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Trust is not enough in dealings with an investment advisor

by Wayne Cheveldayoff, 2005-08-25

If you are relying only on trust in your relationship with an investment advisor, you may be in for a surprise at some point – in the same way that Canadian poet, singer, songwriter Leonard Cohen was surprised to find out recently that $5 million (U.S.) of retirement savings he entrusted in 2001 to a personal manager has been whittled down to $150,000.

Because of Mr. Cohen’s celebrity status, the story gained circulation after MacLean’s magazine reported details, including that he had “trusted absolutely” and now has had to mortgage a house to raise funds to launch a law suit in an attempt to get some of the money back.

Mr. Cohen is far from alone in suffering investment losses and most other cases are never publicized.

The Small Investors Protection Association has estimated that individuals in Canada lose at least $1 billion a year due to improper advice or some other sort of wrongdoing in the investment industry. The exact figure is impossible to obtain because the financial institutions insist on non-disclosure agreements from anyone recovering damages from an out-of-court settlement.

While most cases don’t get reported in the media, Canadian regulators on an almost weekly basis publish discipline orders and fines against some licensed investment advisors for such offences as improper investing activity, inadequate supervision, and failure to ensure an investment strategy matches a person’s circumstances. There are also some reported cases of advisors walking off with the money.

Invariably, when victims talk about their experience, they focus on the fact that they trusted the advisor and the advisor broke that trust.

The lesson for investors is quite obvious: Trust alone is not enough.

You also need to have a written investment policy, to regularly monitor how your portfolio is performing, to feel comfortable raising all types of questions and getting answers in writing, to learn how the industry compensates its people, and to be dealing with a reputable firm with significant resources – not just because those have better compliance processes, but also so that if something does go wrong, you have a better chance of persuading it to make things right or, failing that, of successfully suing to recover losses.

You also should carefully choose your advisor, and that means interviewing a number and then choosing among them, preferably after talking to references.

Carrying out this kind of research and scrutiny is a tall order, especially for those strapped for time. But rest assured that a lot of those who lost money wish they had.

One thing to keep in mind is that the system contains some ‘temptations’ for investment advisors – even where compliance departments exert a strong influence.

One is to avoid talking about the commissions or fees involved, since there isn’t a rule in place that forces disclosure on this. If you don’t ask, you most likely won’t be told.

In fact, Advocis, an organization representing investment advisors, is fighting against a proposal from regulators to force mandatory disclosure of all commissions being earned.

If the advisor makes money through transaction commissions, then is it such a surprise that he or she will dream up ideas to trigger more transactions?

Some advisors have switched to what is called “fee-based” compensation systems where you are charged an annual fee of, say, 1 per cent of total assets, no matter how many transactions occur.

This is a good approach in principle, since it matches the advisor’s interests with yours. The advisor gets paid more only if your assets grow.

However, the opportunity exists for so-called ‘double-dipping’, which occurs when an advisor using a fee-based system takes extra commissions behind the scenes.

This could happen if you purchase any new issues. For example, if you hold individual income trusts, your advisor may recommend consolidating them in a new issue of a closed-end fund (to be listed on the TSX) that plans to invest in 30 or 40 income trusts. It could be a good idea, since that would provide added diversification and reduce risk.

But what you may not be told is that the advisor will get a 5-per-cent sales commission on the new issue and then 0.4 per cent a year as a trailer fee – all in addition to the 1-per-cent annual fee you are already being charged.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.



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©2005 Wayne Cheveldayoff