When it comes to money you want the most competent financial adviser to help you grow your assets and provide you with income, especially at a time closer to your retirement. However, over the past few years hundreds of millions have been lost due to bad investment advice from greedy financial advisers who know very well that the products they promote are way too risky for average investors. The best product for you may or may not be the one that generates the highest commission for them, I have seen many investors blindly trust their advisers and buy a lot of low quality investment products that end up costing them a lot of money. It is important for you to understand that just because something is unethical doesn't make it illegal, and the current regulations do not provide enough protection for you as an investor. It is, therefore, very important for you to know the common tricks.
Some private bankers even went as far as breaking the law to profit themselves. Take the case of Kevin Wallace, an ex-Merrill Lynch private banker who offered financial advices to many Asian tycoons and their families in the late 90s. Mr Wallace was a Harvard Business School graduate, a high profile banker accused of unauthorized trading and later sentenced to jail. Singapore's high court found Mr. Wallace guilty of forging signatures and trading stocks without client permission. The incident was discovered by suspicious clients who complained to Merill Lynch that Mr. Wallace had told them that there was no need to look at the official documents from the bank as they were incorrect. Interestingly, none of the bank's support functions such as risk management, operations, compliance and audit was able to detect the funny business before the clients made a formal complain which triggered a high level investigation.
Mr Wallace was asked to resign shortly after. Merrill Lynch later filed a case against him and the judge ordered a payment of US $25 million to be made by Mr. Wallace to the bank.
There are several common tricks that financial advisers play:
Trick 1: Offering financial advices for "free"
Good, experienced private bankers charge a service fee for conducting careful research and analysis. They would carefully review a client's financial goal, investment time span, risk tolerance and special family needs before deciding whether certain portfolio strategies are appropriate. They would also disclose any conflicts of interests in the asset allocation process. Most advisers you meet out there, however, are only salespeople who get paid by the number of financial products sold. I would say about 60-70% of the advisers belong to this category. Because they do not get paid unless they are successful in selling certain types of products (often complex, risky derivatives), advisers would often recommend products that are inconsistent with your overall investment goal. The "free" advice you received often turn out to be very expensive as your portfolio loses tens of thousands of dollars.
Trick 2: The performance bonus trap
You should pay attention when your hedge fund managers tell you you should feel comfortable letting them manage your money as they are "paid for performance only". For legitimate hedge fund and portfolio managers, their total remuneration package consists of a fixed management fee and a year end performance bonus. While it may seem fair that managers are paid solely depending on the financial results of the portfolios they manage, most investors don't see the problem of "paid for performance only" arrangement. After all, if a manager cannot hit a certain benchmark in terms of return, he or she won't get paid, that's fair game, right?
Wrong. Most investors don't understand that under this arrangement, there is a very strong incentive created for advisers and portfolio managers to invest in risky assets in the hope of higher returns. In order to fully maximize the potential profit, fund managers are likely to include lots of highly leveraged products such as futures and high-coupon, low quality bonds with significant credit risks. In the end, the investors bear a lot more unnecessary investment risks.
Trick 3: Misrepresenting the overall portfolio performance by ignoring funds that went out of business (survivorship bias)
Another common trick that dodgy financial advisers play is misrepresenting the overall portfolio performance. While it may be illegal in certain parts of the country to outright lie about performance, many advisers choose to only present hedge funds that are still surviving today, they simply ignore those that went out of business over the course of years.
Trick 4: Name dropping
It is not uncommon for financial advisers to drop names of highly visible individuals during a pitch, hoping to impress potential clients. It is, however, extremely unethical for an adviser to do so. This is because the confidentiality clauses in 99% of service agreements would have prohibited any such disclosure. Name dropping shows a lack of integrity.