The limitation of relying on advisor designations
In light of highly public cases involving financial advisors disappearing with client money, multiple articles have been written recently on conducting proper due diligence in hiring a financial advisor. Many of the articles start at the same first principles: hire a financial advisor who have accredited designations issued by regulatory bodies. While I do not dismiss this step by any means, there is a structural issue that limits a reliance upon designations as an effective shield against hiring a bad advisor.
Most professionals in North America (lawyers, doctors, accountants, finanacial advisors) are self-regulated. This means, in essence, the members police ourselves; the alternative is to allow the Courts or some other tribunal compromised of non-members to regulate a profession. What most members of the media and public don’t know is that it takes years before a member is disciplined with full public disclosure.
Some of it has to do with simple bureaucracy, some of it with due process and some of it has to do with the need to self-perpetuate the profession. My colleague, who once sat on the disciplinary committee of the Law Society of Upper Canada (the body that regulates Ontario lawyers), once told me that the Law Society of Upper Canada gets upwards of 100 complaints a day. Most are considered by staff to be frivolous, some are investigated and no further action is taken once a lawyer responds and, probably 1-2% do require some disciplinary action.
But the typical process does require that the lawyer and client attempt to work out the issue themselves first before coming back to the regulators. If a breach of the rules of professional conduct is alleged and there may be grounds for such allegations, a thorough investigation has to be conducted with a presumption of innocence (but, in the legal profession, the lawyer bearing the burden of showing he/she acted within the rules). If the investigation finds there is some breach of the rules, typically, a proceeding has to be initiated, a disciplinary board struck, a hearing heard and then a decision delivered and a right of appeal granted.
This process can literally take years. As I stated before, 98-99% of the complaints do not have sufficient grounds to proceed past either “no action required” or a questioning of the lawyer with a satisfactory answer. In the 1-2% of cases where some action is warranted, the lawyer can continue to practice until a decision is rendered (although, in some cases, with restrictions).
I am going to suspect the bodies that regulate the various financial advisory designations work in a similar manner. I am also going to assume that 98-99% of advisors work within their rules (performance and acting ethically are two different issues) and that the Madoff’s of the world are exceptions rather than rules (which is why they make the news, the media does not report on the ordinary, only the extraordinary).
This means, in a worst case scenario, an advisor who is eventually found crooked could continue to add more clients during the time he/she is under investigation (unless they are a terrible crooks and their crimes are easily discoverable). In other words, there is a time period where the public continues to be exposed while the regulators investigate (and fraud is a difficult thing to find).
The credit-crisis also highlighted the down-side of self-regulatory bodies. The regulators are being paid by the same people they are policing. If you bite the hand that feeds you too much, suddenly, you are not being fed much anymore (most securities regulators are paid filing fees for every document filed). Everyone knows who butters their bread and respond, unconsciously or not, accordingly.
Thus, a poor run regulator prosecutes the obvious injustices but takes it easy on the grey areas. Practically speaking, poorly run regulators kowtow to the larger players in the market since they pay the most fees and have the most political power.
It is, by no means, a perfect system but we do not live in a perfect world. However, my point being that a simple fall back to “hire an advisor who is regulated with some body” as a perfect shield against bad advisors is too simplistic (this argument is under-cut even greater since, starting Sept. 28, all persons who sell securities in Canada, regardless of province, will have to be registered with securities regulators under a designated class under National Instrument 31-103).
What I would suggest is to build on the designation and add the following:
- Hire through word of mouth. Most of the great advisors I know (and there are many out there) rarely advertise and are not with big shops. They are in niche shops (think the Jerry Maguire mission statement: less clients, more service) and build their books through word of mouth. The key is to ask how may bear markets the referral source has been through with the advisor. Remember to judge people when times are bad.
- Ask to interview their clients. Professionals don’t like telling you this but they niche (it is good business sense). I have met advisors who love clients that trade or only want clients that buy mutual funds. If you interview their clients and ask about what the advisor recommended, you get a better favor of their working style than any beauty contest can yield.
- Really interview them as people. Do they appear grounded? What do they do on the weekends? What do they want out of life? Do they have expensive hobbies? Its like dating- ask enough questions and you may get back some scary answers. How one lives their lives comes through in their practice style.
- Ask them to build you a hypothetical portfolio. If you see a lot of products you don’t understand, it is not a good sign.
- Taste test. Give them only a part of your portfolio and tell them that. Give your advisor targets to aim before you move more assets over. Keep them hungry.