Benjamin Felix August 25, 2017 Personal Wealth How does a financial advisor decide what to invest your money in? When a financial advisor tells you what to invest your money in, what do they base their recommendation on? Unfortunately it’s probably not as scientific as you might like to think. Through their regulatory organizations, most financial services professionals are obligated to offer their clients an investment that is suitable. Suitability is a broad term, and there are lots of other factors that may affect the advice that you receive. The advisor’s regulatory body, compensation model, and education can all have a significant impact on what they decide to tell you to invest your money in. In this episode of Common Sense Investing, I’m going to tell you about some of the common ways that financial advice can be affected. In Canada, it is currently up to the investor to ensure that their interests are truly being put first when they are receiving investment advice. Most Canadian financial advisors are held to a suitability standard, rather than a best interest standard – meaning that as long as their advice is suitable, it does not have to be in the best interest of the client. Conflicts of interest are generally subtle, and they are ingrained in the way that many Canadian financial advisors do business. I often hear disbelief when I explain to someone that the advice they have received was likely influenced by an incentive commission for the advisor. Financial advisors do not generally have malicious intent, but they are often in a situation where the nature of their compensation puts their interests at odds with the interests of their clients. A financial advisor licensed to sell mutual funds will often receive a commission of 1% per year on the investment assets that they manage. The advisor also has the option of generating a 5% up front commission at the time that they invest a new client’s assets, plus a lower 0.5% per year ongoing. This is referred to as a deferred sales charge or back end load. The catch for the client is that only funds with high management fees offer this form of compensation for the advisor. Low-cost index funds and ETFs do not offer large upfront commissions. A 2016 report from Morningstar explained that expense ratios are the most proven predictor of fund performance, but most financial advisors are oblivious to the fact that high fee products are likely to do more harm than good for their clients. Their heads are full of attractive sales pitches and compensation incentives from fund companies instead of the academic evidence that should be driving decisions in the client’s best interest. A 2015 report published by the Canadian Securities Administrators found that mutual funds that perform better attract more sales, but the influence of past performance on fund sales is considerably reduced when fund pays commissions. In other words, if a fund pays commissions, advisors continue to sell it even if it exhibits poor performance. When receiving investment advice from a financial advisor that is only licensed to sell insurance, the investment vehicle that they are likely to recommend is a segregated fund. Segregated funds are insurance products that are similar to mutual funds with some added insurance features. The insurance features usually include a death benefit guarantee, maturity guarantee, and the ability to assign a beneficiary for the assets on death. To pay for these features, segregated funds tend to have higher fees than mutual funds. The reality is that the features of segregated funds will not usually justify their significantly higher fees. If a financial advisor is recommending segregated funds, it is likely because that is the only thing that they are licensed to sell, even if it may not be the best thing for you. Any time an advisor is recommending segregated funds, it is important to understand exactly what their reasoning is, and why an index mutual fund or ETF is not a better solution. There are plenty of financial advisors in Canada who are good people with good intentions, and who are trusted by their clients. A significant portion of these financial advisors are in a situation where their advice is naturally conflicted due to their compensation structure. Advisors in this situation will usually do their own version of due diligence in order to justify and rationalize the advice that they are giving. Maybe something like finding actively managed funds with good past performance to justify their higher fees. The single most logical way to decide how to invest your money is by surveying the academic literature and available data on investing. Doing so inevitably leads to the conclusion that low-cost index funds are the best option for most people. The unfortunate truth is that most Canadian financial advisors are influenced by other factors. In my next post, I will tell you if now is a good time to invest. Share: Facebook Twitter LinkedIn Email IIROC AdvisorReport