Learn The Dirty Little Secrets That Wall Street Doesn’t Want You To Know. It May Not Be Investment Fraud, But It Sure Isn’t Right.
Let’s begin with a story…
In the early 1990’s I managed a portfolio for a successful hedge-fund. We operated multiple investment systems each with a unique risk profile. One of those systems was a long-short equity portfolio.
We hired a reputable, big-name, institutional brokerage firm to transact the trades for our account and agreed on a commission rate to fairly compensate their services.
Unfortunately, fair compensation was not enough. They wanted more…
“Fraud is the ready minister of injustice.”
The first symptom that something was wrong was when I noticed inconsistent trade execution. I tracked the market for each stock when I called in my orders (yes, we used the phone back then) and noticed most trades were well executed. However, an occasional trade would come back significantly out of line with market pricing at the time of the transaction. The difference was always in the expensive direction.
I quizzed the broker on these trades but he could find no problem … yet the problem persisted. To make a long story short, I did some research and determined that each of the poor executions were NASDAQ listed stocks which this particular brokerage firm made a market in. Apparently, the law allowed that firm to add a “markup” beyond the ordinary bid-ask spread to securities they made a market in – without disclosing it to me.
In other words, not only were they collecting the agreed upon commission on these transactions but they were also charging an additional markup beyond normal bid-ask spreads that was diametrically opposed to the intent of our agreement. When you are doing millions of dollars in trades this can take a lot of money and move it from your pocket to your brokerage firm’s.
The broker feverishly denied any such allegations (he lied) until I offered the account to a competing broker in the same office if he could prove my concerns. Believe it or not, this broker provided internal documents proving his co-worker’s misdeeds in an effort to steal the account (scumbag). I fired them all and moved the account to a competitor. There is no honor among thieves.
The purpose of this story is to show that even knowledgeable investors can be ripped off when Wall Street is legally allowed to hide the truth. The brokerage firm did nothing illegal and there was no basis for a lawsuit; yet, the broker knew his actions were out of integrity because he went to great lengths to hide the truth. He took money he was not supposed to take and that is not okay.
“It turns out that an eerie type of chaos can lurk just behind the façade of order – and yet, deep inside the chaos lurks an even eerier type of order.”
How can both realities co-exist – clear wrongdoing yet nothing illegal? How does Wall Street covertly take money out of your pockets without committing investment fraud, and what can you do to protect yourself?
That is the purpose of this article.
The Antidote To Investment Fraud – Full Disclosure
I believe it should be illegal for any broker, financial advisor, fiduciary, brokerage firm, salesperson, or anyone else having contact with a client’s money to receive any compensation or distribute any payment related to that account that is not clearly disclosed up-front and direct in the form of a financial statement. Written disclosures in contracts are not adequate because few people read or understand them, and no disclosure is completely unacceptable. You must show the client the money – that is the key point.
In the previous example, it should have been illegal for my broker to receive compensation on the dealer markups without my receiving the same information on my financial statements. It should not be legal for them to hide that flow of funds from me. I never would have uncovered the fraud had I not been tracking each transaction closely and gone to extraordinary lengths to gain access to internal brokerage documents.
Few people have the time and energy for due diligence like this. When you place an order to purchase a security you trust that it will be executed at fair market price. Allowing additional transaction costs to get netted into the price shown on the transaction statement so that it is hidden from your view is unfair.
Why should you care? Transaction costs are a critical component of many investment strategies. Knowing your true transaction costs can make or break some investment strategies. It is essential information to the investment decision.
“For a manipulation to be effective, evidence of its presence should be nonexistent.”
It is not fair for a broker to agree to one level of commission but pocket additional compensation behind the scenes that the client has not agreed to. The money is flowing from your pocket to theirs and you don’t even know it. That is an intentionally deceptive practice. Only when the client sees the money does he have the information necessary to understand what financial incentives are affecting his investment account.
In theory, regulations exist to protect you from deceit like the above example, but Wall Street lawyers are clever. They’ve figured out how to satisfy the regulators in legalese filled documents that few read and even fewer understand while simultaneously hiding the money trail that tells the real truth. They’ve supplanted straightforward financial disclosure with impenetrable legalese disclosure. I support the written language disclosures currently in use because they are necessary and valuable. Unfortunately, they are also inadequate.
Full disclosure should require reporting statements that show all payments and money flows associated with a client’s account. No hidden charges, no behind the scenes kickbacks, nothing covert is acceptable. The reason the money trail is an essential disclosure is because dollars and cents are intuitively clear to the average investor where legalese is not.
There is absolutely no justifiable reason for not disclosing this information. All the money is fully accounted for internally by the brokerage firm. Why shouldn’t the client see it? What are they hiding? This one solution would unravel many of the legal yet deceptive practices that influence investment product sales. It is a disclosure practice whose time has come.
What Is The True Cost Of Your Mutual Fund?
Mutual funds report their returns on a net basis. The NAV or “net asset value” represents the market value of your shares and is net of all fees, management costs and expenses associated with your investment. The price you see is the NAV, but then what happens to all the fees and expenses you are paying? Where do they get disclosed?
The answer is they are buried in the prospectus – that legal document that almost nobody reads but everyone should. What you see in your account statements (the documents most investors read) are net numbers that never mention all the expenses and fees you are paying. NAV pricing gives the intuitively misleading impression that there is no cost to owning your mutual funds since you never directly pay it or cut a check. You may know those fees and expenses exist somewhere in the financial ether, but I have never spoken to an investor who can tell me how much they paid for the services of their mutual funds. Do you know how much you have paid in terms of dollars and cents?
The fact is mutual fund expenses and fees vary widely. It is critical information to your investment decision. To be fair, all this information is clearly disclosed in the prospectus. Additionally, a significant advantage of net pricing is the ability for investors to compare a wide variety of fund performances with varying expense and fee ratios.
In other words, net pricing is not necessarily a bad thing. There are advantages that make the practice worthwhile. However, they should balance the practice with proper disclosure in dollars and cents in your account statements showing exactly how much you paid out in fees and expenses. When they show you the money there is no confusion. Additionally, the information is readily available so why hide it?
For example, imagine a hypothetical fund that pays 1.25% in management fees, .25% in 12B-1 fees, and .50% in expenses. If you saw a return of 10% last year you may be surprised to learn you actually made 12% with this fund. The rest got siphoned off behind the scenes in fees and expenses. You just never saw it.
“Observance of customs and laws can very easily be a cloak for a lie so subtle that our fellow human beings are unable to detect it.”
Carl G. Jung
However, if you received an account statement showing $2,000 coming out of your $100,000 investment there would be no confusion about the cost of owning that fund. However, you might start wondering if their services were really worth $2,000 each year, which is exactly the kind of thinking process they don’t want you to have. Similarly, if you notice better performing funds in your portfolio that were siphoning off much lower fees and expenses that would be valuable information that might effect your investment decisions – information that is hidden from your view right now.
Staying with mutual funds, let’s look more closely at the 12B-1 fees many mutual funds pay to financial representatives as a “marketing fee”. This provides an annual trailer of revenue to the broker for parking a client’s money with that fund company. It is an incentive for the broker to not encourage that client to change investments in order to generate another commission. It helps the broker keep “Keds on his kids” without having to make transactions.
“There is a wide difference between speaking to deceive, and being silent to be impenetrable.”
Again, these fees are fully disclosed in the legalese of your fund’s prospectus so there is nothing illegal about them. The problem is not one investor in 10,000 can figure out how much a 12B-1 fee costs them in terms of decreased fund performance due to greater expenses, and very few even know what a 12B-1 fee is or what rate they are paying. Yet, if the client’s financial statements showed the payment from the fund company to the broker you can be assured virtually every client would understand exactly what a 12B-1 was and how much it costs them.
Why make it so elusive? What are they trying to hide? It is important for the client to know all funds flowing as a result of his account because only then can he make fully informed investment decisions. If the broker is paid based on money in the client’s account then the client should see it. Anything less is unacceptable.
Unfortunately, I have never heard of those payments being overtly disclosed. Instead, they are buried in never-read legal documents and paid covertly behind the scenes. What are they trying to hide?
Please don’t misunderstand my point here. I have no heartache over mutual funds and my attack is not pointed at them. I see great value in certain types of mutual funds and utilize their services in my own portfolio. I am merely using them as an example of a system wide problem of inadequate financial disclosure that negatively affects investor’s decision abilities. You must show people the money. Anything less is inadequate.
Telling someone about expenses and fees in a disclosure document is one thing, but showing them the money is something else entirely. Disclosure documents are sterile and detached; whereas, dollars and cents in a client’s account are personal and real.
I coach clients through the process of building their own portfolios so I have seen how their investment decision process is affected when they learn about all the hidden fees and covert payments on Wall Street. It is essential information to making well educated investment decisions, yet it is hidden from most investors.
Why would any company hide these details if there was nothing wrong with what they were doing? Think about that for a minute…
Brokerage Firms Deceptions Revealed
Just so you don’t think I’m picking on mutual funds, let’s broaden the discussion about hidden fees to include brokerage firms. Again, the problem is system wide and is not isolated to any one group.
For example, did you know that investment brokers often receive graduated commission structures to motivate the sale of certain investment products over other products? The full intention of this practice is to induce the pedaling of the more profitable goods for the broker even if they aren’t the best deal for your portfolio.
Would you want to know that your broker is getting an extra incentive to talk you into a specific investment? Of course you would. Does that ever get disclosed to you, the client, when you are getting pitched on the next great investment? Of course not because it would ruin the sales pitch.
Graduated commission payments can bias the investment advice you receive. It is valuable information that should be disclosed at the point of sale and should appear in the transaction confirmation. But have you ever heard one example of this disclosure being made despite the deception occurring uncounted times daily? Never.
It is not enough to just speak the truth, but it must be the whole truth and nothing but the truth. What you don’t disclose is just as important as what you do disclose. Burying written disclosures in impenetrable documents while hiding the money trail should not be allowed.
I’m not picking on brokers any more than I am picking on mutual funds. The problem is system wide. It is part of the way Wall Street does business, and it needs to change.
For example, did you know that many brokerage firms sell your trades to the highest bidder? They can shop your trade executions based on what is most profitable to them instead of you. Let me explain.
When you enter an order to buy 100 shares of XYZ stock there are three components to your total transaction cost:
(1) Commission: This is the one cost most people understand. It is the most apparent component and is fully disclosed, but it is usually the least significant component of your total transaction cost.
(2) Bid-Ask Spread: Every market has a buy and sell price – the bid and the ask. The difference between these two prices represents profit for the market makers and dealers transacting in that stock. When buying stock you pay the premium half of the spread and selling stock earns you the discounted half. The spread can be quite expensive in illiquid stocks but declines as liquidity increases.
(3) Slippage: This represents the difference in price between when your order was entered and when it gets executed. For example, in fast moving markets prices can move quite far between the time your order gets entered and the time it is executed.
“What is the difference between unethical and ethical advertising? Unethical advertising uses falsehoods to deceive the public; ethical advertising uses truth to deceive the public.”
The combination of these three components represents your total transaction cost, yet most investors only pay attention to their commissions. That is the number they see disclosed on their financial statements. The other two components get buried in the price you pay for the security.
That is why many brokerage firms pad their pockets by selling your orders off to the highest bidder: it doesn’t show up on your statements. You aren’t any wiser because the money trail isn’t disclosed, and they get richer.
It’s a classic conflict of interest because your profits require best execution, but their profits require highest bidder for the order. Given the fact that your brokerage firm controls your order flow, who do you think is going to win in this conflict of interest? The net effect is paying the lowest commissions may cost you a fortune. You must look at total transactions costs – not just commissions.
But don’t take my word for it. According to Michigan Senator Carl Levin, “Payment for order flow is a good deal for the broker, but too often a bad deal for their clients. The SEC needs to get after this problem quickly and aggressively.”
Similarly, an SEC investigation found certain unnamed brokers “improperly emphasized payment for order flow in deciding where to send orders.” In other words, your order was executed based on what was most profitable to the brokerage firm instead of what was most profitable to you. That isn’t right. It should be illegal. It is a clear break of fiduciary responsibility.
But it doesn’t stop at order flow because the investment advice you receive to place these orders is biased by clandestine financial incentives. Merrill Lynch settled with the New York Attorney General for $100 million on allegations of recommending stocks to their brokerage clients in an attempt to garner favor in their investment banking business. Other large name brokerage firms have been investigated for similar allegations by the SEC.
Again, this problem is widespread on Wall Street. It is the deceptive way business is done. According to a July 22nd, 2001 New York Times article “When Hidden Fees Erode 401(k)s” some fund companies rebated part of the administrative fees paid by employees as part of their 401(k) back to the employers or outside plan administrators who hired them. Doesn’t that sound like a hidden conflict of interest you would want to know about? Since when should you be paying your employer out of your retirement plan assets?
And if you think these kickbacks don’t really matter then think again. According to the same article a hypothetical 401(k) where you invest $5,000 per year for 30 years with a 10% annual return would grow to $863,594, and a mere .25 percent kickback will reduce that amount by $40,883. That is nearly 5% of the compounded value of the account – it matters. If fees were 1% like on many smaller plans the reduction in account value would be $151,387. Ouch!
In short, not showing you the hidden financial incentives and behind the scenes payoffs is a widespread, very expensive problem.
What Can You Do To Solve The Problem?
The solution is simple: Wall Street needs to show all payments and flows of funds having any relation to a client’s account directly on the account statements in dollars and cents. Net pricing and hidden payments must end, and all financial incentives that bias investment advice must be disclosed at the point of sale. Show me the money flow.
My opinion is Wall Street doesn’t disclose the money flows, biased advice and graduated commissions for one simple reason – they don’t want you to know. They have something to hide. Look at your own life – when you hide facts isn’t it because you are doing something wrong? Is Wall Street any different? This is not some grand conspiracy theory but is simply common sense.
“Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.”
Some might claim me too pessimistic about Wall Street. I see my skeptical stance as merely balanced. I love the investment business, but I hate the way this industry hides its financial conflicts of interest. Unfortunately, reality is what it is whether I like it or not. If something walks like a duck, quacks like a duck, and looks like a duck, then it is probably a duck. There is no value in deceiving ourselves.
If a used car dealer recommended a specific car would you trust him and blindly buy the car? No, you would get it checked out because you implicitly understand his financial incentive biases his advice. Unfortunately, the financial incentives biasing the investment advice you receive aren’t as obvious because they are hidden from view. That is my primary complaint. That is what must be fixed.
Investment companies are no different from car companies. Everybody has something to sell including you and me. Peddling used stocks and bonds is no different from peddling used cars … except people trust used stock salesman because the conflicts of interest are better hidden allowing the veil of fiduciary responsibility to persist in the mind of the customer.
My goal is to lift the veil of fiduciary responsibility from your investment decision. You are responsible for your investment decisions because nobody cares more about your money than their own. Believing otherwise can be expensive.
False belief in the fiduciary myth gives an unfair advantage to Wall Street. The truth is Wall Street isn’t working for your best interests: they are working for their own. They peddle investments to make a buck – that’s their business and there is nothing wrong with it.
What is wrong is how they are allowed to get away with an extraordinary number of deceptions in order to maintain the veil of trust giving them an advantage over you. When you trust then you don’t watch carefully and that can cost you money. As this article has shown, you need to watch your investments very carefully. You should not trust.
I tell you this information not to scare you away from investing because that won’t do you any good. Nobody ever grew or preserved wealth by avoiding investing. Wall Street may not be perfect, but it is the only game in town for paper assets. You have no choice except to work with what you’ve got – warts, blemishes and all. The empowering choice you can make is to invest with both eyes wide open so the ethical shortcomings don’t cost you money. Stop trusting and start asking hard questions. Knowledge is power.
“Where there is a sea, there are pirates.”
Finally, I don’t want to give the wrong impression that Wall Street is filled with pirates. Many good people are doing their level best to provide the greatest service possible in this conflict ridden industry. I have friends and family members in the investment advice business who are honorable and ethical. This is not an attack on all the good people in this industry, but it is an attack on the industry wide disclosure system that is hiding the truth from individual investors.
My job as an educator is to help you become a more informed, educated investor. Approaching all investment advice with a skeptical eye and carefully uncovering all the hidden costs built into your investments is part of making smart investment decisions. I know this isn’t a fun topic, but reality is what it is whether we like it or not.
The bottom line is Wall Street has something to hide, and they prove it every day by hiding it from you and me. When they stop hiding maybe I will start trusting.
In the meantime forewarned is forearmed. Knowledge is power. Use this knowledge to make better, more informed investment decisions so that you put more money in your pocket and less in Wall Street’s pocket.