The Fearless Fiduciary: Are Institutional Asset Managers and Their Investors Both Ducking Fiduciary Duties?
October can be a spooky time, and I am worried this month about a scary fiduciary trend. Are private investment funds playing trick or treat with their fiduciary obligations and are institutional fiduciaries (your pension fund, for example) letting them get away with it? The answers are potentially frightening.
You no doubt have heard the clamor about a single fiduciary standard. That is where regulators would come together and require any financial service provider providing investment advice to be held to a higher level of responsibility in how they treat their customers. In short, they would have to act with loyalty, prudence, and care, and act in the best interests of the client. The other, lesser standard in terms of client interests is known as “suitability.” It requires that financial intermediaries like brokers avoid selling unsuitable investments based on the customer’s general investment experience, level of investor sophistication, and risk tolerance. Comparing the two investor protection standards in the context of Halloween, it is like getting a full Snickers® bar compared to a piece of gum in your treat bag.
Eliminating That Duty
All this talk about fiduciaries is playing out in another interesting way as well. First, the CFA Institute Global Market Sentiment Survey continues to highlight “mis-selling” of financial products as the biggest ethical concern facing markets. Investor advocates everywhere want more investment service providers to act in the best interests of clients. Yet, private fund managers like hedge funds are apparently pulling a Halloween switcheroo. Indeed, when you sign up as a client, fund managers offer a baseline fiduciary duty to their investors. But in executing the account contract, there is a concerted effort to remove or exculpate the manager/general partner of the fund from a number of responsibilities and liabilities they would normally offer as a fiduciary. It is like replacing that nice big Snickers® bar with a wormy apple.
We hear the exculpation trend is growing. At a recent event with Simon Lack, whose book The Hedge Fund Mirage gives lots of reasons to avoid these products in the first place, we discussed the practice of legally shirking fiduciary obligations. Now, limiting fiduciary duties through this contractual bait and switch just adds fuel to the fire, the myth of hedge fund investing as Lack he calls it. And it is mainly large institutional investors that are allowing it to happen.
The Other 800-Pound Fiduciary
Like so many things in the institutional investor community, much could be accomplished with collective action. Whether corporate governance demands, the quality of corporate and financial disclosures, or the contract terms with their investment service providers, these dominant asset owners, themselves fiduciaries, could demand higher accountability and standards. By demanding higher ethical and fiduciary protections, whether it’s a hedge fund manager or any other manager serving these large institutional funds, they would protect themselves and their beneficiaries. More importantly, they would contribute to improved trust and confidence in financial services.
There have been a few brave institutions, mostly big ones with strong bargaining power who can dictate their level of protection and contract terms. But the vast majority of both big and middling institutional investors go along to get along, settling year after year for what they can get in terms of investor protections.
Standard Industry Terms
It is time for this movie plot to change. First, let’s conclude the endless debate on a single fiduciary standard, and create a regulatory scheme that is workable and not overly complex. Meanwhile, it is the community of institutional asset owners that could change the level and quality of fiduciary accountability overnight. A proposed move in London to do just that is under consideration, creating bigger, more influential pension fiduciaries in this case.
We urge a re-examination of collective action, beginning with the creation of a standard set of fiduciary contractual terms and conditions that would become a part of every investment service relationship. Clear, concise, with the requirement that clients’ best interests be observed. Buck up and ask for your candy bar back!