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Ask the investor: Understanding Possible Conflicts of Interest

By Special to The Repository

Posted Jul. 28, 2014 at 7:00 AM

Financial advisers are compensated by commissions. They make their living by selling financial products to their clients. Many investors believe that this form of compensation creates an inherent conflict of interest since a financial adviser may be inclined to recommend products that generate the biggest commissions for himself rather than what is in the best interests of his clients.

Investment advisers, on the other hand, offer fee-based investment advice. For example, an investment adviser may charge a fee of 1 percent of assets under management in order to manage his clients’ money on an annual basis. This form of compensation helps to eliminate any potential conflict of interest since there is no incentive for the investment adviser to recommend any particular financial product.

Another conflict of interest involves the sale of proprietary products. Many banks and brokerage firms offer their own proprietary mutual funds. From my experience, proprietary mutual funds tend to have higher annual expenses and generally produce subpar performance results compared to their non-proprietary counterparts.

So, why do financial advisers sell them? There are basically two reasons. The primary reason is that the management fees (usually around 1.2 to 1.3 percent per year) will be earned by the bank or brokerage firm rather than another mutual fund company.

The second reason that financial advisers are encouraged to sell their firm’s proprietary products is that the client’s account is not as easily portable. In other words, the client cannot transfer proprietary mutual funds to another brokerage firm. If the investor wished to change brokerage firms, he would have to sell the funds at either a gain or loss and then transfer the cash. This could create either a taxable gain or loss in a non-qualified brokerage account.

Doing business with a financial services professional, who has any sort of sales quota, may also create a conflict of interest. For example, insurance agents are often appointed with a number of different carriers. However, many insurance companies require that an agent submit at least a minimum amount of business to them each year — otherwise, the agent’s appointment will be terminated. If the agent has not met the sales quota towards the end of the year, then he may be inclined to recommend a particular carrier’s product to his clients — one that he may not usually recommend if he didn’t need to meet his quota.

Finally, some accountants and attorneys get licensed in order to sell insurance products and securities to their clients. This creates a tremendous potential conflict of interest since their clients initially provide them with their personal financial information for a reason (i.e., preparing an income tax return or drafting a will or trust) other than to be advised to buy financial products. Their clients should be notified ahead of time if the accountant or attorney will be acting in another capacity.

There are a number of ways that conflicts of interest may arise when doing business with financial services professionals.  The above examples are certainly not a comprehensive list. But it is important for an investor to be aware of these potential conflicts so that he or she will know whether or not their best interests are being put first.

Terry Riffle is the managing principal of Paramount Capital Advisers, LLC, in Louisville. Have a financial question for Terry? Email terry@paramount-ca.com or call 330-915-6114.

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