Calculating the costs and benefits of financial advice – a dangerous exercise in the US and a necessary one in South Africa
It may be argued that one of the important functions managers of private wealth provide is that we can help save our clients from themselves. When we (the wealth managers) act on clients’ behalf, in a conservative way, conscious of risks as well as returns, with wealth entrusted to us, we may well help prevent them from making disastrous investment decisions all on their own. Such poor financial decisions may cost them far more than the fees we charge for our advice and record keeping. Earning extra returns for clients, ahead of the fees incurred, is not the only purpose of our fiduciary duties. Saving wealth owners from themselves is perhaps even more important.
A study made by US economist Robert Litan seems to agree. As reported in the Wall Street Journal (online edition, 4 October), Litan in July testified before the US Congress against a US Labor Department plan to regulate financial advisers. His cost-benefit analysis estimated that, during a market downturn, the proposed regulation of financial advisers, with associated higher fees for advice, could cost investors—especially those who aren’t wealthy—tens of billions of dollars. The cost to clients would be incurred by depriving them of good financial advice, such as advice against panic selling, that they may well have chosen were fees for advice lower.
The regulation of financial advice can raise the cost of advice, perhaps through an extra fee, that many clients may prefer not to pay. Hence the greater likelihood of poor investment decisions made without useful advice: not only the mistake of buying at the top of the market and selling at the bottom, but also advice that should and would discourage any naïve or greedy propensity to ignore the relationship between a promised return and the associated risk of receiving much less, or indeed no return at all. The Litan evidence would have been in the form of an examination of the comparative track records of investors achieved with or without advice – in the light of the observed sensitivity of clients to the fees charged for that advice.
Political costs, too
The story in the WSJ is only partly about the benefits and costs of financial advice. It is also about how his testimony cost Litan his job. A veteran of 40 years with the Brookings Institution, Litan offended left-leaning Massachusetts Senator Elizabeth Warren, who is sponsoring the intended legislation. He was accused, in a letter Warren wrote to the head of Brookings, of concealing a conflict of interest by not disclosing that his study was supported by the Capital Group, a very large mutual fund manager in the US. This conflict of interest accusation, according to the WSJ, was made “notwithstanding” that the first page of Litan’s testimony says: “The study was supported by the Capital Group, one of the largest mutual fund asset managers in the U.S.” Senator Warren called that disclosure “vague”—while the WSJ named this accusation “an obvious falsehood”.
A private company with an interest in opposing regulation may often sponsor research in think tanks or universities. Even more often, a government agency may sponsor research inside or outside of government itself with an equally obvious and opposing political and bureaucratic interest in implementing additional regulation. Ideally the research, regardless of its sponsor or conclusions, should be allowed to inform public opinion and the legislative outcomes that may follow. Disclosure of sponsorship is both ethical and wise so that any possibly convenient conflict of interest argument will not prove decisive in any adjudication process.
The quality of any research can surely be tested and cross examined regardless of its provenance, as is the evidence of the so-described “expert witnesses” in our courts, paid for by one or other of the litigating parties. An expert witness, talking to the book of a pay-master, in disregard of the evidence, will soon be found out as biased in any thorough cross- examination and such advice will be correctly ignored.
In South Africa, the Treasury and the Financial Services Board have been much involved in regulating the quality of investment advice provided to savers and by financial advisers. Clearly quality advice is desirable. But, as in the US, it also comes with a price, in the form of higher fees or costs, which potential clients may judge as not worth paying for.
One hopes (but doubts) that a similar analysis of the perhaps unintended costs and consequences, as well as the benefits of additional financial regulation in SA, has been undertaken for our market place. A study of the kind provided by Litan – that explores the danger that many more savers will go inexpertly or inadequately advised and so make poor and very costly financial decisions, because such advice is deemed too expensive – would be welcome.
There are always benefits to be had from every regulation of market forces. There are also always associated costs, some more obvious than others. Both the additional benefits and the full extra costs, associated with an intended regulation, should be calculated, as fully as they can, regardless of where the chips may fall.