Gauging Trust: Are There Objective Measures to Determine Which Investment Advisers Will Act Ethically?
No one would argue with the premise that trust in those individuals and entities who manage investor assets is a fundamental element in any investor-adviser relationship. But how can investors gauge the integrity of the investment professionals and firms they are considering hiring? Are there objective measures of trust that can assist in determining which advisers are more likely to act ethically in the future? Is there objective evidence that ethical behavior by investment firms translates into firm success through achieving better investment returns or gaining and retaining clients? If there are such measures, do investors pay sufficient attention to these factors when weighing their decision to hire investment professionals or do they ignore such factors for managers that have a history of achieving higher investment return? Are clients willing to trade a decrease in performance for the ability to trust their adviser?
In the next few months, CFA Institute will be tackling these issues through collaboration with academics who have addressed similar issues in an attempt to show that the firms that commit to ethics are ultimately more successful, particularly at gaining and retaining clients. The research seeks to examine how both positive signals (adherence to industry codes of conduct, superior disclosure practices, etc.) and negative signals (SEC sanctions, civil suits, criminal proceedings) would be related to relative firm (for public companies) and client performance. The study will also look at how a firm’s commitment to ethics affects client retention/growth.
While not directly measuring ethical conduct, one recent study looked at the relationship between operational risk, including limited disclosure of legal and regulatory issues, in the hedge fund industry using due diligence reports (Stephen Brown, William Goetzmanm, Bing Liang, and Christopher Schwarz, “Trust and Delegation,” Vol. 103, Issue 2, 2102 Journal of Financial Economics). Unethical behavior of firm personnel could be considered a subset of operational risk, with one indicator of unethical conduct being past instances of irregularities. The “Trust and Delegation” work used direct evidence of inadequate or failed internal processes to derive correlation-based measure for operational risk. As stated in the abstract, the paper concludes that operational risk increases the likelihood of subsequent poor performance and fund disappearance, but does not influence investors’ return-chasing behavior. The authors emphasized the importance of verification of information in the context of delegated fund management.
CFA Institute advocates that firms develop a culture of ethics and commit to voluntary ethical standards, such as the Asset Manager Code of Professional Conduct, as a way of illustrating to clients the firm’s commitment to integrity and professional conduct. However, a firm does not have ethics. The personal ethics of individuals within the firm establish the culture integrity of the organization. Firms can enact policies and procedures or adopt a code of ethics to combat unethical persons in their employ, but setting policies and procedures in an effort to model individual behavior is an imperfect method of addressing an individual’s flawed moral and ethical framework. The nature of unethical behavior is that it conceals itself. While a strong indicator of a firm’s corporate commitment to ethics, the existence of a code of conduct, by itself, is not sufficient to prevent unethical behaviors of individuals within the firm.
One obvious red flag would be past instances of bad conduct. Arguably, past instances of working adversely to client interest would show your “ethical” type. Investors should carefully consider the existence of past violations. In this case, the news may not be encouraging. According to a study by Diligence Review Corp., firms registered with the U.S. SEC that handle 90% of managed assets have some issue related to past adverse regulatory events or the firm’s organizational structure. Diligence Review Corp. analyzed the July 2012 SEC Form ADV data from 11,622 registered advisers with close to $50 trillion under management. According to the study, 6,285 managers had either a “red flag” (defined as a “significant adverse regulatory event” disclosed in ADV) or a “yellow flag” (defined as “a potential risk item that a prudent investor would seek to investigate and understand prior to investing”).
Within the context of the principal-agent relationship in the investment industry, investment managers have the motive and opportunity to take advantage of clients for their own benefit if not stopped by their moral framework. Conflicts of interests are inherent in delegated investment management. The existence of conflicts of interest don’t, in and of themselves, signal unethical behavior. However, the burden of proof is on the manager to disclose to clients how those conflicts are managed. Disclosure through regulatory filings such as the ADV is only the start. Full transparency through conflict disclosure should be seen as a signal that the manager is willing to acknowledge and address potential problematic issues. If firms are unwilling to address conflicts or fail to disclose past problems, that should be a strong signal to investors that the firm may not be fully committed to acting in their best interests. Once the warning bell sounds, the burden shifts to investors to engage in due diligence to investigate the alarm to determine if there is a fire, and if the nature and size of the fire is significant enough to leave the building.