Taxing

It is very noteworthy that the Australian government of the day charges all tax payers a commission on their earnings and transactions for the services it delivers to them as citizens. While some argue that the so-called rich and big business should pay a higher share of the taxation burden, undeniably some such stakeholders already subsidise the cost of services to many citizens who either pay no tax at all or very little by comparison. While we will never hear of a government referring to taxation as a ‘commission’ it nevertheless remains that tax is not an hourly based fee – and nor could it ever be – and it’s not a fixed fee. Even the most strident of political conservatives would have to concede that tax is a (very complex) socialisation of the costs of running a nation, of paying for the services governments deliver to their citizens.

With this in mind and considering the deficiencies evident in both hourly and fixed rate fee systems, it really is difficult to accept an argument that asset portfolio based fees are entirely wrong; that they have no place as a charging system in financial advice.

Full information – freedom of choice

In the context of portfolio management, with full information as to how much and when fees are charged, clients can withdraw from the services if they deem them too expensive. If sufficient clients ‘walk’ it is the market speaking. Eventually, sufficient clients leaving and citing excessive fees forces the business owners to adjust their pricing and expenses in order to survive. This is the commercial risk that every business owner undertakes every day; misprice your services and/or under deliver on your service promises and your business’ future will be in question.

Let’s just look back to disclosure – or the total lack thereof – in savings and term deposit accounts (Part 2). There is no disclosure yet banks and the like are charging fees for the services they provide. The Net Interest Margin (NIM) is the principle of income generation by banks across the world. If we contrast Australian bank NIMs in 2015 to NIMs before banking deregulation in the 1980s, then the decline has been quite substantial. Ironically, the decline in NIMs for banks is what largely drove their entry into the personal financial advice arena. They either generated profits from other services or they were out of business due to competition entering the deposit and lending markets and putting downward pressure on NIMs.

In financial advice services, the overriding fee issue is that clients must have full and accurate disclosure of all costs at all times. While this is a first principle of ethical conduct, it is also a legal requirement. With all fee information available, clients of financial services business can run ongoing ‘value for money’ assessments. If they believe they are paying too much they have options; look to negotiate lower fees with the licensee or leave.

The perfect fee charging system?

It does not exist. There is no perfect fee charging method; they are all flawed in some way. They all have advantages and disadvantages for clients and the firm.

Hourly rates can be abused to the detriment of the client and to the lives of practitioners pressured to work hideous hours per week in the hope of advancing higher in the firm based on their billings. Fixed fees have the potential to see lower portfolio clients subsidise higher portfolio value clients and vice versa. Under asset based fees clients pay more in good times and see subsidisation of small portfolio clients by higher portfolio clients. Lastly, asset based fees are open to abuse if advisers recommend investing over debt reduction. There is no form of charging that for results in a ‘win win’ for all parties all of the time.

At law there can be no excuses for disclosure breaches. Disclosure gives clients the information needed to make a value for money assessment at any time and allows them to make a decision to remain as a client, or leave the firm, or seek to negotiate lower fees or even the same fee with increased service levels.

The bottom line is if clients perceive what they pay and how they pay is not good value for money, they will leave. If they’re happy they will remain as clients. It is their decision to stay or leave.

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Asset Based Fees

As the Canberra architects of FoFA went about putting initial and trail commissions to the sword, asset fees became the primary point of contention in financial services. Indeed, they seem to have become the latest demon to infest the financial services discourse; but are asset based fees really as toxic as many commentators argue quite strongly?

Before responding, consider two term deposit account customers with a bank or credit union. One has a deposit of $1 million and the other customer’s deposit is $100,000 and both are invested (loaned to the bank) for 12 months. During the period of the deposits, both customers will likely receive exactly the same number of statements and it’s highly likely they’re sent to the customer electronically. They will both receive a similar letter as maturity of the deposit approaches. Granted that the $1 million account holder might – might – receive a courtesy phone call to advise of prevailing interest rates as maturity approaches, both customers will likely absorb a similar amount of time from the bank/credit union term deposit officer with either rollover or withdrawal instructions. However, they divergence when we consider how much the bank is charging each term deposit investor (the lenders) to find a borrower(s).

Notwithstanding the complexity of bank capital management and Capital Adequacy Ratios, KPMG (2013) reported that the Net Interest Margins of the four major Australian banks were all above 200 basis points or 2% p.a.

So our $1 million term deposit holder is effectively paying say $20,000 per year for a very similar level of service that the $100,000 term deposit customer pays just $2,000 for. That phone call from the bank as maturity approaches has in effect cost that investor another $18,000 a year. One argument to support such a disparity might be that the bank is making more on the $1 million account because, in part, it is removing the risk which would fall to the deposit account holder if she tried to lend directly to a borrower. More to lend equals more to lose if things went wrong.

Assuming the term deposit holder does not withdraw all or part of their holding, the bank will earn the same each year on the deposit – the same 2% or better Net Interest Margin.

Looking now to asset based fees for portfolio management services, I’ve seen such fees range from 0.50% p.a. to an eye-bulging 2.50% p.a. The number is not the primary issue because, ultimately, the market as a whole will eventually pass judgement on whether or not a fee is too high; witness the pressure on managed funds’ MERs over the last twenty years. The issue is the whether or not asset based fees – as a method of charging – are exceptional in the context of the modern commercial and economic environment?

They are not exceptional. Banks and other deposit holders all charge their own form of asset based fees via their Net Interest Margin – the difference between what they (the banks) borrow at from the depositor and what they can earn when they (the banks) lend the money out. The larger deposit customers of such institutions are unquestioningly subsidising the cost of services to smaller account holders from which the banks et al earn very little because there is less to earn a margin from. Quite simply, the larger account holders give the banks greater leverage to make more revenue.

It’s worth noting that the fee – the Net Interest Margin – is never and never will be – disclosed to depositors. Contrast that to requirements under the Financial Services Reform Act (2002) to disclose all fees and charges in writing to clients of financial advisers.

Similar to the subsidisation of service costs which exists in bank deposits, in asset based portfolio management fees, the larger portfolio owners are to some extent subsidising the cost of services provided to smaller portfolio holders. The numbers will vary from firm to firm and portfolio to portfolio but there will always be some measure of cross-subsidy happening in every financial services business.

Under asset based fees, when portfolio values rise through market lift or additional capital from clients, the fee income to the firm rises. Conversely, when portfolio values decline through market falls or client withdrawals, revenue for the firm falls.

The long stated claim of asset based fee chargers is that they share with their client in the outcomes of their advice – their intellectual (portfolio management) property skills. Some will argue that market lift is not IP but, really, it is. If the advice was to have a component of portfolios in the share market in order to attain an increase in capital over time and portfolios do increase as a result, then that is IP. Similarly, if portfolios decline at a point in time, it too is as a result of IP and for the period of portfolio declines the fees paid by clients will reflect the fact that it was the IP which saw the values fall.

Conflicted

One glaring conflict of interest for asset based fees exists when advisers, rather than recommend for example, reducing a home loan or other non-deductible debts, recommend the client invest through the firm which then charges asset based fees accordingly. In this example, keeping the client in debt results in higher fees to the licensee/adviser. Until the passing of Future of Financial Advice (FoFA) legislation, a similar conflict existed when advisers recommended clients borrow to invest and therefore earned a higher fee due to the higher portfolio value through leveraging. That conflict has now been removed by FoFA.

Interestingly, anecdotally at least, we’re seeing some asset based fee charging firms place caps on the maximum fee they will charge higher portfolio value clients. This could be the beginning of a quasi asset/fixed fee model.

In the final of this 3 part series, I’ll discuss how asset based fees are ever-present in other parts of the economy and ask: Could the economy function without them? How could financial services function if asset based fees were banned? And passing I’ll look at how governments help themselves to asset based fees and commissions in order to provide services to tax (fee) payers.

The post All forms of adviser remuneration are imperfect! (Part 2) appeared first on AdviserVoice.

All forms of adviser remuneration are imperfect! Part 1

All of them. None are perfect. Somewhere, somehow, each of them is flawed and some clients pay more than they might otherwise under an alternate method. Under all models, a portion of clientele is subsidising another type of client in very much the same way as bank customers with large balances subsidise small deposit holders. Indeed, this is exactly the same outcome as the Australian taxation system which, arguably, is where the government of the day takes a commission on every tax payer’s earnings, every year.

But back to adviser remuneration – let’s tick them off from the top.

Commission

Commission is gone. Well – not quite. Trailing commissions are still rolling in to the bank accounts of advisers who choose not to rebate it to clients on ‘business written’ before 1 July 2013 but the point is that its imperfections were there for all to see, especially law makers when they eventually got around to looking at them. There were major flaws – read: major conflicts of interests – in the so-called up front commissions system and despite the fact that legislation in the Financial Services Reform Act (2001) required full disclosure of all commissions, including trail commissions, I very much doubt there was ever 100% compliance across the sector. Grandfathered trail commission notwithstanding, commissions are dead and long may they remain so.

Hourly rates – the Holy Grail?

Some of the loudest voices in the anti-commission/anti-asset based fees discourse seem to be those who espouse hourly rates as the morally superior model of adviser remuneration. But is that really the case? The time based fee charging methods are extraordinarily vulnerable to abuse – to overcharging. Quite simply, hourly rate fees lead to inefficiencies which result in overcharging.

Over the years I’ve witnessed some accounting firms charge much higher fees for their work on Self-Managed Superannuation Funds which have higher asset levels. How can it be that a SMSF with $2 million of assets results in accounting fees of circa $5,000 per year when a fund with the same number of members and the same number of investments but with just under $1 million results in fees of $2,000 or so? Where are all the extra hours? More to the point, what were all the extra hours required for?

You might also wonder why, for example, a law firm charges $240 for an emailed three sentence response to a single emailed question. At least my plumber jumps in his truck, drives to my home, looks at the job and drives to his next job before charging me a $240 call-out fee even if he can’t fix it on the spot. You might wonder why both accounting and law firms seem prone to providing estimates of fees for work to be done but that the final cost tends to be in excess of the estimate.

In exactly the same vein as the conflicts of interest embedded in commission based remuneration, hourly rate chargers are conflicted – fundamentally conflicted. The client of an hourly rate charging firm is largely uninterested in how long a job takes. Rather, it’s the outcomes they primarily focus on – the end results of the work they are paying for and the cost of having the work done. On the latter, the more efficiently the service provider can deliver the service the happier the client will be in terms of the fee charged. Yet, it is in the financial interests of the hourly rate charger to prolong – to draw out – the time taken to complete the work. What’s in the client’s interest – an efficient conduct of the work required at a price they believe is reasonable – might not be in the interests of the firm if it means lower fees.

If we start from a presumption that in addition to trust, successful, enduring, commercial relationships should be founded on a ‘win win’ basis, then hourly rates fail – hourly rates are a ‘win lose’ with the client not even on the podium. Right about now the backs of every accountant, lawyer and every hourly rate financial adviser are starting to hunch up as they take exception to a suggestion that they would consciously extend a job timeline in order to raise a higher cost invoice to the client. Years of education and experience in learning their profession suggests to them that they can get client work done at a much higher standard than the next person without that education and experience. But taking offence doesn’t change the fact that the conflicts of interest exist under hourly rates as they do under the commission based model of remuneration.

As a junior lawyer in Melbourne said in her blog several years ago: “My career prospects are threatened because I’m more efficient than most of my colleagues . . . If I can respond to an email in six minutes but the next lawyer takes twenty five minutes, it’s not difficult to work out who will be billing the higher fees for the firm and there goes my upward career trajectory.”

Of hourly rate method of charging by legal firms, in a 2010 Law Week address, West Australian Chief Justice Wayne Martin said: “. . . there are serious problems with time billing in that it rewards inefficiency, encourages lawyers to spend more time, limits customer satisfaction and does not focus on outcomes.”

In 2007, the American Bar Association (ABA) Journal published a paper titled The billable hour must die by Chicago lawyer, Scott Turow. In closing, Turow said: “If I had only one wish for our profession from the proverbial genie, I would want us to move toward something better than dollars times hours.” Trurow’s paper also addressed the failings in hourly rates in terms of the pressure it forces onto practitioners to meet billable hours targets.

It is instructive that as long ago as 1989 the ABA was investigating alternate fee methods and established a task force which released a paper: Beyond the Billable Hour: An Anthology of Alternative Billing Methods.

Applied in an entirely ethical, win win, methodology, subject to what the hourly rate actually is, there is an argument for hourly rates having an application in financial services however it will never be the silver bullet – the solution which reigns supreme over all others.

By any measure, proponents of the hourly rate method for financial services are very late to the game; so late that they have failed to recognise that many in the accounting and the legal professions have acknowledged the flaws in hourly rate billing (both for the client and the practitioner) and are trying to adopt methods which can result in ‘win win’ fee method outcomes.

And it would be naïve in the extreme to believe that in hourly based fee charging licensees, we would not witness a similar deleterious outcome as that experienced by the law and accounting; mounting pressure on advisers to bill more and more hours to boost revenue and profitability.

Fixed Fees

I have been observing and participating in the adviser remuneration discourse for more than twenty five years and the latest method to gain prominence is the ‘fixed fee’ approach. In essence, clients are charged an agreed fee per year under an agreement which makes provision for indexation to, say, CPI. The agreement might also see the planning firm make provision for the right to charge higher fees if the anticipated level of work increases.

One fixed fee system I am aware of sees all clients pay a flat $3,500 plus GST per year. This entitles the client to portfolio management and advice or advice only services. It also sees the firm provide Centrelink application and reporting services under the same fee. It’s not a perfect system. Someone with $100,000 of investment capital (either under advice or not) is arguably paying much more than they might otherwise pay if, for example, they were paying by an asset based fee arrangement. The client with $1 million of capital under management by the firm (or not under management) is clearly ‘free-riding’ on the $3,500 coat-tails of the lower level FUM clients who are paying the same fee.

The first obvious point to suggest is that the $1 million FUM client should pay more. If so, how much more? Twice the $3,500 fee or more again? But then, is the $1 million FUM client really taking up that much more time and resources of the firm than the $100,000 FUM client? Alternatively, is the $100,000 FUM paying too much? If yes, and if the firm were to lower those fees then it’s going to need more clients to maintain earnings. Alternatively, it could lower the fees for the $100,000 FUM clients and increase the fees for clients with larger balance portfolios.

While the above is but one example of fixed fee charging, it nevertheless underscores the imperfections which exist in that method.

Click here to read Part 2 and Part 3 of the series.

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Around 85% of all advisers are associated with product manufacturers and it probably wouldn’t take a forensic examination of the numbers to conclude that the majority of Enforceable Undertakings from ASIC and disciplinary actions from professional associations in recent years have been handed out to the very large licensees and/or their representatives.

While it has been thirty years in the making, in many respects it has been a frenetic rush by the large licensees to accumulate massive amounts of funds under management. In the case of bank owned licensees, the rush was predicated on the deregulation of banking in 1980s; simply put with increased competition in home lending and related margin compression, banks had to find other arenas to generate profit and while the chase for funds under management was but one alternate source for them, it nevertheless has been integral in maintaining and then increasing their profits over time.

In the aftermath of the recent Senate Inquiry into the Commonwealth Bank’s scandalous management of both their planners and the related complaints, many planners might well be feeling they are being ‘tarred with the same brush’.  The news media will only ever tell their consumers bad news and with CBA et al, there has been plenty of it. It is wasted effort to think that at some stage the media will report the good that truly professional financial planners bring to the lives of their clients and their families. It’s never going to happen.

While the very large licensees feature prominently in the public relations damage caused to financial planners generally in Australia, it doesn’t take bad media to create dissatisfaction with the services provided to representatives by a largish licensee.  Advisers who have been in their role for several years might well question the value proposition of representing a licensee which they do not own and over which they have minimal, if any, say.  Areas such as levels of fee sharing and Approved Product Lists are two areas where concerns can arise.  And then there is the declining certainty of Buyer of Last Resort (BOLR) provisions.

So if you are serious about providing genuine professional advice and are tired of having a ‘guilt by association’ air about the business you represent or you are questioning the value for money you are receiving from your licensee, then you have a choice of two options. The status quo is of course the path of least resistance and for many, this is all they will ever want in their career. People who are happy to practice under someone else’s licence and who are happy to not take the burden of liability in the first instance. Note that failure to comply with a licensee’s legal obligations can still see representatives targeted for litigation – by the licensee.  For those who reject the status quo and who are really serious about building a professional services business, there is the option of applying for their own AFSL.

Gaining control of your business destiny

In 1995 at the annual FPA Convention, I presented a paper titled: “Gaining control of your business destiny – becoming a licensed dealer”. Back before the Financial Services Reform Act 2001 (FSRA), licensees held either a ‘Securities Dealer’ or an ‘Investment Adviser’ licence.  As the name suggests, dealers were licensed to ‘deal’ in securities; to arrange the purchase and sale of securities and they outnumbered Investment Advisers who could advise but not ‘deal’ in securities. Dealers could have either a ‘restricted’ licence or an unrestricted licence which generally meant the latter could deal in any form of securities. By contrast, generally speaking, restricted licensees were not able to deal in listed securities. As a side note, you will still often hear AFSL holders referred to as ‘Dealers’.

The 1995 paper was warmly received and criticised in seemingly equal proportions. Some existing licensees spoke against it during question time due to the simple (yet unspoken) fear of seeing their advisers leave and set up their own license. The supporters were advisers who had the reached the point in their career of questioning the status quo of working under another party’s licence.

Ten years later, in 2005, an adviser approached me at the FPA convention and said words to the affect that he wanted to thank me for that 1995 paper because it had prompted him to establish his own licence. At the time of the 2005 convention, he was in a ‘work-out’ period having recently sold his business for a very handsome amount of money. He said that getting his own licence was pivotal to being able to build his business under independent ownership and better prepare if for an eventual sale.

Changing licence eligibility

It’s now twenty years since I first obtained an AFSL (An Unrestricted Securities Dealer Licence in 1994) and the intervening period has seen a significant lift in the eligibility criteria. With the various iterations of the Corporate Law Economic Reform Program (CLERP) and the onset of the FSRA, it has become a more rigorous vetting process by the regulator.

However, it might come as surprise to some that it is far from difficult provided you study the requirements in detail and assess if you and your business can comply.

But first – what does your representative’s contract say?

Many advisers will have restraint of trade clauses in their contracts with their licensees which might have a serious impact on their cash flow once they leave and begin business under their own licence. The first point to make here is to be sure to have your lawyer review the contract so that you can make an informed decision about your situation if you obtain your own AFSL.

Your current contract might have a serious impact of the commercial viability of going out on your own. That said, it might just mean you need to plan how you will survive while you serve out the restraint period. One prominent adviser had a two year restraint of trade clause which he duly planned for in leaving his then licensee in 1997. The very day after his restraint period expired he commenced, with military like precision, a series of advertised seminars in towns and suburbs across the state he had former clients in and, he would proudly tell you, he eventually regained more than 90% of his previous clientele.

The easy part

The easiest part of applying for an AFSL is the application itself. The online form can be progressively saved on the ASIC site allowing you to continue completing the form at any time at your leisure. The key here is to know exactly what type of licence you are applying for. Some issues to consider:

• Will you want to be able to advise on listed securities?
• Will you want to advise on superannuation products?
• Will you want to hold a life broking licence?
• Will you want to advise on bonds and deposit type accounts?

The more difficult part

The more arduous part of the application process is the so-called ‘proofing documents’. These are the documents which you prepare to prove or validate the information you have given on the application form. This is where the largest time component is spent in applying for an AFSL and this is where you need to have a thorough understanding of the relevant legislation in order that you can demonstrate your capabilities and that of your organisation. It is possible for ‘sole operators’ to make application for an AFSL however the ASIC license assessors will be looking at the person’s resource capabilities to meet his/her obligations under the FSRA.

Regulatory Guidelines

In applying for an AFSL you will be referred to various Regulatory Guidelines (RG) and these are essential reading in the process of ensuring you will be able to comply with the requirements of the Acts.

In addition to the three parts of the AFS Licensing Kit, RG 104 Licensing: Meeting the general obligations is an excellent first source of information in assessing whether or not you will be able to meet the requirements of holding an AFSL. In this document you will find information on:

• Key compliance concepts
• Your broad compliance obligations
• Your risk management systems
• Your people
• Your resources

For example, RG 104.21 details how your obligations will be dependent on the nature, scale and complexity of the type of licensee business you wish to operate.

In regard to risk management, RG 104.62 states:

RG 104.62 We expect your risk management systems will:

(a) be based on a structured and systematic process that takes into account your obligations under the Corporations Act;

(b) identify and evaluate risks faced by your business, focusing on risks that adversely affect consumers or market integrity (this includes risks of non-compliance with the financial services laws); 

(c) establish and maintain controls designed to manage or mitigate those risks; and

(d) fully implement and monitor those controls to ensure they are effective.

With reference to the above comments on ‘proof documents’, your proof document in regard to Risk Management would need to clearly illustrate how your AFSL business will comply with ASIC’s expectations. This is where the real workload lies in the overall application process.  In effect, the AFSL application itself will be a dozen or so pages in length whereas the proof documents – in total – will be many times that quantity.

Planning

There are several components to planning to obtain an AFSL and they are essentially split into pre and post licence issuance segments.

The application process will absorb quite some time however with a concentrated focus and disciplined attention to preparing your proofing documentation, it is possible to successfully navigate to a licence being granted within ten to twelve weeks depending on individual circumstances, assuming you have successfully proved your eligibility.

The immediate period after you commence operations under your own licence is crucial. You need to know how your cash flow will be impacted by the change and, in your application, you will need to evidence to ASIC how you will manage your cash flow, both initially and in an ongoing basis. Some of the issues to address include:

• Capital expenditure in the establishment phase?
• If clients are transferring with you to your new AFSL, how soon after commencement will your fees be received and what will the business’ cash flow position be?

Equally important is the need to communicate your change to clients.  Again, to restate, you need to be sure that you are meeting any contractual obligations under your existing representative agreement before communicating with clients.

You will need to have Professional Indemnity insurance cover in place to a level which complies with ASIC’s requirements. If ASIC is going to approve your application, you will be asked to provide evidence that the required level of PI cover is in place.

Licensing Kit

ASIC provides applicants with very detailed information on how to apply for an AFSL in its three part Licensing Kit.  The kit is three downloadable documents which step through the process of making the actual application itself and the preparation of the proofing documentation. It should be the first reference people interested in obtaining their own licence.

Not for everyone

It must be stated: obtaining an AFSL is not for every financial adviser. There are many for whom it is entirely unsuitable. If you are in the business of simply selling investment products then an AFSL is most likely not for you. However, if you are serious about building a business which is owned in every respect by you/your business partners then it might be right for you. If you are serious about compliance and prepared to take on the responsibility for advice and portfolio management for clients, then it could be for you.

For and against

There are arguments for and against on both sides of this discussion. If you are considering your own AFSL as an option for your career, then you need to research the readily available information from ASIC and assess your capacity to obtain and retain a licence. If you proceed to apply, then allow plenty of time to prepare the application and proofs and carefully plan the transition for your business.

While it is easy to stand out from the crowd with your own AFSL you need to be sure to consider your clients in the whole process – after all they need to be the end beneficiaries of any decision to establish your own AFSL or remain as a representative of another party’s licence.

They should come first in all of your deliberations.

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From the introduction of retail unit trusts in the 1980s and the subsequent emergence of master trusts and access to wholesale unit trusts in the 1990s, the underlying theme of this evolution has been one of efficiencies underpinned by cost savings for both product manufacturers and investors. By the early 2000s unlisted index funds, both retail and wholesale, started to garner more presence in advisers’ portfolio recommendations. Roll forward to the second decade of this century and Exchange Traded Funds (ETFs) are now taking an increasing share of the capital deployment route for investors.

So what is it about ETFs which sees them receive a seemingly ever increasing flow of adviser recommendations for clients? AdviserVoice’s Ray Griffin spoke with John Hewison CFP of Hewison Private Wealth (Melbourne), Paul Dunn of Meridian Wealth Management (Melbourne), Tim Mackay CFP of Quantum Financial (Sydney) and Adrian Zoppa CFP of Hood Sweeney (Adelaide) in an effort to identify how advisers are using – or not using – ETFs in their advice to clients. He also then takes a close look at Exchange Traded Australian Government Bonds and how they provide access to government bonds in the retail market.

As the name suggests, ETFs are investments which can be bought and sold on an investment exchange and which can have a variety of underlying asset exposures. Shares both domestic and international, fixed interest (bonds), listed property, currencies and commodities exposure can all be accessed through ETFs. While the first ETF launched in 1989 in the United States was a passive share market passive index exposure, there is an emerging trend for ETF providers to market active funds.

In terms of equity ETFs, perhaps their closest relative is Listed Investment Companies (LICs) in that they are both bought and sold on, in the case of Australia, the Australian Securities Exchange (ASX). However, at that point they traditionally diverged with ETFs typically having been passive index exposure whereas LICs are investing in companies based on research and analysis which complies with the LIC’s investment strategy. Like LICs, ETFs provide low cost access to markets with Management Expense Ratios (MERs) as low as 0.05% p.a.

By early 2014, with the total number of ETFs being traded in Australia approaching one hundred, funds under management had reached circa $10 billion. According to a 2013 survey by BetaShares and Investment Trends, approximately half of the 102,000 ETF investors in Australia were SMSFs.  Globally, ETFs account for around US$2.4 trillion with more than 5,000 funds listed on 59 exchanges. With such numbers, ETFs are anything but the latest ‘fashion of the month’ investment.

ETFs more generally, tick both the efficiency and cost reduction boxes and are increasingly finding favour with both advisers and investors alike.  However one of their drawbacks, some advisers might argue, is that they can deliver exposure to assets which, given a choice, an adviser might not wish to recommend to clients.  In the case of index exposures, it could be argued that an ETF is a quasi-recommendation for all the assets which comprise the index; it’s a case of taking the good with the bad, as the adage goes. For actively managed ETFs it can still be the case that an investor is buying assets which they might otherwise prefer not to be exposed to. It has to be said however that this aspect applies equally to all managed investment products; at any one time a fund of any ilk might hold assets which if addressed in isolation might not carry a ‘Buy’ recommendation from an adviser.

Structure

The emergence of ETFs in the US in the late 1980s saw investment managers transfer components of/their entire share portfolios, heavily weighted to the S & P 500 Index, to fund managers who contracted to track and administer the performance of the holdings over time. The fund manager issued units and there was a relationship between the unit price and the value of the underlying shares.

In effect, rather than administering large numbers of share certificates, which in the US could mean hundreds of share certificates, institutional investors could hold a single asset which was units in a fund. The economics of this delivered lower administrative fees for investment managers.

Source:

http://www.ifa.com/images/articles/etf_concern_diagram2.jpg via http://www.betasharesblog.com.au/etf_creation/

The units are only available to wholesale investment managers; the Authorised Participants. The delineation sees institutions dealing in the wholesale, primary, market and individual retail investors participating in the secondary market.

 ETFs in Australian portfolios

While financial advisers have been using ETFs in Australia for many years, the strategic application in portfolios varies quite markedly.

Melbourne based Hewison Private Wealth specialises in managing and administering portfolios of direct investments.  Founder and Managing Director, John Hewison says his firm has been including ETFs in portfolio recommendations for around eight years. “We have used them for both index exposure to a sector such as REITs for example and for sector exposure such as International Emerging Markets or International Global Top 100 companies. We typically use ETFs in specialist areas where we would find it difficult to get direct access or prefer to utilise an index approach.” He said. “However, our typical allocation is small at around 10% of a portfolio.”

While Hewison Private Wealth will use LICs over ETFs for some sector exposures, Quantum Financial’s Tim Mackay cites the greater propensity for LICs to trade either side of Net Asset Value (NAV) as a reason to rank ETFs ahead of LICs. “We prefer them over LICs as they don’t face the same problem that LICS do of trading at a discount or, less frequently, trading at a premium to NAV.” he pointed out. Quantum Financial utilises ETFs to deploy a so-called thematic investment strategy on a client by client basis with no specific level of portfolio allocation. “We think that ETFs provide the ideal tools to easily and precisely construct portfolios based on asset allocation, enabling us to create efficient portfolios in a modular way as easily as snapping Lego pieces together. And they increasingly cover most asset classes and are cheap, liquid and reliable.”

Meridian Wealth Management’s Paul Dunn however notes that just like LICs there can be occasions when ETFs don’t trade at NAV. “They don’t always trade at NAV like an unlisted fund. Premium and discount factors always need to be considered.” Meridian Wealth’s portfolios can hold up to 20% exposure to ETFs subject to any active tilts in place. “We use them to provide specific exposure towards any strategic theme that we want included within a portfolio like, for example, CTN for microcaps or IOO for large global market caps and the like.” Dunn added. “We like the liquidity and broad based exposure and the biggest advantage is being able to buy and sell directly on the overseas exchanges where a lot more options are available.”

In contrast to the higher and more active use of ETFs at Quantum Financial and Meridian Wealth Management, John Hewison points out that ETFs do not fit Hewison Private Wealth’s investment philosophy. “We generally like to use direct investments so ETFs don’t really fit our broad philosophy of going direct to markets where we can. That said we typically use ETFs in specialist areas where we would find it difficult to get direct access or prefer to utilise an index approach.” He said.

Hood Sweeney’s portfolio allocations are based on a direct approach to assets along with strategic inclusion of managed funds with the usage of both asset types being centred on a value bias. “We’re active portfolio managers but we’re very focused on the long term and fundamental business valuations and we’re keen to understand the likelihood of continuing dividends.” Notes Hood Sweeney’s Adrian Zoppa CFP.  “While we’re yet to make substantial use of ETFs in portfolios, we believe that for some investors there is an argument for low cost, well diversified, equity ETFs that are consistent with the client’s investment strategy.” He added. “The return investors should demand from such ETFs should be at a high risk premium over the risk-free rate and the objective with the equity ETFs in the portfolios is that a 5-10 year time frame is adopted.”

While not all advisory firms are recommending ETFs in portfolios, in 2014 there is no shortage of choice in fund styles. While the original ETF raison d’être had been market cap funds with index or market segment exposures, increasingly so-called smart beta funds are being launched which are structuring funds based on non-market cap factors such as dividend yield and valuations. Put simply, the new breed of ETFs are far less sedentary than traditional market cap funds. 

“We’re closely watching the way this sector is developing and we’re quite interested in the more sector specific ETFs which are coming onto the market.” John Hewison said.

Tim Mackay’s Quantum Financial builds portfolios with as few as eight investments, all of them ETFs. “You can put together a wonderfully simple, diversified, cheap and coherent portfolio based on investment themes such as blue chip shares, broad index shares, high dividend/imputation shares, small cap shares, resources and so on.”

Tactically, Quantum Financial leans toward so-called ‘core and satellite’ construction techniques with cores comprised of diversified low cost ETFs and satellite investments based on high conviction positions in direct shares or funds they see as outperforming. “We see this as the best of both worlds.” Mackay said. “Clients save in fees in the core or passive components and this is complimented with the active satellite positions.”

According to Paul Dunn, Meridian Wealth uses ETFs to complement the firm’s active portfolio management style.  “They provide us with broad based exposure for portfolios as well as themed exposure to complement our active style. They provide very good liquidity especially when gaining exposure to market sectors that are often very thin or limited in size.”

In focus – Exchange Traded Australian Government Bonds (ET AGBs)

One of the more interesting recent developments in the ETF market in Australia was the launch of a facility on the ASX for trade in Australian Government Bonds (AGBs). Up until the mid-1980s, Australians were able to invest in AGBs in amounts as low as $20 via their local bank branch in over the counter transactions (OTC). In some respect, this was a carry-over from the issue of war bonds during the Second World War when citizens lent money to the government to fund the war effort. Some readers might recall the somewhat patriotic, flag waving, television advertisements of the late 70s and early 80s for ‘Aussie Bonds’. For several decades following World War 2, small OTC AGB investments were still possible in bank branches all over the nation.

However, by the 1980s the high cost of administering many tens of thousands of individual investments and the cumbersome, unreliable, nature of raising capital via that method, saw Treasury withdraw back to dealing only with large, authorised, institutions to fund the government’s Bond (medium to long term) and Treasury Note (short term) requirements.  As a consequence, direct access to investing (lending money to the government) in AGBs for the vast majority of investors disappeared. While most Australians had indirect access to AGBs via superannuation funds, life insurance policy statutory funds (i.e. so-called Capital Guaranteed funds) and managed (unit trust) bond funds, the primary market participants were only the very large authorised institutions.

Retail trade in bonds

In late 2012, as a first step in developing a broad and liquid corporate bond market under the Competitive and Sustainable Banking System (2010) policy, legislation was passed to facilitate retail trade in Federal Government Securities. The rationale for the change was to reduce the government’s reliance on foreign funding and a goal of reducing the prominence of equity and property allocations in superannuation funds which can be vulnerable to sharp market value declines with a corresponding sudden lapse of confidence in that form of savings retirement vehicle.

While the ‘paper’ or physical bonds are not traded on the ASX, the rights to the physical bonds are traded electronically as with any other security on that exchange. Austraclear is a subsidiary of the ASX and is the wholesale securities depositary which holds legal title to the AGBs. The holder of an Exchange Traded AGB holds the right to receive all interest (coupons) and principal payments applicable to the underlying bond; the beneficial ownership. This ownership takes the form of a CHESS Depositary Interest (CDI) and it is the CDIs which in effect link the wholesale bond market (institutions) with the retail market.

Types of Exchange Traded AGBs

The two types of ET AGBs are Treasury Bonds (eTBs) and Treasury Indexed Bonds (eTIBs) with each having a minimum one unit which is equivalent to $100 Face Value of the bond over which they are issued.

As with any interest bearing security being traded on an open market, the market price of Exchange Traded Australian Government Bonds (ET AGBs) is driven by its yield to maturity and it is also impacted by the prevailing inflation and interest rate expectations. The market price of the securities move above/below face value in accordance with such expectations.

Making a market

The Commonwealth Bank of Australia, JP Morgan and UBS are the three market makers appointed by the ASX to access liquidity in the wholesale bond market. These participants are also required to provide continuous Bid and Offer prices on all ET AGBs. The market makers must quote a minimum volume of ET AGBs and quote a maximum spread between the bid and offer price which is concomitant with the spread in the wholesale market. At present their obligations include quoting a minimum 50,000 Treasury Bonds and Treasury Indexed Bonds which equates to around $5 million (50,000 x $100) on the bid and offer.

Risk and reward?

The price for the perceived greater security of investing in a government borrowing with a high credit rating comes, in part, in the form of a yield which is low relative to some other types of securities. Governments with high international credit ratings can borrow at lower rates than those with lower ratings. For investors in AGBs this means that while the yield is low the risk of capital loss is low and it is these characteristics which see roles in portfolios for clients with lower tolerance for portfolio volatility.

The above comments about risk notwithstanding, it’s instructive to note that the GFC put an end to the view that government debt is risk free debt.

An ET AGB versus an Index Bond ETF?

As mentioned earlier, the purchase of any fund of investments bring with the possibility that some of the fund assets are, at a point in time, sub-optimal. In the case of an Index Bond ETF, understanding the average terms to maturity and yields are essential to gaining insight into how the market price might perform over time under various scenarios. In the case of an ET AGB, an investor is buying rights to a single bond not multiples of them. There is a single yield to maturity and but one term to maturity. The risk, it could be argued, is easier to identify when compared to a fund which has a bundle of bonds at various coupon rates and maturity dates. Bond fund managers would rightly point to the spreading of risk which a fund with a range of maturities and yields can provide.

In the case of a Global Index Bond Fund there is of course the issue of currency risks – a buoyant AUD and an unhedged fund does not bode well for capital stability.  In addition a global bond fund will, notwithstanding the principles of diversification and risk management, potentially hold government bonds in economies with less than stellar credit ratings.

These are some of the risk-reward trade-offs to consider when evaluating the two forms of exchange traded investments.

Exchange Traded Investments – Summary

For the time being at least, with a tailwind of relatively robust economic data from around the world, exchange traded investments of various types are gaining increased prominence in Australia investment portfolios. Their role in portfolios varies from passive index exposures for minor portfolio proportions to much larger and more active allocations which advisers will look trade as their outlook for a sector or commodity changes.  ET investments deliver reduced costs and under normal market conditions they provide liquidity.

While not strictly a ‘fund’ as advisers know them to be, Exchange Traded Australian Government Bonds provide retail access to investors for amounts as low as $100 per unit.   ET AGB investors do not have legal title to the underlying bond however they do hold the rights to all coupon and principal payments related to the bond.

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So you’re back at your desk and starting to wind up for 2014 after some time away from the inevitable, accumulated, end of year mental fatigue. Last year was a reasonable year in the markets – no major market-wide collapses at least – and with fingers crossed you’re hoping 2014 will at worst be similar.  There’s a new government in Canberra and improving consumer confidence albeit somewhat labile; interest rates remain low and while the December quarter inflation edged up a tad interest rates look stable for the time being. Nevertheless, the RBA still has inflation leg-roped and with glacial like regularity, pockets of good news continue to emerge from the USA and to a lesser extent Europe. But will portfolio construction be that straight forward from 2014 on? And what messages are you giving your clients about the foreseeable future for portfolios?

While portfolio construction and ongoing management is but one aspect of the services provided by an adviser, for many consumers it remains the reason why they seek initial advice and ongoing service. It is, for many, the yardstick by which they measure the value for money they believe they are receiving.  So getting portfolio construction right more often than not remains a central part of an adviser’s service offering.

A changing landscape

Although the Australian economy has run counter cyclically to much of the developed world since the GFC, it’s clear that the dream run might be nearing an end if not already over. Trends from the most recent business and consumer confidence surveys point to the private sector looking further down the road than a change of government, low interest rates and Christmas retail sales.  It (business) is getting well and truly under the bonnet and finding reasons to be concerned.  The rest of the developed world – while less critically situated than five years ago – remains delicately poised between another crisis and a sluggish, elongated, recovery.

Chart 1: 5 years of a downward trend in business conditions. Is business confidence, after a momentary lift in 2013, now reverting to trend? Source: RBA, NAB.

While business confidence surveys have tracked a choppy path since the GFC, over the last three years consumer sentiment measures have been trending upward with associated peaks and troughs.  For advisers, the trend differential between consumer and business confidence measures should be noted.

Chart2: Source: RBA

The parallel of confidence between consumers generally and the value of yearly housing finance approvals (Chart 3 below) results in an almost mirror image of data outcomes in recent years. As consumers leave the GFC behind them up go home loan approvals.

Chart 3: Housing Loan Approvals

Source RBA Chart Pack

While first home buyers, especially those in some capital cities, still appear to be shut out of the market, it’s noteworthy that the value of housing loan approvals appears to have breached the pre GFC peak. In contrast, however, consumer sentiment is yet to reach the pre GFC levels.

Looking at the currency, with the A$ at around $0-90 US and a forecast continued downward trend there might a period of ‘imported’ inflation waiting in the wings which, to some extent, more broadly, should be offset by more competitive pricing of Australian exports.

However, some large companies with decades of drip feeds of government funding, are beginning to sound the retreat while a previously government owned business is now calling for greater protection on international air routes to and from Australia.  Calls for increased productivity and an apparent coalescence of labour pressures in the mining, energy, motor vehicle manufacturing, retail and public sectors and it’s apparent Australians that have a job are going to be asked to do even more in their working week.

Added to this palette of conditions is that the ‘asset bubble’ descriptor is being cast about like confetti for certain investment sectors here and overseas.

Welcome to portfolio construction 2014/15/16…

And for your clients this means?

For your clients this means you need to be reviewing your asset allocation models and run some scenario planning across them.

• What if, the A$ fell to under US$0-80 cents? What does that do to your GDP growth expectations? What does it mean for inflation? What are the implications for international assets – should you be recommending higher weightings to get the currency ‘free-kick’? Or should you not?

• What if unemployment rises (e.g. resultant of mass lay-offs in the motor vehicle industry and the knock-on impact through the supply chain), consumption falls and business investment halts?

• What if the A$ finds some buoyancy and the RBA moves rates lower again in an attempt to reduce the relative attraction of Australian interest rates in world markets? What if still lower rates results in a rush of confidence in the housing sector pushing prices higher again and eventually leading to interest rate rises and a further strengthening of the A$?

• What if the recent December quarter inflation data pushes the interest rate levers toward a rate increase?

• What if unemployment were to hit 10% and what if Australia were to enter its first recession in more than two decades?

• What if… by now you should be getting the picture.

Relatively straightforward portfolio modeling spreadsheet techniques should allow you to understand the potential outcomes of these and myriad other future scenarios.

• What happens to your clients’ income returns and what can you do about it within the risk parameters for clients?

• What about portfolio growth? Will there be any and if so what might the risks be?

In investing terms, income and growth (or the lack thereof) are all you’ve got to show clients over any length of time so it’s crucial that you set your clients’ expectations within the realms of feasible outcomes. And this is the most crucial point; while your scenario planning findings might give cause to alter your portfolio asset allocations, it’s what you tell your clients to expect which will impact most greatly on their assessment of the value they receive from you versus what it costs them.

There is an adage: ‘Under promise and over deliver’ and for financial advisers it should be their morning mantra when they settle into each day’s diary of appointments. As an adviser, you have a very large influence on what your clients’ expectations of portfolio performance outcomes will be. Paint a picture too rosy and you’re going to ratchet up the risk of complaints and losing clients if markets behave in a manner different to what your clients are expecting. Paint a picture of the real world conditions and clients will, if nothing else, see that you’re across your brief of looking after their money.

This is not about being pessimistic – far from it. The overriding goal here is to be realistic with your clients. It’s about understanding what you can and cannot influence.

You have absolutely no ability to influence world economic performance and market returns. You, in isolation, have no capacity to alter government fiscal policy. You have no control over world events. You have no ability to rewrite nightly news bulletins that will greatly influence whether or not consumers – your clients – will be confident or pessimistic. You cannot influence investment decisions made by boards of companies. None of these are within your sphere of influence or capability.

What you can do, however, if you stay well informed about the major economic data for Australia and overseas, is form a view as to what might lie ahead for your clients’ portfolios.  It automatically follows that if you and your colleagues are forming a ‘house view’ on what might be coming down the investment return pipeline for clients, you can then begin to prepare clients for it.

You can be sure of one thing: clients have a great dislike for surprises on the downside of portfolio returns. However, falling values and periods of weak performance are part of the journey of long-term investors so it’s beholden of advisers to get their clients ready for such times.  A disciplined approach to this sees advisers ready their clients with realistic commentary about current conditions, and what might lie ahead, during regular client meetings and presentations and through all written communications.

Walk the walk

That however, is not sufficient – your job is not done until client portfolios reflect the ‘house view’ of the potential economic and market conditions. It’s one thing to be a good, realistic, communicator, but you have to follow through and be a good asset allocator.  While allocation models will vary over different client age groups with younger clients having more time to withstand extended periods of major economic and market downturns, all clients need to be given realistic expectations. Young clients listen to daily news bulletins; young clients get nervous about their financial security and young clients don’t like to be surprised.

No surprises for you

And while we’re on the topic of surprises, you should never be blindsided by economic and market events unless they result from acts of terror or sudden outbreaks of war.   On this point, even the US’s Central Intelligence Agency had no idea that Iraq was going to invade Kuwait in 1990 so there will always be a risk that events can overtake you and your clients’ portfolios.

That exception notwithstanding however, it is entirely possible for every financial adviser (anywhere in the world) to gain great insight into the Australian and world economy through the monthly publication of the Reserve Bank of Australia’s ‘Chart Pack’. Around 80 charts can be downloaded, at no cost, every month and the information can readily form the foundation of how you and your colleagues develop your ‘house view’ of economic conditions and investment trends. That information along with other sources of data can greatly assist in your asset allocation scenario planning.

It could be argued that the most important thing an adviser can do for all her clients is to be realistic with them. While it is the subject for another paper, it’s arguable to that setting realistic expectations for clients is part and parcel of the ethical conduct expected of a fiduciary.

While that might be so, you cannot be realistic with clients unless you understand what’s happening in economies and markets here and internationally. And you cannot be realistic with clients unless you take that information and develop of view of what could lie ahead for clients and then communicate that to them. While nothing is ever guaranteed to occur, better to be have formed a view and prepared clients than for both you and your clients to be blindsided.

Think about it

And one final suggestion. In professional practice, with all the day to day commercial pressures, the daily random noise of market news and commentary, dozens of emails and phone calls, and now the pressure of social media marketing, it can be difficult to find the time to give proper consideration to what the data is telling you.  Take the time to schedule ‘thinking time’ into your month so you really can get an understanding of what’s really going on in the world.  Be that an hour or so or an entire morning, it will be a great investment of time in being able to set clients’ expectations in real terms.

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

The post Portfolio allocations for clients in the ‘real world’ appeared first on AdviserVoice.

Future2’s annual cycling fundraising event starts soon.

Future2’s annual cycling fundraising event takes to the road next month on a 1250 k route from Melbourne to Sydney.  When the Future2 Wheel Classic arrives in Sydney on 13 October, 5,000 km will have been covered in four Wheel Classics, raising hundreds of thousands of dollars to help disadvantaged young Australians towards brighter futures.

The annual fundraising event has attracted sponsorship from AMP Financial Planning (Gold Partner) for a third year, with a number of its planners and staff taking part this year.  Matrix Planning Solutions is Silver Partner for the fourth year running.

Thirty one keen cyclists have signed up for what promises to be one of life’s unforgettable experiences – a challenge of mental and physical stamina that will bring the satisfaction of knowing they are helping some of the most at-risk and in-need kids in Australia.

Each cyclist has set up an online fundraising page and is seeking the support of friends, family, colleagues and anyone who wants to recognise their herculean effort and selfless dedication to a great cause.  Donations can be made at www.future2fundraising.org.au/event/f2wheelclassic2013 .

Of the 31 cyclists:

• 13 have participated in earlier Wheel Classic events
• 3 – Peter Bobbin, Ray Griffin and Roger Simionato – have ridden in all four events
• 9 are riding the whole Melbourne to Sydney route
• 5 teams are participating: AMP Sparks, Bravien Financial, Hillross Bendigo, Les Trois Originals and Milestone Financial

“The Wheel Classic sets a gold standard for innovative fundraising by a professional community,” said AMP Financial Planning Managing Director Michael Guggenheimer.

“The Future2 Wheel Classic is a journey for the financial planning profession as a whole – not just those cycling in the event.  It demonstrates the move towards professionalism for financial planners, reflected also in their long-standing commitment to helping others.  As the ride makes its way from Melbourne to Sydney via Bendigo, Shepparton, Wodonga, Khancoban, Jindabyne, Canberra, Bowral and Wollongong, we will take that message into every community.”

The post Financial planners with a heart – and strong legs! appeared first on AdviserVoice.

(Click here to see CPD: Professional Ethics #1  and here for CPD: Professional Ethics #3)

Graeme is the founding principal of a modest financial planning firm that employs two advisers and two support staff and which has its own Australian Financial Services License.  The firm has just over two hundred clients with around $120 million of portfolios under management.  Many of the firm’s clients have been with Graeme since he established the business in the mid-1980s and as such, are well into their retirement years. He has a very strong professional relationship with his clients and some have become good friends with him.

He regards his nephew Mark as the ‘son he never had’ and they are very close with Graeme filling the paternal void left in Mark’s life after his father died when he was just nine years of age.  Mark is employed with a technology company as its Director of Marketing and he holds 12% equity in the business. The company, ‘TeckEth’, listed on the share market last year with an initial pubic offering that saw 40% of the company sold to investors. The IPO price resulted in a day one market capitalisation of TeckEth of $350 million that saw Mark’s equity valued at around $42 million.

Revised forecasts

However, since listing, TeckEth’s share price has fallen dramatically due to ongoing market concerns about the company’s recurrent failure to meet forecast new product launch dates.  On the back of statements to the market by TeckEth, analysts have revised their earnings forecasts downward and the resultant decline in share price now sees Mark’s equity valued at just $5 million.  In effect the share price has been savaged and the company is going to be hard pressed to meet market expectations unless it can raise $20 million to finalise the Beta testing and subsequent marketing of its new software product.

During their regular ‘last Friday in the month lunch’, Mark explains to Graeme the predicament that TeckEth is facing.  He explains how he believes the company’s share price should return to a substantially higher level once the new software is launched and earnings improve.  Mark delicately raises the question of whether or not Graeme would be able to assist with the raising via recommending it to clients of Graeme’s firm.

Overly pessimistic

Mark goes on to explain that due to falling support for the share price, all of which in Mark’s mind is overly pessimistic, the underwriting broker is not confident of getting all the otherwise modest capital raising filled.  From previous discussions Mark knows that Graeme’s firm manages over a hundred million dollars for clients and suggests to him that a $5 million allocation would represent a relatively small amount of the firm’s overall portfolios.

Graeme explains to Mark that he would need to give the idea very detailed consideration because of the risks involved in technology companies.  As he says that he sees Mark’s facial expression change from one of warmth to one of concern.  It prompts him to say to Mark: “Don’t worry, mate – I’ll see what we can do – but I can’t promise anything – you know that don’t you?”

Subsequently, Graeme begins to think the request through more fully as he drives back to the office.  He knows that there is risk involved with a company like TeckEth but on the other hand, he tells himself, it would be nice to have an investment that is a real winner – an investment that really delivers on capital growth during what has otherwise been a difficult period for portfolios in terms of growth.

Graeme’s clients are mostly retirees and his approach to portfolio construction for them for very many years has centred on allocations to assets that deliver consistent, competitive, income streams in a tax effective manner.  His much-stated mantra to clients of ‘income over growth’ rings loud in his ears as he ponders the discussion with Mark.  He thinks about the extra cash all portfolios have held for several years now and the return on which is declining as the central bank continues its easing program.  He begins to justify such a recommendation to clients on the basis that it would represent a small proportion of portfolios – less than 5%.

Recommendation

Three weeks later and Graeme is writing a letter of recommendation to all clients to apply for shares in TeckEth via the capital raising.  In his advice document Graeme goes to great length to point out that the investment is high risk with no guarantee of success.  He explains that there is a chance that the company could fail completely and that could result in the total loss of capital.  However, he goes on to say that the forecast earnings for the company, once the new product is released, is expected to result in a fully franked dividend of 3.50% p.a. and that this will see the investment fall into line with the firm’s preferred requirements.  Graeme pointed out, in the letter of recommendation, that he too was going to personally invest in TeckEth as he knew this would give clients, particularly the more cautious clients, the final piece of comfort they would need to follow his advice.

In the back of his mind, as he drew closer to completing the letter of recommendation, was the issue of his relationship with Mark.  Graeme knew he was conflicted but justified his actions by the fact that he was also going to be taking the risk – right alongside his clients.

In the following weeks almost all of Graeme’s clients accepted his recommendations and TeckEth was successful in getting all but a million dollars or so of funds required with the shortfall being met by the underwriting broker. After the raising, the share price initially remained relatively stable, in line with overall market movements.

However, several months later the share price moved 25% lower in one day’s trading following Tecketh’s announcement that its Director of Product Development has resigned citing a ‘desire to pursue other endeavors’.  The market knows how to read resignation code and instinctively discounted the share price knowing that there were serious internal problems at TeckEth.  The share price languished for several more weeks while the company commenced a recruiting process and during this time Graeme was under considerable duress as he worried about his clients and the value of their TeckEth holdings.  He constantly agonised over whether or not he should recommend that clients sell their holdings or simply ‘ride it out’?

Mark missed the last two ‘last Friday in the month’ lunches with Graeme and so Graeme phoned him to see if all was well.  Mark was harsh in his criticism of the market’s pessimism about TeckEth and went on to say that he was facing a pay cut because it had become obvious that the product launch would now face further delays.

Graeme, thought it time to front Mark with the question: “Do you think I should sell?” Mark advised in the negative citing the big lift the price should enjoy once the product launched.  Mark claimed that independent analysts have confidentially reported to the board that a product launch that achieves 75% of targets should underpin a substantial lift in the share price – well beyond the IPO price.  On current pricing, on average, clients are facing a loss of around 30% of an investment that originally represented around 4% of their portfolios.

Added complexity

The other adviser in Graeme’s business, Susan, has 10% equity in the firm and has been increasingly concerned about the TeckEth situation.  She is is perplexed as to why Graeme wanted to recommend it in the first instance and why he is now equivocating over whether or not to recommend a sale now.  Susan believed that Graeme had ‘railroaded’ the Investment Committee meeting when he proposed that they recommend it to clients.  She could not understand why Graeme had stepped outside an asset selection process that had been successful for very many years but, as a minority shareholder in the firm, felt she could not override his strident push to recommend it to clients.

Postponed

Over the last three months Graeme has postponed the monthly Investment Committee meetings telling Susan “There is too much on right now – it’ll just have to wait.”  Ordinarily, a matter such as TeckEth would be on the agenda at such meetings and the two advisers would form a consensus view to either confirm a ‘Hold recommendation or a ‘Sell’ in regard to assets on the Approved Products List which were causing concern.

In recent meetings with clients, Susan has found it increasingly difficult to speak with conviction about TeckEth.  Some clients, those who are more attuned to what’s happening in general in markets and who read the daily commentary in mainstream media, have asked her what is the firm’s view on TeckEth given its problems?  She has struggled between telling clients what she really thinks about TeckEth – that they should sell it – and what the current ‘House View’ on the company is which is, based on an Investment Committee meeting four months ago, Hold.

Disclosure, finally

Susan final manages to pin Graeme down to hold an Extraordinary Investment Committee meeting to specifically focus on TeckEth.  As Graeme opens the meeting, she can’t help but notice how reserved he is – how reticent he seems to be about getting the discussion started.  After a minute or so of hesitation, Susan cuts straight through and says: “Look – I’ve got no idea why you wanted to recommend this in the first place but you’re the boss so you always get the final say. It’s bizarre, Graeme, TeckEth is completely left-field of what we normally do for clients – why on earth are we in it?”

Graeme is stumbling to find the words he’s wanted to say for months now but resisted hoping that things would improve for TeckEth and save him from the certain professional and personal embarrassment a full disclosure would cause.  Finally, he comes clean to his business partner and tells her of his relationship with Mark at TeckEth.  She is furious with him but doesn’t say so to him and the meeting concludes with a decision to review the issue next week after, at Graeme’s suggestion, he speaks to Mark again.

A rock and a hard place

That night, as she confides in her husband about the conflicted position she unwittingly finds herself in because of Graeme, Susan contemplates resigning from the firm but is worried about the impact on her 10% equity in the firm.  Over the last three years Graeme has transitioned more than half the clients to her and if she leaves there might be cash flow issues for Graeme’s business if the clients were to follow her to another firm. This would undoubtedly deleteriously impact on the value of her investment in the firm.

Simultaneously, she knows there are restraint of trade clauses in her partnership agreement with Graeme.  She is between the classic ‘rock and a hard place’ – if she resigns on a matter of professional principle she has no certainty of income and risks losing value in her 10% equity in Graeme’s business.  On the other hand, she knows the firm has breached disclosure requirements and that in order to become fully compliant, clients will have to be notified of the conflict. She knows that would jeopardise the professional relationships with clients and the fees they pay which makes the business solvent.

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

The post Professional ethics #2 appeared first on AdviserVoice.

(Click here to see CPD: Professional Ethics #2  and here for CPD: Professional Ethics #3)

The series is Case Study based on blends of real situations as recounted by advisers.

James and Sarah have been your clients for several years now and came to you seeking advice and ongoing management of their SMSF investment portfolio.

While you have provided them with several Statements of Advice to apply a portion of their sizeable cash holding within the fund to investments from your Approved Products List, to this point they have failed to implement all of your recommendations.

Your firm is being paid more than $5,000 in fees per year in accordance with the agreement however there is little evidence – in terms of asset allocation – that correlates your advice to the portfolio structure.  There are several real property assets along with unit trust holdings within the fund all of which you have had no input to in terms of their appropriateness for the clients’ objectives.

When the dilemma first became more prominent in your thinking, you phoned the clients and explained that you are not really comfortable with the situation – that you feel as though you’re being overpaid. The clients remarked: “No that’s fine – we’re happy with what you’re doing.”

However, with increasing unease, you remain concerned about the situation. Since that discussion, on several occasions, you have explained to the clients that they are effectively paying you to manage cash and suggested they are not getting true value for money.  However, the clients continue to insist they are happy with the current situation and don’t wish to change it.

To compound the situation, the clients have now moved overseas for several years and you are now required to deal with their Power of Attorney who is Sarah’s nephew, David.  The clients have requested that all correspondence be addressed to them care of David who – they have said – will act for both of them if required.

Commercial issues
Backgrounding the situation is that you and your business partner have become increasingly concerned about overall revenue for your business.  There has been an above average level of client attrition with the subsequent revenue consequences.

With difficult market conditions persisting, client retention has become the main focus for the business and you are implementing a program to ensure client service delivery and client retention.  This is a 180-degree turn-around from the major focus of increasing client numbers that emerged from your annual strategic planning retreat with your business partner and staff.

Following the retreat a plan was implemented to better utilise the new client potential that sits within the network of family and friends of existing clients.

To this end James and Sarah have a strong circle of influence among their family and friends. You sense that in time this might lead to some of these people seeking advice from you and this would be good for the business.  You could choose to retain them as clients and thereby retain the opportunity to have some of their friends/family members become clients.

An inheritance?
In your last review meeting with the clients, Sarah explained that her elderly mother was quite unwell with Parkinson’s Disease and likely has just a few years to live. Sarah went on to explain that she, as the sole beneficiary of her mother’s estate, is likely to inherit several million dollars in due course.

Sarah went on to remark: “… and when that happens we’ll get you to manage that money too.”

Risk to your business?
While you are concerned about the ethical elements that are embedded in this situation, you also recognise the inherent risks to your business in continuing under the current arrangements with the clients. These risks centre on, for example, potential litigation that might arise if the clients were to claim you should have advised them not to invest in a particular asset(s).

You are conscious of the many and varied costs associated with an action by an aggrieved client including damages, if found to be negligent; time costs from dealing with the claim; stress and anxiety of the process even if you are not found to have been negligent.  Regardless of the outcome of such claim, you also know there could be damage to your professional reputation in your community and there could be an impact on all employees of your firm.

Turn a ‘blind eye’?
You explain your dilemma to your business partner and point out the difficulty in meeting all stakeholders’ priorities. The clients want to keep paying fees at the current level; the firm focus is on client (and fee) retention and you want to do the right thing by all parties.  Your business partner argues that you should ‘turn a blind eye’ and act on the clients’ instructions – after all, they did say they are happy and don’t want to change the current situation.

Some options
You have reached the conclusion that there is no perfect outcome in the situation, given the clients’ determination to buy and sell assets as they wish.  So you think about what your options are and justify them as follows:

1. Keep accepting the fees and stay entirely with the current situation – after all, there is the push from management to retain clients.
2. Terminate the agreement now without further discussion with the clients – this will fail the ‘client retention’ test but will reduce litigation risk to you and your business partner.
3. Seek to re-arrange the service agreement with the clients to better reflect the services being utilised. However, this will result in reduced fee income for your firm.

So the key points are…

• The clients are not following your advice
• The SMSF has assets on which you have not advised the clients
• Your firm is being paid $5,000 + per year for professional services
• You and your business partner are heavily focused on client retention and service delivery resultant of the current above average level of client attrition
• Unless her mother changes her Will, Sarah is to receive more than $2 million inheritance when her mother dies
• David and Sarah have a strong circle of influence which in time should result in new clients for your firm
• You have been requested to deal with an, as yet, unseen nephew for all matters
• You are meeting all the agreed service obligations – eg meetings, reports etc – whenever the clients will allow you to
• The clients seem very happy to keep paying the fees

The primary dilemma
There are several issues at play here – not just the $5,000 per year in fees this year and beyond but also the prospect of acquiring new clients via the clients’ spheres of influence along with the prospect of a large inheritance for Sarah.  Added to these aspects is the potential risk to your firm from the clients or, indeed, their estate if they were to die.

However, the primary ethical dilemma facing you right now is: Should you go on collecting more than $5,000 per year in fees for managing and reporting on cash?

or

Should you forego the fees and terminate/modify the service agreement with the clients?

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

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When the 2013 Future2 Wheel Classic hits the Melbourne to Sydney road on 5 October, dozens of ‘virtual’ cyclists from the financial planning community may have covered the distance already –  cycling the 1250km in 10 weeks rather than 9 days.

Future2, the foundation of the Australian financial planning profession, today launched the inaugural Future2 Virtual Wheel Classic, calling on cyclists to sign up to help raise money for disadvantaged young Australians.  The Virtual Wheel Classic shadows the ‘real thing’, allowing cyclists to cover the distance in the gym or on the road.

Registrations can be made online from today for a fee of $100, which includes the cost of a Wheel Classic branded cycling jersey.  Cyclists may opt to ride any number of days and must cover the distance between 1 August and 13 October (the final day of the actual Wheel Classic), logging their progress using Strava software.

Each Virtual Wheel Classic rider will be invited to set up a fundraising page and to raise at least $300 – helping Future2 reach a $170,000 fundraising target set for this year’s event.  If they raise over $500 their registration fee will be refunded – or can be returned to Future2 as a tax-deductible donation.

Ray Griffin, a founding trustee of Future2 who, with fellow trustee Peter Bobbin, was the inspiration for the event and rode in the 2010, 2011 and 2012 Future2 Wheel Classics, thanked Helen McCarthy of Think SMSF for the idea of the virtual ride.

“Helen is one the cyclists out there who really want to be involved and raise some money for Future2 but can’t join us in October”, Ray said.

“She has already signed in as our first Virtual Wheel Classic rider and we hope her passion for cycling and desire to raise money for Future2 and disadvantaged young Australians leads the way for lots more to do the same,” he added.

Future2 Chair Steve Helmich said, “The cyclists who commit their time and energies to training and participating in the Future2 Wheel Classic – and the Virtual Wheel Classic – are not only making an important philanthropic contribution, they are fostering widespread respect and trust in the financial advice profession.  We salute their efforts, and the individuals and businesses that have the vision to support them with donations and sponsorship.”

The 2013 Wheel Classic has attracted the support of AMP Financial Planning as Gold Partner and Matrix Planning Solutions as Silver Partner.  In addition, it has the support of:

• Ride with Velosophy – Cycle Coaching partner, who offer free coaching for all registered cyclists
• Tom Kerr Auto Centre, West Ryde – Support Team partner, contributing two escort vehicles
• Shepparton Tri Club – Support Team partner, contributing a purpose-built cycle trailer
• Victoria Wealth Management – Support Team partner, contributing a 4WD and Hari Maragos’s invaluable time
• Aspen Parks – Accommodation partner, contributing a night at the Boathaven Holiday Park in Wodonga.

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