Ethics in Investment Management: How to Get It Right

Is investment management a business or a profession? How do you build an ethical culture? And how do you deal with stewardship of client assets, the management and disclosure of conflicts of interest and structuring and reporting fees and compensation? These were some of the difficult questions that experienced investment professionals debated at the inaugural Professionalism Conference organized by CFA Society of the UK in London on 19 April 2013. Here are the highlights.

Building a Professional and Ethical Culture

Giving the opening keynote, Charles Ellis, CFA, said that asset management companies around the world face the same tension between the profession and the business: Should profits dominate the standards of practice, and should business success be a consequence of serving the interests of clients? According to Ellis, the “biggest challenge” for the investment management industry is to “find the pathway to reassert the dominance of the profession over the business.”

Ellis said the best-in-class share similar characteristics: They have an inspiring sense of purpose, place clients’ interests first, focus on teamwork, and recruit only the very best. The one consistent thread across these firms, though, is that they have “superior ethics.” Back in the seventies, Ellis would ask professionals which was the best-in-class firm, and he would repeatedly get the same answers — McKinsey & Company, Goldman Sachs, and Arthur Andersen. Over time, some of these firms have sustained their success, others have not. He said that Arthur Andersen is a “dreadful example” of how the finest of firms can be destroyed from within, and Goldman Sachs will have a hard time getting back to the professional standards it had once achieved.

Ellis remarked that “complexity is a very bad neighborhood for ethics,” and it is easier to get the culture right in smaller private firms that have a single line of business. On building and retaining an ethical culture, he stated that “the ultimate test” for firms is to “see yourself as others see you.”

Stewardship — Serving Clients and Serving the Profession

“Stewardship is a succinct expression of the duty of care [of client assets] experienced by investment professionals,” and “it implies a willingness to do the right thing without expecting immediate reward,” according to the 2013 Annual Professionalism Report by CFA UK. The soft but critical issue of stewardship was discussed by a panel featuring Colin McLean; Natalie WinterFrost, CFA; Guy Sears; and Michelle McGregor-Smith, CFA.

All participants seemed to agree that it is often easier to identify bad stewardship than good, and clients may sometimes be unduly concerned with short-term returns without necessarily adjusting these for risk. Despite such challenges, the panel discussed a number of things investment managers can do to help achieve good stewardship:

• Communicate to clients how variable the performance can be even under the best of investment managers.
• Where possible, invest the time to get to know your clients and their goals, and this will likely be more doable when investment managers also provide investment advice.
• Move from performance-based reporting toward goals-based reporting.
• Stick to good stewardship, even if some clients do not necessarily understand or value it.

The panelists also agreed that the investment profession — and not just individual professionals — should challenge industry practices that don’t serve the clients’ interests.

Conflicts of Interest – Transparency, Management, and Mitigation

Investment management faces an inherent conflict of interest because firms offering investment management services are supposed to deliver financial performance both for their owners and their clients. This also presents the classic principal-agent problem in which the principal (the client) is less informed than the agent (the investment manager), notes the report by CFA UK.

This inherent conflict of interest is made worse by the fact that investment managers are competing against each other to outperform the market when there is considerable evidence that doing so consistently is an anomaly, if not an impossibility.

From the event’s panel discussion — which featured Saker Nusseibeh; Ben Kottler, CFA; Richard Dunbar, CFA; and Charles Ellis, CFA (who also gave the keynote speech) — the following ideas surfaced on how to deal with conflicts of interest:

• Be transparent about the conflicts of interest and how they are managed.
• Align incentives (e.g., by linking investment management fees to long-term performance).
• Complement alignment of incentives with other measures, such as 360-degree reviews within investment teams so that teams are working together.
• At the very outset, agree in writing with the client what the purpose of the fund is, what risks must be avoided, what the realistic aspirations are, and why the portfolio will be structured in a certain way.
• Avoid unnecessary complexity in financial products, as complexity is often used as a pretext for unfair practices.

Fees and Compensation – The Challenges of Alignment and Transparency

“Well-designed client fee structures and manager compensation structures can align the interests of the client and the manager, but poorly designed structures can encourage behavior that is not in the client’s best interest,” according to the report by CFA UK. It goes on to state that performance fees, given asymmetric participation, are often an incentive to act against the client’s best interest. For instance, fund managers whose performance is insufficient to trigger the fee payment may increase their risk taking to close the gap.

The complex issue of investment management fees was discussed by a panel featuring Jeffrey Molitor, CFA; Dan Draper, CFA; and Craig Baker. All of the participants seemed to agree that there is a perception that some unfair fee structures are being used in the industry, but there is no such thing as “a right fee structure” as it depends on things like the objectives of the client. Customized performance-based fee structures can easily become too complex to understand. They often have an embedded call option for the investment manager, and clients may not necessarily understand how much they will end up paying at various performance levels.

The panel raised the following points about improving performance-based fee structures:

• It would help the industry to have a set of principles and standards for creating fee structures.
• Base fees relating to assets under management could come down, covering primarily fixed costs of running an investment management business, and the relative proportion of performance fees could increase.
• Clients should be given complete transparency on what the investment management fees would be at different levels of performance.
• Performance-based fee structures can benefit from using longer-term horizons, high-water marks, and clawback options in favor of the client.
• Clients should also be given disclosure on compensation arrangements for investment managers within the investment management firms.

Regulation and Ethical Culture in Financial Services

Clive Adamson, the director of supervision at the UK’s new conduct regulator, the Financial Conduct Authority (FCA), explained the regulator’s interest in the culture of financial services firms and why the FCA will be assessing it. “Culture is the DNA of the firm,” he said, noting that it shapes “how decisions are made at all levels of the organization.” He was of the view that “in many cases where things have gone wrong — whether it is PPI mis-selling or the LIBOR scandal — a cultural issue has been at the heart of the problem.”

Adamson linked the issues of culture to the erosion of trust in financial services, noting that many customers believe that “the cultural approach of doing the right thing has been lost in financial services.” Having the right culture means financial services firms should earn a profit by serving the needs of their customers and not merely using their customers to maximize profit, according to Adamson. “An effective culture is one that supports a business model and business practices that have at their core fair treatment of customers and behaviors that do not harm market integrity,” he said.

Responsibility for organizational culture lies with everyone at the firm, led by the senior management, and it cannot be delegated to the compliance function, Adamson said. He cautioned that culture is hard to change, and it takes dedicated and persistent focus over many years to change deeply embedded behaviors. Senior management at financial services firms have to demonstrate company values through their actions and support the right behavior through performance evaluation, employee development, and reward.

Integrity First: Advocacy Papers by CFA UK

CFA UK has recently published three advocacy papers on stewardship, conflicts of interest, and fees and compensation. These papers offer case studies and practical recommendations, and they are available free of charge.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.