The Informed Investor
5 Warning Signs to Recognize Conflicts of Interest
In the United States, about half of all medical doctors accept some form of payment or gifts from pharmaceutical or medical device companies.[1] You are correct if you suspect these payments influence doctors’ recommendations to patients. The results of 36 individual studies showed the same outcome: “Industry cash influences how doctors treat their patients.” The same type of influence affects politics (through lobbying), magazines and newspapers (through sponsored content), and social media influencers (through paid sponsorships). It also, unfortunately, affects the financial industry.
When financial advisors are offered incentives—commissions, bonuses, paid vacations—in exchange for promoting a specific product, their lens becomes clouded. Even if they don’t intend to, they will likely be swayed by those incentives. That was also the case for me years ago when I worked for a commission-based brokerage company. Even though I tried to act in my clients’ best interests, there was always company-wide pressure to push certain investment products. And that creates an inherent conflict of interest.
How can you recognize potential conflicts of interest?
For the average investor, the signs may not be obvious. Companies might expertly conceal fees or obfuscate their sponsors. What, then, is the everyday investor to do? I recommend taking the following five warning signs into consideration:
1. Unclear Sources of Revenue
How does a company make its money? What are the sources of compensation? With fee-only wealth management firms, income is generated through its clients’ fees — often charged by the hour or taken as a percentage of the client’s assets under management. The answer isn’t always so simple for other financial companies. Some companies generate income through commissions, by charging fees for buying or selling securities, or by earning interest on clients’ uninvested cash.
The investing app Robinhood has gained popularity as a commission-free service with no minimums for investing. While that might be true, it must make its money somehow, right? After all, it is a publicly traded company and beholden to its investors who are counting on its continued growth. So, how does it do it? Mainly, it sells customers’ orders to high-frequency trading firms. This controversial practice relies on sophisticated computers and complex algorithms, which can edge out the average trader or cause extreme fluctuations in the market if an algorithm is triggered. The practice itself is not illegal, but removing humans from trading and relying solely on machines can cause plenty of trouble. For Robinhood, that trouble culminated in the Financial Industry Regulatory Authority (FINRA slapping it with a $57 million fine and order to pay $13 million in restitution because thousands of customers were approved for options trading when they weren’t eligible and other misleading communications and trading practices. This was a clear sign that Robinhood was not acting within the best interest of its customers. The lesson here is to be cautious with companies whose revenue sources are unclear.
2. Vague Language or Hidden Terms
Clarity is key when it comes to avoiding companies with apparent conflicts of interest. Does the company clearly outline its fees, terms, and the cost of its services? Or is all that buried in dense legal jargon in terms of services? If financial advice is advertised as free, be wary! The company needs to make money somehow, and those sources of revenue may be hidden away in complicated user agreements.
3. An Offer or Performance That’s Too Good to Be True
In 2008, one of the most elaborate Ponzi schemes in history collapsed, and its mastermind, Bernie Madoff, was brought down with it. For years, Madoff hoodwinked investors into believing they were making consistently high annual returns by investing with his “exclusive” wealth management company, Bernard L. Madoff Investment Securities, LLC. Madoff attracted throngs of investors with his high returns, image of exclusivity, and earning trust and respect in the financial community. However, his client’s assets were not invested in a variety of blue-chip stocks as he claimed but were instead funneled into a single bank account, which Madoff could access at will. In the meantime, he funded investor’s payouts through capital gained from new clients. The scheme fell to pieces during the Great Recession of 2008 when investors began trying to draw on their investments, and eventually, Madoff’s sons reported his activities to authorities.
The Madoff Ponzi scheme was a hard lesson for the many investors who were, collectively, defrauded out of tens of billions of dollars. The crux of the lesson is this: If something seems too good to be true, it probably is. In the case of Bernie Madoff, investors were consistently realizing higher-than-average returns, even when the market was down. This is an extreme example, but it applies to other situations as well. Those who claim “exclusive” or “insider” knowledge that isn’t verifiable are likely spinning yarns and could ultimately be looking out for their own interests above yours.
4. Commissions/Personal Stakes
If a company or individual stands to gain compensation through selling a particular product, that is a clear sign of a conflict of interest. Some commission-based wealth management firms often incentivize their teams with sales contests or push them to sell a certain product. Other examples exist in the financial arena. Bankers might receive a commission for opening a certain number of accounts in a given quarter. Insurance salespeople earn commissions for new clients they enroll in their company’s program. Credit card representatives earn bonuses for getting new members to sign up for their cards. The list goes on.
A few years ago, Wells Fargo found itself in hot water because of the widespread fraudulent behavior of its employees. Bankers had opened over a million unauthorized bank accounts without the customer’s consent in order to meet unrealistic sales goals. Why? Because they were incentivized to do so. Wells Fargo offered quarterly bonuses if the bankers met the company’s ever-increasing standards. To receive their payout, the bankers had to provide a certain number of “solutions” to customers each quarter. “Solutions” could consist of any combination of new bank accounts, credit cards, lines of credit, loans, etc. Driven by this monetary incentive and sky-high company standards, desperate bankers began opening bogus accounts.
Although this questionable behavior may be difficult to detect, a savvy consumer will recognize when someone is pushing a product. If a banker is prompting you to open a second or third bank account when you’ve already said no, you have to wonder, “What’s in it for them?”
Additionally, if you’re working with anyone who earns a commission—from used car salespeople to those selling insurance—it’s a good idea to question their true motives.
5. No Accreditation
Medical doctors are required to take board certification exams every few years to prove their medical expertise meets the current standards. These exams aim to verify whether a physician is up to date with knowledge and skills. And that can literally mean the difference between life or death for a patient.
Financial advisors are not necessarily required to carry specific certificates, but it is telling if they do choose to pursue accreditation. A CERTIFIED FINANCIAL PLANNER® (CFP) designation is earned through rigorous coursework, professional experience (at least 6,000 hours), and an in-depth exam. Ethics is a core pillar of the coursework and is emphasized throughout the process. An internationally recognized Chartered Financial Analyst (CFA) designation is earned through intensive coursework, hands-on experience, and a three-part exam. Adherence to ethical guidelines is also part of earning one’s CFA.
If your financial advisor has accreditations, this usually demonstrates dedication to the field and care for the customer. Look for one or more certifications, in addition to a commitment to the fiduciary standard of care. The fiduciary standard of care requires that a financial advisor act in the client’s best interest when offering personalized financial advice.
When it comes to obtaining financial advice, it is important to look for any conflicts of interest. Is the person being paid a commission? Do they have a personal financial stake in your choices? Are you staring down an offer that seems too good to be true? Are the terms of service opaque or hidden in pages of legalese? Know the warning signs and be on the lookout for conflicts of interest.
References
1. Mitchell, A & Korenstein, D. (December 4, 2020). Drug companies’ payments and gifts affect physicians’ prescribing. It’s time to turn off the spigot. Statnews.com. https://www.statnews.com/2020/12/04/drug-companies-payments-gifts-affect-physician-prescribing/
Learn more about David Bromelkamp
Hello! I’m Dave, the founder and chief executive officer of Allodium Investment Consultants, located in Minneapolis, MN. I am also the author of AdvisorSmart for the Individual Investor: Your Guide to Selecting a Financial Advisor to Get Better Financial Advice. I am dedicated to educating individual and institutional investors about financial planning and investing. When I’m not helping people make investment decisions, I enjoy traveling, hiking and spending time with my wife and family.
The information provided is for educational purposes only and is not intended to be, and should not be construed as, investment, legal or tax advice. Allodium makes no warranties with regard to the information or results obtained by its use and disclaim any liability arising out of your use of or reliance on the information. It should not be construed as an offer, solicitation or recommendation to make an investment. The information is subject to change and, although based upon information that Allodium considers reliable, is not guaranteed as to accuracy or completeness. Past performance is not a guarantee or a predictor of future results of either the indices or any particular investment.