The Inoculated Investor http://inoculatedinvestor.blogspot.

com/

How do we Regain Confidence in Financial Professionals?

Over the course of the last few years, many investors have lost confidence in financial professionals as a
group. From advisors to money managers, the volatility of the global markets combined with the increasing
complexity of financial products has led investors to question the aptitude of and the incentives that drive
these professionals. At the forefront of this movement to re-examine the value added by the money
management industry as a whole is Vanguard’s founder John Bogle. Through a number of speeches and
interviews, Bogle has been very candid regarding his perception of the failure of money manager to keep
their clients’ best interests at the top of the list of their priorities. In an April interview with Gretchen
Mortenson in the New York Times, Bogle had this to say:

“We [the mutual fund industry] own all this stock but we pretty much do nothing… Given their
forbearance as corporate citizens, these managers arguably played a major role in allowing the
managers of our public corporations to exploit the advantages of their own agency.”

Along with questioning their motives, Bogle blames mutual fund managers and Wall Street analysts for not
being able to foresee the substantial issues that were developing within financial companies as the credit
crisis got more severe:

“How could so many highly skilled, highly paid securities analysts and researchers have failed to
question the toxic-filled, leveraged balance sheets of Citigroup and other leading banks and
investment banks?”

His proposed solution to the above mentioned failures is one that I tend to agree with in principle. The
fiduciary standard in the United States is taken very seriously and those who are bound by this code are
liable for any breaches of their duty. However, institutional money managers do not have the explicit
requirement to act as fiduciaries for their clients. In fact, there are a number of conflicts of interest that
often preclude individuals at certain institutions from acting solely in the best interest of shareholders.

In the face of all this, Mr. Bogle suggests that we force our agents to relearn what being a fiduciary
means. A fiduciary, these managers seem to have forgotten, acts for the sole benefit and interest of
another. We need to replace the agency society with a fiduciary society, he argues.

To achieve this, Mr. Bogle says, the government must apply a federal standard of fiduciary duty to
institutional money managers. This would force them to use their stock holdings as a cudgel, to
demand that directors and executives of corporations honor their responsibilities to their owners.

“We need Congress to pass a law establishing the basic principle that money managers are there to
serve their shareholders,” Mr. Bogle said. “And the second part of the demand is that fiduciaries
act with due diligence and high professional standards. That doesn’t seem to be too much to ask.”

To be fair, there are plenty of money managers who believe they have a fiduciary duty to their investors and
shareholders, regardless of whether there is an explicit obligation or not. Hedge fund managers in the mold
of Baupost Group’s Seth Klarman are often very articulate in their explanations of how they put
shareholders first. The problem is that the fee structures of many hedge funds and mutual funds incentivize
managers to attempt to maximize their own profits, sometimes at the expense of their investors. These
perverse incentives often cause the most devastation at firms that are asset gatherers, use excessive amounts
of leverage, or have limited risk controls. This is why Bogle believes that money managers should be held
to a fiduciary standard. If financial professionals were held personally liable for taking unnecessary risks,
creating conflicts of interest with their shareholders or blatantly acting on their own behalf, then maybe
investors would achieve better risk-adjusted returns and face less risk of permanent capital impairment.

Sounds great, right? We apply the fiduciary standard that exists for many other professionals to money
managers and all of a sudden they are forced to focus on shareholder welfare. Assuming these people are
competent and suitably skilled, this has to be good for investors, right? Maybe holding people accountable
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

would not have completely prevented the current crisis, but one would assume that at least on the margin
this would have been a positive. I sure thought so but now I am concerned that this potential solution may
not be anywhere near enough.

Specifically, in this weekend’s New York Times, there was a fascinating article by Paul Sullivan that makes
Bogle’s somewhat simplistic proposal look inadequate. What if the poor performance of money managers
in 2008 and early 2009 was not all due to volatile markets, conflicts of interest, the lack of due diligence, or
greedy individuals? What if the main driver was incompetence or insecurity?

Mr. Crosby [of Pricewaterhouse Coopers] said the survey questioned managers who advised
clients with $500,000 to $20 million.

Of that sampling, only 7 percent said they felt strongly that they had received adequate training to
complete their job to the highest standard. A little more than half said they felt they had received
some training. What is shocking is the rest — some 36 percent of wealth managers surveyed —
said they believed they were not fully qualified to do their job.

Over 1/3rd of people who worked at the 238 private banks and wealth management firms in the survey
admittedly felt that they were not qualified to do their jobs???!!! That number is astonishing. If this is a
representative sample, it is no wonder that people have lost faith in the money management industry as a
whole. They don’t even have faith in themselves. This suggests to me that the combination of a lack of
training and insecurity among money managers has played a significant hand in the poor performances of
many funds over the last few years. In uncertain markets, people who do not feel qualified to advise clients
are likely to become paralyzed and the inaction that results could be devastating to the portfolios they
oversee. Free falling markets like the ones we saw after Lehman’s crash in 2008 and in the early parts of
2009 are challenging for the most secure and experienced manages. I can only imagine how hard it was for
the 93% of people from the aforementioned survey that did not feel as though they had received sufficient
training.

This data certainly complicates Bogle’s solution to the problems in the money management industry. The
combination of conflicting incentives, poor training, and unqualified managers is a scary trifecta for
investors. In this case establishing a fiduciary standard only would potentially solve part of the problem. If
managers did not have the necessary skills or confidence to navigate treacherous markets and preserve their
clients’ wealth, then all we would end up doing is trying to hold people liable for incompetence. From an
investor’s perspective, there is no difference between losing all of your savings due to a manager’s
insufficient aptitude and his attempt to maximize his own profits by taking on excessive risk. You are out of
luck in either case.

In conclusion, I think the results of the study argue for more training for money managers and potentially
even standardized tests to evaluate knowledge and even temperament. It seems clear to me that in-house
training programs, certifications like the CFA and MBA degrees are not enough to guarantee that these
professionals are qualified to manage millions of dollars of clients’ assets. Maybe along with a fiduciary
standard, the leaders of this country could develop a systematic way to continually teach and challenge
those who we entrust with our money. I know that in some other professions, even experts have to pursue
continuing education courses and take periodic re-assessments of their skill sets. Without some kind of
reform I fear that we are doomed to have money managers who are not qualified to advise clients in the
most benign markets, let alone the turbulent markets that we face today.