brokers act the way they act. Again, to emphasize, it is not that people who work for banks are bad people, they are simply put in a bad situation.
What’s the solution?
The typical solutions to conflict of interest problems are found via transparency and creating better advisor/client incentive alignment. This is why we see a large push towards fee-only independent investment advisors with a fiduciary duty to do what is best for their clients. And of course, even in an independent advisor practice there are inherent conflicts of interest issues. This is where a culture of compliance and transparency play a key role. Another solution, sought by the SEC, is to have the fiduciary standard be uniform across all advisors.
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