One of the most entrenched principles of securities market supervision is ‘non-merit regulation’ — a guiding light of the Securities and Exchange Commission since its founding in 1934.

The idea behind ‘non-merit regulation’ is that the SEC should focus efforts on getting issuers and intermediaries to provide disclosure of material facts about securities being marketed and traded, leaving it to investors to decide whether a security is a good investment or not.

Advantages of ‘Non-Merit Regulation’

There are a lot of good things to say about ‘non-merit regulation’. For example:

1. The policy keeps the government away from directing flows of capital in the economy;

2. Government officials are no more able to determine what are good and bad investments than anyone else; and

3. As long as the government stays away from deciding the merits of a particular investment, it will never be blamed for investments that go sour.

Judging from the competence of many local, state, and federal officials demonstrated in Hurricane Katrina, it may be a good idea to keep government out of the business of determining investment merit.

How Smart Are Investors and Their Advisers?

However, the flaw in ‘non-merit regulation’ is that it assumes that investors will have the time, inclination, and intellectual capacity to study and evaluate the huge volume of ‘material facts’ now available under the securities laws of 1933 and 1934.

‘Non-merit regulation’ might have been a reasonable policy in 1934, when less than 5% of the population invested in stocks and when companies and their balance sheets were much simpler.

Now, however, over half of American households own equities, directly or indirectly, and the great majority of individuals admit, candidly, that they don’t have a clue about stock and bond markets.

Most U.S. investors must rely upon third parties — fund managers or investment advisers — to study and evaluate information for them.

But how much smarter are these ‘advisers’ than the people they advise?

Varying Degrees of Professionalism

So, it would seem reasonable that investment advisers on whom the well-being of millions of retirees now depends, would be at least as competent when it comes to safeguarding investors’ money as, say, a doctor or aeronautical engineer would be regarding their clients’ health or flying safety.

However, the hurdles that an individual must pass to qualify as an investment adviser are remarkably low, consisting mainly of taking a short course, answering multiple-choice questions, filling out a form, paying a few fees, and perhaps, working for a time for someone who has already passed the same low entrance barriers to the profession.

The harder questions on the Series 65 exam have to do with government regulations — necessary knowledge in keeping the advisor out of jail — while the questions that might indicate ability to know the difference between a good and bad investment are really pretty basic — things like knowing the difference between a Treasury bill and a money market fund.

The result is that the retirement plans of millions are often entrusted to those who may not be up to the task.

Built-in Conflicts of Interest

It’s not that being a good investment adviser is so easy that the regulator can ignore the qualifications of those who would manage the assets of others.

It is that the career of ‘investment adviser’ evolved from stock and bond sales, with emphasis on getting orders rather than on the technical aspects of investments.

Even today, despite efforts to spruce up the business with credentials, investment advisers are often paid by commissions, directly or indirectly, or charge fees based on the value of assets managed, and are often, in the final analysis, persons whose motives are in conflict with those of their clients.

Some even receive a percentage of the client’s profits and an ‘incentive’. (Do you give your doctor a bonus if you come out of the operating room alive?)

Very few charge for their services, as do other professionals, on the basis of time and the quality of their work.

Some advisers combine investment counseling with preparing tax returns and setting up legal documents on trusts and estates. However, although expertise in taxation and settlement of estates of the deceased is extremely useful in planning long-term investment strategy, it is not the same as portfolio management and investment selection.

In fact, the knowledge required to be able to advise on the tax advantage of a particular investment has little to do with the ability to determine the intrinsic value of that investment or its suitability as a conveyance of value over twenty or thirty years.

Touchy-Feely Guidance From the SEC

Instead of providing investors with useful advice that might actually help them safeguard their money over decades until retirement, the SEC delivers platitudes and guidelines suitable for those who expect to lose money and want to be prepared to sue their advisers.

On the [1] page, we find this advice:

• “Its never too late to start asking questions…”

• “You can find out about investment advisers and whether they are properly registered by reading their investment forms …”

• “How to handle problems: Act promptly! …”

• “If your financial professional can’t resolve your problem, then talk to the financial professional’s supervisor. … ”

• “Send us your complaint by using our online complaint form…”

• “Let your financial professional know you are taking notes …”

• “Use our form for taking notes when you speak to your financial professional …”

The underlying assumption of the SEC’s advice to investors seems to be that ‘investment advisers’ are really not to be trusted and that, like sex offenders, the market regulator can do little more than take their names and give lip service to keeping tabs on them.

The SEC’s advice to check out an adviser on the government database is pretty much of a joke. Although the SEC provides a search engine for the investment adviser registration form ADV, as of 2005 this service covered only investment advisory firms and not individuals or firm personnel.

The information on the ADV form, although useful to police seeking the last-know-address of suspected felons, is not helpful in selecting an adviser on whom the investor’s retirement future may depend.

The ‘information’ provided on ADV form includes:

name, address, business hours, phone number, and vague information in connection with the advisory business, such as whether the advisor deals with more than $25 million in client assets.

The ADV form does not provide any guidance regarding the knowledge or methods of a firm on its personnel regarding security analysis, portfolio management, risk appraisal, or knowledge of investments outside the scope of the SEC, such as real estate, gold, or commodities.

The ADV form does not even reveal which areas an adviser has expertise, nor does it provide any clue as to an adviser’s level of competency.

The ADV form gives no information at all on the amount of commissions and fees the adviser may receive from third parties, and perhaps, more importantly, areas of the investment market for which the adviser receives no fees and therefore may be unlikely to direct clients’ money.

Pity the Poor Investor

If the securities market regulator is too timid (or intimidated by securities industry lobbyists) to ask what may turn out to be embarrassing questions of investment advisers, how likely is it that an investor, admittedly unsophisticated and easily conned, will have the know-how or even the courage to ask questions like:

“What commissions or fees do you receive from third parties on the securities you plan to put in my portfolio?”

“On what basis will you decide what investments are the best for my portfolio?”

“How did you get to be an investment adviser? How long were you in training?”

“How will you determine if investments are too risky for my retirement plan?”

“How do you determine the intrinsic value of an investment and decide whether the market price is too high?”

Some successful investment advisers that cater to elderly investors are very slick operators indeed, with attractive front offices reeking of money, success, and prudent counsel.

Some have Sunday morning television shows that bring in clients, offering ‘free’ preparation of tax returns and video-taped testimonials of happy customers.

Furthermore, many advisers rely on their ability to impress their clients by speaking of alphas and betas, by making references to Nobel laureates, and by repeating bromides from the “[2] Common Stock Legend“.

(See: “[3] Fallacies of the Nobel Gods“.)

How Investors Make Decisions About Equities

All this is prelude for one of the main points of this article, which is to suggest some useful reading for capital flow analysts.

The Investment Company Institute has released the report, “Equity Ownership in America, 2005″, which reveals the role of advisors in the investment decisions of millions of U.S. households.

This 12-page report is available in PDF format, without charge, on the Investment Company Institute [4] website.

Chapter 3 of this report deals with the use of professional financial advisers and reveals that 77% of individual investors outside of employer-sponsored plans that own equities, directly or indirectly, use investment advisers to some degree in decisions to buy, hold, or sell stocks.

An Overview of the Investment Advisory Profession

Information regarding the investment adviser business can be found in the report by the Investment Adviser Association and National Regulatory Services, entitled, “Evolution-Revolution: A Profile of the Investment Advisory Profession June 2005″.

This 16-page report is available in PDF format, without charge, on the Investment Adviser Association [5] website.

This report says that there were 8,164 investment advisers registered with the SEC in 2005, managing $26.8 trillion in assets. The business was highly concentrated, with 4.1% of the firms handling 83% of discretionary assets.

The report indicates that most advisers were not independent, but were affiliated with other players in the market:

30% with broker-dealers; 18% with investment companies; 34% with other investment advisers; 10% with futures commissions merchants, commodity pool operators, or commodity trading advisers; 15% with sponsors of syndicates or syndicators of limited partnerships; 6% with real estate firms; 7% with pension consultants; 7% with insurance companies or agencies; and 13% with banks or thrifts.

The report states that 94.5% of all advisers charged fees based on the amount of assets under administration.

How Percentage-Based Fees Distort the Market

The trend for some years has been for investment advisers to set their fees based on the size of clients’ portfolios. In part, this has been because of the SEC’s policing of so-called “churning” by registered representatives of brokerage houses with discretionary power over clients’ accounts.

(Note: Churning refers to the practice of generating trades in a discretionary portfolio for the purpose of increasing the broker’s commissions. In egregious instances, churning can eat up most of portfolio value.)

For the investment advisor, fees based on the size of a portfolio are attractive: the cost of managing a portfolio does not usually increase in proportion to assets under management, and the advisor cannot be accused of “churning”.

Most clients also like the idea that costs of advisory services will have a predictable relationship to the size of their assets. The ‘fixed percentage fee’ arrangement seems fairer and unlikely to encourage “churning”.

However, there is a subtle flaw in the logic of fees based on portfolio size that works against the best interest of the investor. For some investors, highly dependent upon income and adverse to risk — such as an elderly widow with modest resources — the most advisable investment might simply be bank certificates of deposit, treasury bills, or money market funds.

In such cases, a fee of one percent of the value of the investor’s portfolio might eat up twenty percent of the investor’s income, while the investment advisor will have seemed to have done little to justify a fee.

To make the percentage-based fee appear reasonable, the adviser will be inclined to select equities rather than fixed income securities, because of supposedly higher returns on equities (i.e., “[6] The Common Stock Legend“).

In other words, percentage based remuneration introduces a bias in favor of equities and riskier investments when this might not be in the investor’s interest.

Even the most callous adviser would feel uncomfortable charging one percent a year to keep funds in bank certificates of deposit, although this might actually be the best strategy for a particular client.

When we consider that in 2005 U.S. investment advisers were managing
$26.8 trillion in assets, 94.5% on a percentage fee basis, this ’subtle bias’ can result in tremendous distortions in the equity market that are not in the interests of most investors, or the economy.

With this in mind, we should ask, “How well does the SEC protect investors?”