Talking About Risk? Advisors, Industry Must Do Better
While some financial advisors can be intentionally vague when detailing embedded risks to clients, others do not fully understand the risks themselves, says the author of a new book that looks at the "incestuous" relationship between Wall Street, Washington and regulatory agencies/
Either way, advisors must better explain to clients the many types of risk embedded in their investments, according to financial planner Larry Doyle, founder of DM Income Advisors, in his new book In Bed With Wall Street.
The lack of clarity about risk is pervasive within the advisory industry and the financial industry more broadly, says Doyle, who has held a number of sales, management and trading positions at investment banking firms for the past 30 years at companies such as Credit Suisse, Bear Stearns, Union Bank of Switzerland, Bank of America and JP Morgan Chase. For the past four years, he has focused on the financial advisory space, where he currently manages his own practice. Most investment offerings and financial products are intentionally vague in terms of detailing the true embedded risks, he writes in his book. Disguising risk is an art form on Wall Street. Bankers are exceptionally creative in structuring products that seem attractive to investors while simultaneously driving revenue for their firms. Someone with institutional expertise might be able to spot where the risks lay, but retail investors and often even retail brokers are hard pressed to do the same."
According to Doyle, these issues permeate the industry and flow down to advisors who are the connection to the clients. The onus is on advisors to abide by their fiduciary duty and better communicate risks to clients.
"Wall Street, Washington and regulatory agencies are so closely aligned in promoting and protecting each others interests at the expense of investors, consumers and the American taxpayer," he explains, citing the Madoff scandal as the most obvious illustration of that relationship.
The advisors are ultimately the final point or outlet in a system that has deeply embedded problems that go straight to a lack of disclosures and transparency, says Doyle. This makes the job of the advisor exceptionally challenging and often they are conflicted in properly serving client interests.
From RIAs to wirehouses to banks, advisors want to get something sold they're salespeople, says Doyle. "Advisors of all types wear two hats: they want to engage clients and they want to be compensated."
Some advisors are intentionally vague because of the compensation system they operate under, according to the author. Often advisors operating on commission, which is more common in the wirehouses, are more vague but transparency comes down to the individual advisor as opposed to the system or type of advisory firm they operate under, he continues. "Sadly, many advisors are suffering because wirehouses and broker-dealers get painted with a bad brush, so they are dealing with reputational damage that has nothing to do with their own advisory practices."
Additionally, management will often push advisors to conduct business with existing clients, Doyle says. With little meaningful benefit for the client, this activity can generate significant payouts for the advisor and in turn the manager, he notes, based on discussions with advisors who have witnessed the activity firsthand.
An excerpt from the book, released Jan. 8:
Investors are typically left to the mercy of their financial planners and brokers to interpret the finer points of a wide array of investment offerings. Even if you can find the disclosures embedded in a prospectus, being able to properly interpret and understand them is something else entirely, especially for retail investors.
Doyle proposes that all advisors institute an outline of risk parameters with every client -- to be aimed at both retail and institutional investors. He envisions this outline as a supplement to the official prospectus for each investment offering. The parameters, he says, could provide a simple description and numerical grades for degree of risk for each of the following components:
1. Market risk: how does the value of the investment fluctuate relative to the market?
2. Interest rate risk: how does the value of the investment fluctuate as interest rates in general and the yield curve specifically shift?
3. Liquidity risk: what is the expected level of market liquidity connected to the investment?
4. Volatility risk: how does the investment respond to shifts in the level of volatility in the marketplace? Will the investment outperform or underperform as volatility moves up and down?
5. Credit risk: what degree of risk is there to specific corporate, sovereign, or agency credit embedded within the investment?
6. Prepayment risk: what degree of risk is there that an underlying mortgage backing the investment will prepay or not prepay so as to impact the duration and valuation of the investment?
7. Currency risk: what degree of risk does the investment have to a specific currency or a basket of currencies and how does it respond as those currencies shift in valuation?
8. Structure risk: where in the capital structure of the transaction is the specific investment. What is the risk that the structure erodes or breaks down and how does that impact the valuation of the investment?
9. Counterparty risk: what is the risk of the entity with whom an investor engages to be able to perform and remain an ongoing concern?
10. Extension risk: what is the risk of the investment extending in duration or vice versa shortening in duration and how does that impact its valuation?
11. Transparency risk: how much information can you really glean and fully understand on the investment and how much does the market fully understand and appreciate the specifics of the investment?
In addition to these parameters, a prospectus and offering memorandum should highlight in bold print and in one spot all of the fees, charges, loads, expenses, and other costs associated with the product or transaction, delineated in laymans terms. If these parameters had been in place prior to the market meltdown, regulators would have been in a much better position to protect investors and dealers alike. Such an outline would not have precluded the possibility of financial fraud on Wall Street, but it certainly would have highlighted risks and mitigated losses.
Advisors contacted for this story admit to already addressing a handful, but not all, of these risks with clients. One RIA who preferred not to be named noted that he doesnt go into such detail when explaining the risk associated with his clients investment decisions.
I dont think most advisors specifically articulate and discuss each of these risks with clients, but frankly most would probably answer we address all of these risks by investing in well-diversified portfolios, says another advisor, Michael Kitces, director of research for the Pinnacle Advisory Group in Columbia, Md.
Doyle, however, notes that an explanation of a well-diversified portfolio shouldnt be a crutch to avoid answering clients risk-related questions. "I question whether all advisors advising on mortgages for example talk with clients about how specific investments will perform if there is a spike in volatility, says Doyle. I would challenge many advisors that they are not fully assessing all of these risks.
Clearly, the best ones do, but there are a lot of advisors out there who don't, he says. I'm raising the bar in an attempt to bring rigor to the advisory process," says Doyle.