How do we know we are doing the right thing? Several years ago, I interviewed an industry veteran for a potential role at Iron Capital. I informed him that we had a zero tolerance for ethical violations, and he assured me this was music to his ears. Integrity was the most important thing in the world to him. In fact, he actually referred to himself as Mr. Integrity.
Mr. Integrity was working at Fidelity at the time, and while we were still considering him for a position, we needed his help. I don’t recall the details, but to get what we needed for a particular client, we had to assure Fidelity that we would bring a certain amount of business to their platform. This is not what Iron Capital does; we are not salespeople, so we were not willing to comply with Fidelity’s demands. We asked Mr. Integrity if there was another way, and he suggested that we simply lie: Tell Fidelity that we would do what they wanted, then once we got what we needed, just forget about it. He assured me that Fidelity didn’t even have a way of verifying after the fact.
Everyone thinks of themselves as ethical, but when push comes to shove, most will act out of pure self-interest. Dan Ariely is a professor at Duke University and a pioneer in behavioral economics. In his book, “The (Honest) Truth About Dishonesty,” he presents several studies which prove that most people will cheat if given the opportunity, and that conflicts of interest are stronger than most think.
Our industry is full of conflicts of interest, and regulation has centered around dealing with conflicts through disclosure. Ariely showed that when conflicts were disclosed, the individuals who disclosed the conflicts actually acted worse. His theory is that disclosing the conflict eases their guilt.
There are obvious conflicts in our business, but some are less so. For example, exchange traded funds (ETFs) versus mutual funds. ETFs have grown in popularity, and the reason often stated is that they are less expensive than mutual funds. That is because mutual fund fees include both the cost of managing the fund and the cost of servicing an account: A mutual fund has shareholders who buy into the fund at the net asset value, and the fund creates new shares every time a new investor joins. The fund has to manage an account for each shareholder.
ETFs, on the other hand, are traded on an exchange like stocks. The only disclosed fee is for the investment management as there is no account at the fund level; the account would be at the brokerage firm level. Salespeople tell you that ETFs are less expensive, but that might not be the case. I had a boss who loved to say that costs are like water balloons – squeezing one end simply makes the other end bigger. The ETF does not charge for account servicing; that expense is instead paid for by the cost of trading, which is the dealer spread. The ETF is not necessarily cheaper when all costs are considered, but the administrative costs are transferred away from the fund family and to the broker-dealer.
ETFs are more popular on Wall Street because Wall Street makes more money on ETFs. The idea that they are always cheaper is at best a half-truth, but it is a half-truth that also benefits the business model, so they are widely accepted and pushed by those who benefit. This is how conflicts work.
In our institutional business, there is a trend for consultants to take on more responsibility in managing retirement plans. The wonky term is that they become a 3(38) investment manager, which is a term that comes from ERISA regulation. In plain English, it means the adviser takes discretion to select the fund lineup for a retirement plan. Most argue that the adviser should then be paid more because she has more control and theoretically more liability. The reaction from most advisers is that if they have complete control, then the lineup should reflect all of their favorite options. Historically plans would be customized to fit the needs of a particular plan sponsor, but now the adviser makes the choices, and all of their plans look the same. The rationale is that they should put best-in-class options in every plan, but in reality there is no one best option. The truth is that making every plan look the same drastically reduces the amount of work for the adviser.
Higher fees for less work – that is a pretty big conflict. This doesn’t mean that ETFs are not appropriate in some circumstances, or that picking only the favorites may not work out. It does mean that these types of decisions, and many others, are often more conflicted than we all wish to admit. Being ethical is hard, and it takes a considerable amount of self-awareness. The world would be a better place if we all made that effort. At least that is my perspective.
Chuck Osborne, CFA