The Role of Financial Advisers: What Should Clients Expect?

Categories: Asia Pacific, Asset Manager Code of Professional Conduct, Economics
Tony Tan, CFA

In recent times, there has been increased scrutiny of the role of financial advisers. In Singapore, this has taken the form of the Financial Advisory Industry Review recommendations. In Australia, such matters are under the purview of the Future of Financial Advice reforms while in India it falls to the Investment Advisors Regulation.

However, as these changes in the regulatory landscape are still evolving, what can the client do to take charge of the situation? Because financial advisers are essentially agents of the principal, a better understanding of the role of an agent is warranted.

The Evolution of Agency Theory

According to the most widely referenced paper on agency theory, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” by M.C. Jensen and W.H. Meckling, an agency relationship is defined simply as “a contract under which one or more persons (the principal) engages another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent.”

Unfortunately, the dilemma arises over the uncertainty of whether the agent will, in fact, act in accordance with the wishes of the principal, leading to what is known in scholarly literature as “agency problems.”According to researchers, this arises due to a combination of the human elements of self-interest, bounded rationality, and risk aversion (Eisenhardt 1989) with ineffective enforcement of contractual arrangements (Fama and Jensen 1983).

Scholars’ views largely fall into two categories: the Positivist Agency theory and the Principal-Agent theory. Although both address the same concern associated with the contractual relationship between two self-interested individuals seeking to maximise their individual utility, they differ in approach — the positivist is non-mathematically and empirically inclined, while the principal-agent has greater mathematical rigor but is non-empirically oriented.

In resolving this dilemma, the positivist uses the governance structure to mitigate these agency problems. Meanwhile, the principal-agent approach attempts to solve this agency problem through the design of optimal contracts. By combining both approaches, agency theory is concerned with the protection of the principals’ interests due to these agency problems, which typically are of two forms: a moral hazard problem that occurs when the principal’s objectives are not aligned with the agent’s, and second, when asymmetrical information flow from the agent’s perspective prevents the principal from monitoring the activities of the agent to ensure that those actions are beneficial.

According to Jensen and Meckling , the consequence of the above is to incur an agency cost that represents a monitoring expense for the principal, a bonding expense for the agent, and a residual loss due to conflicting objectives. In the words of Brian Hindley, author of “Separation of Ownership and Control in the Modern Corporation,” there is not much reason to doubt that “if managers are free from the control of the owners, they will divert wealth from them.”

Your Rights As an Investor

As you can see, agency problems associated with the financial advisory industry are not new. So what can you do as an individual investor to protect your rights and interests?

CFA Institute recently launched the Future of Finance initiative, which aims to “to shape a trustworthy, forward-thinking financial industry that better serves society.”

The first product released is the “Statement of Investor Rights.” This was developed to advise buyers of financial service products of the conduct they are entitled to expect from financial service providers. These rights reflect the fundamental ethical principles that are critical to achieving confidence and trust in any professional relationship and are a tool to help individuals get the information they need and the level of service they deserve when engaging financial professionals. Simply put, it tackles the moral hazard and asymmetrical-information-flow problems directly by forcing financial advisers to be on guard that their clients know their rights and expect the agent’s behavior to be of a certain standard. These rights are:

  1. Honest, competent, and ethical conduct that complies with applicable law;
  2. Independent and objective advice and assistance based on informed analysis, prudent judgment, and diligent effort;
  3. The client’s financial interests taking precedence over those of the professional and the organization;
  4. Fair treatment with respect to other clients;
  5. Disclosure of any existing or potential conflicts of interest in providing products or services;
  6. Understanding the client’s circumstances, so that any advice provided is suitable and based on the client’s financial objectives and constraints;
  7. Clear, accurate, complete and timely communications that use plain language and are presented in a format that conveys the information effectively;
  8. An explanation of all fees and costs charged, and information showing these expenses to be fair and reasonable;
  9. Confidentiality of the client’s information;
  10. Appropriate and complete records to support the work done on the client’s behalf.

Demanding that financial professionals abide by these principles helps build trust in the financial professional and/or firm that an individual investor engages, which ultimately will lead to a collective restoration of trust, respect, and integrity in finance. And tools such as the CFA Institute Asset Manager Code of Professional Conduct enables firms to make clear their commitment to adhering to the highest ethical standards and putting client interests first.

It starts with YOU to make that difference!


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