Three’s a crowd.

Photo: Andrew Martin. Source: Pixabay

Imagine you’re relaxing at the beach, or sitting down to dinner, just you and a close friend. You have some sensitive personal issues on your mind, things you’ve been meaning to discuss for a while. It’s been hard to find the right time to broach the topic. Just when you start to get going, the restaurant owner comes by and asks how things are going. Fine, you reply, hoping to get back to the issue. But the owner doesn’t move on. They keep engaging, asking how you like the entrée, if the lighting is good, whether you might come back. Then they pull up a chair and sit down – asking if that’s okay, of course. But what can you say? They’re the owner.

That’s the position many people find themselves in with their investments. They *think* they have a personal relationship with their advisor. They know about fiduciary duties, they’ve been careful to understand fees, incentives, and conflicts. They’ve even read the fine print on the account statements and code of ethics. But even after doing all this work, they find themselves in a bind. The owner of the restaurant comes by and sits down. When someone owns a stake in a firm, they’re entitled to a seat at the table. After all, it’s their capital.

We pay for advice all the time. Lawyers give us personalized guidance on legal matters; medical professionals advise us on our health; architects provide custom designs for buildings. These professionals don’t usually have outside investors committing funds and looking for a return on their equity. Law firms are partnerships; doctors are often part of a health network; other professionals often form their own firms. Finance, on the other hand, has a legacy of outside capital with a “seat at the table.”

People understand why banks need capital. They take deposits and make loans, and their capital provides a buffer so they can remain stable if there’s economic trouble. Despite the challenges of the pandemic, there were almost no bank failures. Even during the Global Financial Crisis a decade ago, the vast majority of financial institutions came through unscathed.

But advisory firms don’t need a lot of capital. Most advisors use third-party custodians, so their clients retain control of their money. Advisors can “rent” software designed to help them provide services and solutions for their clients’ every need — from life-and-financial planning to analyzing taxes to investments and customized analysis. Advisors can leverage their expertise in these issues and care for lots of clients, but they don’t need to make large capital expenditures. They’re not building a big factory to crank out financial widgets.

Financial Widget Producer? Photo: Micael Gaida. Source: Pixabay.

That third seat at the table, however, can get in the way. Advisors have a fiduciary duty to act in their clients’ best interest, but they also have a fiduciary duty to any investors to provide a return on capital. That’s why law firms don’t accept outside investors. That’s why our medical information is subject to HIPAA rules. That’s why accounting firms are structured as partnerships. The ethical conflict that outside investment creates can get in the way of advice and actions that should be in a client’s sole interest.

That’s a reason folks admire Vanguard and TIAA-CREF. These firms have managed to hack the need for outside capital to demand returns. It’s part of the reason they’ve been able to pursue low-margin businesses and establish themselves as low-cost providers. (There are other issues that arise from their governance structures, but that’s for another day.)

The financial industry has rightly focused on conflicts of interest and fiduciary duties. Investors need to know if an advisor will profit from the advice they’re giving. But often, it’s not the advisor who profits, it’s the firm that employs the advisor. The advisor may not earn anything directly, but the firm will. That conflict may be hidden in the fine print or may not even be disclosed. But it’s there.

If we go out for dinner with friends and the restaurant owner pulls up a chair and sits down, we can leave. That’s just creepy. There are lots of restaurants out there. The good ones know to stick to their cooking. And let us enjoy our meal.

Photo Nenad Maric. Source: Pixabay.