Potential Conflicts Within the Investment Industry
The investment industry in America has always been riddled by conflicts. Traditionally, these conflicts were of a simpler nature, out there in the open for everyone to see. As such, it wasn’t very difficult to spot and avoid them.
In this day and age, it’s a different story altogether. Factors like globalization and a massive increase in the number of investment choices have made the industry much more complex. Now, it’s an extremely complicated financial system that has numerous conflicts within itself.
While more experienced and successful investors are better prepared to find their way around potential conflicts, the general populace might not completely understand the situation. This article aims to educate such people about how things stand in the investment industry at present.
Potential Conflicts Within the Investment Industry
In an investment industry that contains numerous financial professionals, intermediaries, products and services to choose from, the best interests of an end investor can often be overlooked. Investment industry agents and regulators are indeed trying to foster more transparency for investors by reducing conflicts. However, even the Securities and Exchange Commission (SEC) does not aim to totally remove potential conflicts. Rather, it’s primary aim is the full disclosure of such conflicts that can ultimately harm end investors.
In such a scenario, the undeniable truth is that there is still a long way to go when it comes to totally eradicating potential conflicts in the investment industry. Let’s take a closer look at some of the major ones.
Cost Savings are not Passed on to Investors
According to a study from the New York University Stern School of Business in 2012, the cost savings achieved in the investment industry are not passed on to investors as they should. Going way back to 1886, the study measured the unit cost of various financial services. In other words, it wanted to measure the cost that investors pay in order to engage with the financial system in America.
The study found out that the annual cost to investors was relatively constant at around 1.5% to 2%. However, the overall income of the financial sector accounted for only 4% of GDP in 1950, whereas it had doubled to 8% by 2010. This statistic suggests that all monetary gains achieved through improvements in technology and otherwise are pocketed by the industry itself instead of being passed on to end investors.
The Proliferation of Financial Intermediaries
One of the primary reasons why end investors are being denied some profits is the proliferation of financial intermediaries who stand in between. Investment advisors, brokers, record keepers and the like add layers to all financial transactions. Several of these intermediaries provide varied services that are paid for by the investors’ funds. In the end, the increasing costs equates to a reduced profit margin for the end investor.
For instance, participating in a 401(k) can involve more than 5 intermediaries – a plan advisor, third-party administrator, record keeper and multiple mutual fund companies. All of these intermediaries are required as they provide necessary services towards a 401(k) plan. However, investors have little or no control at all over how much these services cost. Moreover, most of these services need to be paid for, and the investor is the one who bears the brunt of these payments.
Moral and Ethical Implications
When it comes to commission-based investment products like mutual funds and annuities, the underlying morals and ethics of financial agents can have a massive effect on possible investments. While selling products that offer transaction-based compensation, an agent’s integrity and personal preferences regulate how transparent they are with the investors they are selling such products to.
The ‘suitability rule’ regulated by the Financial Industry Regulatory Authority (FINRA) does require an agent to determine whether the product being offered is suitable for the investor’s current financial situation and objectives. However, at present, the regulation only requires a product recommendation to be ‘suitable’ for an investor, rather than being in the investor’s ‘best interests’.
Compensation Related Conflicts
Another huge conflict in the investment industry is regarding the fees and compensation received by financial agents, especially investment advisors. Generally, such advisors are paid more money by their companies to sell more volatile investments. Conversely, they get a lesser amount of money to put an investor in less volatile investments.
The conflict is obvious here – should investment advisors earn more money by putting investors at greater risk, or should they protect the investors’ money, albeit by receiving less compensation themselves? This can often turn out to be a tough choice for most, and in the event of the former option being chosen, it is the end investor who might have to suffer.
Hidden Fees and Costs
The hidden fees and costs of certain investments can eat away at the profit margin for investors. What makes hidden costs even more dangerous is that in most cases, they are very hard to detect. Investment banks, brokers and other fund institutions are conflicted in the sense that they sometimes don’t reveal all the hidden fees in order to serve their own interests.
As an investor, you have the right to know the exact amount of money that you will have to pay while making an investment. However, many, if not all, companies obscure their fees so that they can quote an affordable upfront price to lure investors in. Only when the investment has been made do they start revealing these ‘hidden’ costs that ‘can’t be avoided’.
To Sum it Up
Ultimately, potential conflicts in the investment industry can lead to reduced quality of information in the financial market. This can create asymmetric information issues, which in turn can prevent the channeling of funds into the most profitable investment opportunities for end investors. Consequently, the financial market and its economy can also become less efficient – a problem that needs to be avoided at all times.
If you are looking to invest, or want more information on the investment industry, do consult top financial advisors today.