This discussion covers two different models for financial adviser businesses in New Zealand.  The first is where advisers are “tied” and only sell in-house product.  Let’s call this model “restricted advice”. The second is where the adviser is free to select any product in the market.  Let’s call this “independent advice”.

The distinction is an important one because as the FMA notes in a document on its website “vertically integrated distribution models, where a market participant is the provider, manager and distributor of a product, can exacerbate conflicts of interest and result in poor investor outcomes.”  Elsewhere the FMA says “advisers in vertically integrated structures play a key role” to “test the investment information” for in-house product and question whether the products “are suitable for the customer”. 

Advisers play a key role promoting customer (consumer) interests.

What are consumers’ expectations?

What do consumers expect when they go to a vertically integrated bank ¹ for financial advice?  If they are looking for a mortgage then they don’t expect their bank to show them mortgage products from other banks.  If they want to make a term deposit they don’t expect their bank to show them the term deposit rates of other banks. 

Should we consider complex investment products to be the same as mortgages and bank deposits?  The FMA says yes.  They argue a consumer does not go to a bank and expect them to show complex investment products from another provider.  But is there any independent evidence supporting this? 

It seems unlikely that investors associate the manufacture of complex investment products with banks like they do with mortgages. If you ask 100 consumers to name a fund manager, those who could would name “Carmel Fisher” or “Brian Gaynor”.  Neither of them works for a bank. 

When consumers talk to their bank about complex investment products, the consumer viewpoint is very different to a mortgage or term deposit conversation.

A lot of the difference is because with mortgages and term deposits consumers generally have some product knowledge. They know the questions to ask and they can easily access tables comparing providers. 

Contrast this with complex investment products where there is almost total information asymmetry. The adviser has the information and knowledge, while the client is often totally reliant on them.  From a customer perspective the sale of complex investment products is quite different.

This should not be controversial – indeed the FMA website says “information asymmetries are common to all financial markets, with investors usually having inferior information to the financial service providers who offer the product or service.”  The FMA go a step further to say the information asymmetry combined with a conflict of interest can result in something of a disaster for the consumer – “when conflicts of interest are combined with information asymmetries, it can be difficult for investors to know whether a market participant is acting in their best interests”  (note the FMA’s unexpected use of “best interests” – shouldn’t they refer to “interests first”?!)

For these reasons a consumer going to a bank (or any financial adviser) probably expects they will be shown the best investment product, and not simply given “restricted advice” relating to in-house product.  In essence, complex investments are not mortgages.

Can disclosure fix this?

What if the bank adviser hands a piece of paper to the consumer explaining that they will only be sold bank product?  Can disclosure fix the problem?  Probably not.

In New Zealand we don’t have a great track record of disclosing information in a way consumers can easily grasp.  Simply including this information in the adviser’s primary disclosure statement doesn’t help – it may or may not be read.  If it is read it doesn’t explain what it actually means – that the adviser will not look at other product in the market that may be less volatile, cheaper and better performing than the in-house product. 

It is not just the fact that only in-house product is sold that is problematic, it is the implications of this.  The downside of being sold an inferior in-house product is that it may underperform.  Higher fund manager fees of 1% p.a. over 20 years on $100,000 can build up to an astonishing $55,383 difference².  Simple disclosure will not help an investor grasp this.

Here’s a real life example of how disclosure alone cannot fix things.  

Have you ever driven a car to a service station and wondered which side of the car the gas tank is on?  Sometimes you may have had to guess.  But look closely at the dashboard of your car – next to the fuel tank indicator is a small arrow or triangle.  Virtually every brand of car has one, and it tells you if the gas tank is on the left or the right.  This “full disclosure” has been in front of you in possibly every car you’ve driven in the last decade – your eyes will have seen it but you probably didn’t know its significance so it meant nothing to you. 

Too often investment product disclosure is like the gas tank arrow on the car dashboard – there is full disclosure but no one knows the implications.  Simple disclosure of “restricted advice” is not a good fix.

What does the alternative (“best interests”) actually mean?

Critics of the “client best interests” standard say that the duty is so high it is impossible to meet.  An adviser has to research every product in the world and choose the best for the client - a duty that simply cannot be satisfied.

This absolutist approach seems unnecessarily extreme.  Whether the words chosen are “putting client interests first” or “acting in the best interests of the client” or something else, it does not matter.  What matters is what the duty means.  It should be fair to consumers and have substance – it should mean something like:

“As an adviser I am a professional.  I believe my process is objective and independent, and is of the best quality that can reasonably be expected.  I genuinely believe I am promoting my customer’s key interests.  For example from the universe of product available in the market I have selected an approved product list that hand on heart I believe is going to fit best.  If any product happens to be my firm’s own in-house product, I have chosen that product because I believe objectively it to be the best product in the market for my customer”. 

Note how the hurdle for adopting an in-house product should be a very high hurdle. This standard is fair to consumers and advisers.  It is not an impossibly high standard.

Of course hindsight may later prove the investment selection was sub-optimal.  The manager of a bond PIE fund chosen may underperform.  An AUT chosen may have had no currency hedging as the NZD rallied. A global equity ETF may have given large cap exposure while mid-caps outperformed. But as long as the adviser’s selection process was genuine, independent and robust, the standard should be met.  It is not impossible.

Other professionals in almost identical circumstances can comply with a “best interests” duty.  A fund manager building a multi-manager global equity fund owes a statutory duty to act in the “best interests” of unitholders.  This means researching and selecting what the manager sees as the best global equity managers for the multi-manager fund.  If a fund manager can satisfy that “best interests” duty (by selecting what they see as the best global equity managers) why can a financial adviser not do likewise (by selecting the best global equity product in the market)?  The obligations are not impossible.³

Final thoughts

Here are some final thoughts to ponder:

Look from the consumers' viewpoint:  Do consumers understand that the “restricted advice” model is different to the “independent advice” model?  More importantly, do they fully understand the implications of the difference?

More disclosure doesn’t always help:  With complex investment products is there a way that better disclosure can bridge the information gap between adviser businesses and their clients?  (Probably not as we face the “fuel tank disclosure” problem).

The adviser’s standard must be fair to consumers:  Putting “client interests first” or acting in the “clients best interests” does not need to be an impossible absolutist standard.  But it needs to be fairer, more independent and a higher standard than what “restricted advice” currently provides.

What we need in New Zealand financial markets is a sensible and consistent consumer-centric approach to both regulation and our overall industry framework.  Some might describe it as creating “fair efficient and transparent” financial markets.  But does this apply with restricted advice? 

When it comes to “restricted advice” the FMA supports a narrow interpertation of “client interests first”.  Yet the FMA’s “Strategic Risk Outlook 2015” ⁴ clearly states that one of seven strategic priorities for FMA operations for 2015 to 2018 is:  “Aim:  sales processes and advisory services reflect the best interests of investors and consumers.”  Did the regulator just say sales and advice should reflect the “best interests of investors”?  Boom. 

If the FMA’s Strategic Risk Outlook policy is adopted into the Code of Conduct a “best interests” duty would be imposed on investment advice.  Job done!!

John Berry, Director
Pathfinder Asset Management Limited

Disclosure of interest:  John is a founder of Pathfinder and invests in all Pathfinder’s funds. 

Footnotes:

¹ This commentary is not intended to pick on banks – but they are the most convenient example to use for financial advisers that are vertically integrated with a fund management business.  Most banks focus advice around their own investment products  – the key exception is BNZ which to their credit provide “independent advice”. 

² The $55,383 difference assumes one manager returns 6% pa net of fees and the other manager returns 5% p.a. net of fees on $100,000 over 20 years.   No allowance is made for inflation or tax.

³ Note that a fund manager owes a duty to act in the best interests of unitholders as a class while financial advisers owe the duty to investors as individuals. 

⁴ https://fma.govt.nz/fmas-role/what-we-do/strategic-priorities/