Update Regarding Pension Consultant Conflicts of Interest
Recent articles in the New York Times and Pensions & Investments discuss a settlement between the Nashville & Davidson County Metropolitan Benefit Board and its former pension consultant UBS Paine Webber. These articles describe some of the conflicts of interest involved in the pension consulting industry. Since 1995, we have written extensively regarding consultant conflicts and have encouraged pension funds to seek to quantify the harm to funds related to such conflicts. Unfortunately, most funds continue to accept pension consultant assurances that there is no cause for concern. We were pleased to have provided services in connection with the successful resolution of the Nashville matter. Interested readers may wish to go to http://www.nashville.gov/htmlpgs/news/news6.htm for additional information regarding the settlement.
Speech for Florida Police and Firefighters Pension Trustee Educational Seminar
The Best Investment Advice: Fundamental Truths about the Business of Managing Your Money
What I have to tell you today I hope will be one of the most important investment speeches you ever hear. I want to give you an overview of the investment business, the business of managing and trading your money-an insider's guide, that will serve you well in the future, both in your personal investing and in your role as a pension trustee.
Let me begin by quoting a few lines from that classic song, I Heard it Through the Grapevine. If you aren't old enough to remember the song from the 60s, you may recall it from the dancing California Raisins commercial years later. The words I want you to keep in mind every moment you are listening to a broker, money manager or pension consultant are: Momma said believe half of what you see and, son, none of what you hear. To paraphrase the song for our purposes: When it comes to investment matters, believe half of what you read and none of what you are told.
Here are six fundamental truths about the investment business that are often overlooked that should be remembered.
Tenet 1: The gap between perception or reputation and reality in the world of investing is huge. Think of the difference between a Rolls Royce and a Toyota Corolla. To the uninformed, a Rolls Royce is the ultimate automobile. It has an untarnished reputation. The car symbolizes wealth. It is simply the best car money can buy. But is it? Ask experienced mechanics and you'll get a very different story. The reality is that a Rolls Royce is a gas guzzling, outrageously high maintenance automobile, engineered with luxury, not performance in mind. Now if you want an impressive piece of automotive jewelry, buy a Rolls Royce. On the other hand, for about one-tenth the price, you can get a Toyota that runs forever. The Rolls reputation for excellence is perhaps undeserved or misplaced. In investing, as in automobiles, you do not always get what you pay for. The most expensive is not necessarily the best. And the oldest firms, the household names, frequently deliver a mediocre product.
Tenet 2: It is far easier, through skillful marketing and legal maneuvers, to create the perception of investment savvy than to deliver consistently superior investment results. Virtually every investment firm, if all the facts were known, would be far less impressive than its reputation.
Tenet 3: There is far more money to be made convincing you to invest in a scheme than not to. The makers of the most profitable products can afford to saturate the public with advertising. Investment products are highly profitable, a lot more profitable than selling bars of soap.
Investment firms spend millions pushing their products on investors. Yet investors are not willing to spend much money having those products objectively reviewed. Not surprisingly, the firms that offer truly objective evaluations of investment products make very little money, as compared to investment firms. Also not surprising, the quality of "due diligence" services is not particularly good. The few services that claim to diligently review investments fail to even effectively monitor investment performance, much less compliance, ethics and other considerations. It's hard enough to get reliable information about the performance of a money manager, much less how the manager went about getting that performance.
Think about it: I cannot possibly make as much money telling you not to invest in a hedge fund, an investment product with exceptionally high fees for the manager or marketer, as they can make getting you to invest in a hedge fund. Remember that for every dollar spent debunking financial products, thousands are spent selling those products. As a result, you will seldom hear the truth about a financial product. Marketing dollars at work will always drown out cautionary voices.
Tenet 4: The cast of characters that have a vested interest in the success or failure of financial products that are offered to the public is far broader than you think. Remember legal, tax and accounting opinions, pension consultant recommendations, portfolio manager and broker testimonials, all play a role in marketing financial products, not just slick brochures and advertising produced by the money manager itself.
Enron would have never been possible without the concerted effort of legislators, lawyers, tax experts, accountants, financial analysts, investment banks, traditional lending banks, brokers, portfolio managers, actuaries, and benefit and pension consultants. All of these people stood to make money by supporting the myth that an investment in Enron made sense. It's not just the companies themselves that benefit from perpetuating the illusion that certain investments are good. Lots of professionals make a living providing services to these companies.
Tenet 5: The legal consequences related to making negative statements about financial performance inhibits critical commentary. There are severe limits on how far you can go in telling investors the truth about investment firms and products. We are currently engaged in a legal fight with the National Association of Securities Dealers about publishing the Siedle Directory of Securities Dealers that will give investors critical disciplinary histories of every brokerage firm in the country. This book will allow investors to determine, before they invest with a brokerage firm, whether that firm has violated any laws or regulations and how many times they have been sued in arbitration. All the information in the Directory is publicly available, objective and quantifiable. Why would any regulatory authority oppose such a book? A regulator wouldn't…… but the NASD is not a regulator. The NASD sent us a fax at 10 o'clock Friday night February 22nd saying if we publish this book, they'll sue us.
Why is the NASD interested in protecting brokerages and keeping from the public all the disciplinary problems brokerages get into? The NASD is a strange beast called a "self regulatory organization." Brokerage firms pay money to the NASD to represent them in their interactions with the public and the SEC says as long as the NASD does a half-decent job, it will leave regulation of brokerages to the NASD. Folks, self-regulation doesn't work. Talk about a conflict of interest. It's trusting the wolves to protect the sheep! The NASD is no friend to investors. Make no mistake about it, the NASD primarily exists to advocate on behalf of brokerages, not to protect investors. And every few years the SEC gives the NASD a good kick in the pants. We'll let you know the outcome of the case.
When you hear that two-thirds of all financial analysts' recommendations are "buy" or "hold," as opposed to "sell," there is a reason for this. In addition to the fact that investment firms make money from the companies they review when they issue buy recommendations, there is a risk of suit when you issue a "sell" recommendation. Recently people have started to ask the question of whether you can sue an analyst for pumping up a stock, like Enron, when its tanking. But this is less of a concern than the risks related to hammering a stock.
I don't want to make too big an issue of the legal environment in which we live but keep in mind always that the consequences of publishing a critical review are harsher than a positive review. Companies don't sue you for saying nice things about them. They will sue you if you say something bad-even if what you're saying is true.
Tenet 6: The prevalence of secret, sealed settled cases of fraud and wrongdoing in the money management and securities industry is so substantial as to effective undermine the regulatory scheme. Virtually every lawsuit settlement these days has a non-disclosure provision. The degree of wrongdoing that exists is widespread and unseen. It would turn your hair gray if I could tell you every case I've seen. Just because you don't see it or hear about it, do not assume the wrongdoing is not out there. I often get accused of exaggerating the extent of wrongdoing. Someone might say: prove it. Unfortunately, my answer has to be: I'm not allowed to. So how do you know I'm telling the truth?
Fortunately, there are cracks in the wall of secrecy. For example, recently the NASD has come under a lot of criticism for allowing brokers to "expunge" or erase instances of wrongdoing from their records. The public is becoming aware of the tricks companies play to try to maintain the public's confidence while getting away with scams. You don't just have to take my word for it; there are other commentators out there who are drawing attention to the subject of secrecy agreements that are not in the public interest. You may want to look at an article I wrote called Hidden Crimes; Too Many Secrets: How Money Managers Hide Wrongdoing From Investors.
Now let's get away from general truths to specific characteristics of pension funds, money managers and brokers.
The Inverse or Perverse Pyramid of Regulation
Let's begin with what I call "the inverse or perverse pyramid of regulation." In the investment management and brokerage industries, regulation of those who exert the greatest power over money is the least and regulation of those who exert the least power is most rigorous. Regulation of brokers is the most intense. They are required to be licensed, take continuing education, get fingerprinted, are subjected to FBI checks, and disclose their criminal and disciplinary histories to the public and submit to a mandated supervisory chain of command. Brokers handle retail money mostly, not the really big bucks. Money managers are subject to less rigorous standards. Some are registered with the SEC and some are not. There are minimal licensing requirements, fingerprinting is not required. The disclosure obligations are limited. Money managers have far greater responsibility than brokers for handling money far larger amount of money, yet they are less regulated and may in fact be completely unregulated. It is impossible to be an unregulated, unlicensed broker. It is possible to be an unregulated, unlicensed money manager. They're called hedge fund managers and their numbers are mushrooming today. Finally, regulation of pension consultants, the firms that have the greatest power over the greatest amounts of money, the power to hire and fire managers and brokers, is nonexistent. Pension consultants can pretty much do anything they want and not be accountable.
In conclusion, the inverse pyramid of regulation is a reality that you should keep in mind.
Now for a few related points about regulations and professional standards of the industry. Brokers, money managers and consultants have no minimal educational standards. You do not have to be a high school graduate to be in any of these professions. Misrepresentation regarding educational and professional credentials is commonplace throughout the workforce and the investment industry is no exception.
Regulation of these individuals is not as good as it should be or as good as you think it is. Do not get lulled into a false sense of confidence when it comes to handing money over to people, no matter how professional they may appear and how prestigious their firms may be. Every day the newspapers carry stories about investors who trusted the wrong individual or firm. Do not believe there are regulators out there combing the earth for violators. More often than not, regulators arrive on the scene after the damage has been done. Too little, too late is the general rule. Ask anyone who has been the victim of a financial crime how helpful regulators were. Did they get their money back? Did the criminal go to jail? "No" is probably the answer to both these questions.
When dealing with money managers, it is important to identify the true role or the responsibilities of the individual you are speaking with. Most firms that market to pension funds separate their staffs into three functions: marketing, client servicing and investing. Marketing involves selling to new prospects. Client servicing involves taking care of existing clients. Finally you have portfolio managers or investment personnel who actually managing the money. Identifying the role of the individual you are talking to is critical to assessing the veracity of what you are hearing. Marketers, as salesmen, are far more likely to say whatever you want to hear. Did your firm invest in Enron? Of course not, the marketer may say-before he even checks with the portfolio manager. The client servicing person's role is to merely keep you happy. They are more likely to check with someone within the firm who knows the answer to your question before answering it. Client servicers are not required to be as persuasive as marketers and are not compensated based upon how many clients they bring in. So they are likely to be more circumspect. Marketers and client servicing people are not inherently untrustworthy. Some are particularly good. But if you want a definitive answer on an investment matter, you may need to speak to the individual handling the money. So it's important to identify the responsibilities of the person you're talking to and to ask the right person the right question.
And it is always, always, always advisable to get answers to important questions in writing. I can't tell you how many times in the course of investigations I've asked a portfolio manager questions and had conversations like this:
Q: Have you done any business with ABC brokerage firm?
A: No, never.
Q: Are you sure?
Q: Would it surprise you to know that according to the trading records, you did 98% of your trading with that firm?
A: That figure seems a bit high.
A bit high? I thought he said he hadn't done any! Get answers in writing because anyone in the investment industry may avoid telling the whole truth and answers may change depending upon what's expedient at the moment.
I was visiting a very wealthy family in the Mid-West and the husband wanted me to talk to his wife about how she should invest a few million dollars of her "walk around money." She told me she had just visited her local bank branch and met a very nice young man there who would be managing her money for her. I explained to her that this young man was simply a broker who would play no role in managing her money. Her money would probably be managed in a distant city where the bank was headquartered by a portfolio manager she would never meet. The investment performance she would receive might be good or bad but she had no basis for judging what it would be from her interaction with the nice young man at the branch. Since she did not understand how money managers are structured, she had a very unrealistic picture of how her money would be managed.
Now for some special comments about dealing with pension consultants. Many of you have now or will be approached by brokers from national firms that will offer to do your consulting for free. I have heard trustees from some Florida funds proudly proclaiming they're getting their pension consulting services for free. To this I say to you: I will PAY you a million dollars to be your consultant.
Am I crazy? How can I do that? Because anyone you put in the position to be the gatekeeper of your fund, to control which money managers you hire and fire, can, by virtue of his position, make millions on the side. He'll get every manager you have to do brokerage business with him and set up every kind of kick-back you can imagine. We've seen cases where a consultant has made $4 million a year off a small fund. His fee should have been about $100,000. Yes, folks, I'll pay you a million dollars for the right to squeeze four times that amount out of your managers and your fund. So before you go thinking you're getting a good deal from your pension consultant, you'd better take a good hard look at how he's making his money. The last thing you want is to have it come out in your local newspaper that you've been getting a raw deal and overpaying millions of dollars for consulting services.
In conclusion, I don't want to sound too pessimistic about the investment industry. It's a fascinating, complex world of opportunity. I'd like you to be as excited about investing as you would be if you were going to buy a new car, the car of your dreams. But keep in mind, that a lot of dreams turn into nightmares. When speaking with a car dealer, you would probably keep in mind all the games that are played in the car business. You might read consumer reports and research the model.
When it comes to handing your hard-earned money to someone else to manage, you need to do a whole lot more research than you would on a car. Chances are, you're risking a lot more money than when you're buying a car and it's a whole lot easier to lose that money in the stock market than it was for you to earn it working. Be careful. It's a jungle out there. When it comes to investment matters, you are on your own today more than ever. There are serious problems in the marketplace. The games that are being played by the unscrupulous are becoming more and more complex, thanks to the global marketplace, computers and the internet, accounting tricks and regulatory loopholes. On the positive side, we have more tools available than ever to ferret out the scams. Those of us who would like to help you avoid financial pitfalls are fighting an uphill battle where the legal and regulatory system is often a hindrance. Hopefully, the end result of the rapid period of change we are undergoing today will be that more people will have access to more reliable information than ever before.