Active retail investors earn lower returns than their passive counterparts—it is a major theme here at Later Living. Today I’ll add one more argument for passive investing: active investing exposes retirees and others to greater likelihoods of dishonesty and conflicts of interest.
Active investors are gunning for superior returns. They hunt for stocks believed to be underpriced (or overpriced), then buy (sell). They hunt for short-term market direction, hoping to buy into an upward moving market and sell at the top. Their costs are high, and through all their active seeking they are vulnerable to the myriad of special arrangements and conflicts of interest that pervades securities markets.
An Edward Jones Story
From 2003 through 2009 I had an account with the investment firm Edward Jones. I bought $5,000 of bonds issued from a large bank holding company. An Edward Jones investment representative rang our doorbell one day as he was walking through our neighborhood making cold calls for new clients. I was impressed with this young man’s gumption and decided to start an account. I had always been a passive investor, but then being retired, I was thinking of becoming more active. I had time, and with years of training in economics, maybe, I hoped, I could beat the market.
During the time I had the account, our representative called every month or two with some new ideas for investment. He invited us to breakfasts, lunches and dinners to hear presentations about the economy as well as special investment products we might buy. Edward Jones would send economists, industry analysts and insurance specialists to these meetings, and we were all made to feel as if we were receiving thorough, up-to-date information about Wall Street, the investment world and the economy. We were among the insiders.
Our Edward Jones representative inquired about my other investments, and I told him I invested mostly in index funds. He replied with something very close to, “Hell, we can beat those index funds hands down.” He then brought out literature on an array of mutual funds from American Funds, recommending them as generally superior.
I took the material home. Soon thereafter I read an article in the Wall Street Journal about the fact that American Funds, Putnam Investments, and selected other fund companies paid Edward Jones to recommend their funds to its clients. The book, “Unconventional Success,” by David F. Swensen recounts the episode. He cites data from a financial consultant that 90 to 95% of the mutual funds that Jones representatives sold were from the preferred list of fund companies that paid Jones for recommendations. According to the Wall Street Journal, favored fund companies also “pay for Caribbean cruises and African-wildlife tours for Jones brokers.”
A client would like to think that brokers make recommendations solely in their client’s interest. In this case, Jones brokers had a substantial conflict of interest, and our representative made recommendations consistent with his own interests. Sometimes called “pay to play,” this conflict of interest is still common among mutual fund companies.
I brought the Wall Street Journal article to the attention of my representative, and he had very little specific to say. He stopped trying to sell mutual funds to me and focused instead on additional bond purchases. I didn’t buy, deciding instead to wait and see.
In 2008 my bonds declined sharply in value and stayed low through early 2009. Edward Jones recommended holding the bonds until mid-2009 when they said, “sell.” My representative relayed the corporate recommendations to me. Following their recommendations, I sold and realized about a 40% to 45% loss of principal. Of course our account representative mentioned the upside—my wife and I would have a plump capital loss deduction on our tax return.
This was a good lesson for me in active investing. Edward Jones recommended mutual funds without telling me or others that the fund companies were paying for access and providing special perks to Jones brokers who sold many such funds—that was a serious conflict of interest in my mind.
The Wall Street Journal recently published an article about special stock research conducted for a select few—”big, fast-money traders” but unavailable to retail investors like most retirees. The WSJ cited a note written by one such specialist about “chatter” that orders for parts used in Apple’s iPad were down, presumably implying that Apple saw declining demand for one of its premier products. Apple stock slid nearly $10 that day, and sources say the note was part of the reason.
Active retail investors, even those spending large amounts of time studying investments, do not have access to such research.
Ethical Lapses, Wrongdoing
In July, Labaton and Sucharow, a law firm that litigates securities cases, published a study of integrity in the financial services industry. The law firm hired a pollster to survey “senior individuals” including fund managers, bankers, analysts, and asset managers in the United States and the United Kingdom. Labaton and Sucharow wanted to know in the aftermath of the recent financial crises whether corporate integrity was “any better today than it was four years ago?”
- 24% of respondents thought rules may need to be broken to be successful.
- Only 41% reported that people in their firms had “definitely not” engaged in unethical or illegal behavior. Twelve percent believed it likely that staff in their own firms behaved unethically or illegally.
- 39% believed it was likely their competitors engaged in unethical or illegal behavior
- 16% said it was “fairly likely” that they would engage in insider trading “if they could get away with it.”
- Only 30% felt the relevant regulatory agencies effectively deterred, investigated, and prosecuted violations.
- 30% believed their compensation or bonus plans pressured them to compromise ethics or violate the law.
- More than 25% had observed or had first hand knowledge of wrongdoing.
- 14% thought their employers were likely to retaliate if “faced with a report of wrongdoing in the workplace,” while only 35% “felt certain” their employers would “definitely not” retaliate.
Yet 86% reported they felt their employers “put the interests of clients first” and 84% felt their companies had strong ethical values.
The survey presents a world in which large percentages of senior individuals in the financial services industry believe rules need to be broken, unethical behavior is fairly common, wrongdoing has been observed, regulatory bodies are ineffective, and compensation plans pressure people toward wrongdoing. When retail investors “go active” and enter that world, the dangers are surely real.
A passive investor buys and holds a representative sample of the entire market, and intra-market gyrations over short time periods are irrelevant. Precisely because such an investor is inactive, he faces less exposure to the risks of special arrangements and wrongdoing.
When I forayed into active investing, even though I owned only one company’s bonds, I constantly wondered what criteria would help me decide how to act on recommendations from our account representative. He usually passed along recommendations from Edward Jones, which consisted of statements like, “We think this stock (or bond) is a good investment because it’s a good company and the future is poised to favor that industry.” Of course I did not beat the market.
With passive investing in index funcs, I know I am buying into the economic growth of the United States and the world, balancing my family’s risk exposure by holding stocks, bonds and real estate. It is a simple and understandable formula. Costs are low, and I am all but guaranteed average market returns.
And I have plenty of time for photography, blogging and motorcycling.