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August 15, 2018

Kevin Karpuk CFA

“Insiders will blithely compromise market integrity for their own profit, and we, the uninformed public, are their dupes.” - Alison Frankel, Reuters
I took some vacation time recently which means catching up on reading. On this break, there were two books on my list that seemingly could not be more different but, upon reflection, had some striking commonalities. The first one I delved into was Destiny of the Republic by Candice Millard[1] about the assassination of James A. Garfield, the 20th President of the United States, and the missteps of his medical team. The second was Open Secret: The Global Banking Conspiracy That Swindled Investors Out of Billions by Erin Arvelund regarding the rigging by market participants of interest rates before, during and after the Great Recession. While differences between the two abound, the similarity is that combining ravenous desire (fame in the former and greed in the latter example) with a lack of transparency[2] often leads to conflicts of interest which result in suboptimal outcomes.

The opening quote was admittedly meant to catch the reader’s attention; however, it implies a level of helplessness for the end investor that need not exist. There will always be unethical people in any field; however, there are some steps that can be taken to mitigate the risks of becoming one of the “dupes.” An important design consideration for investors should be open architecture, i.e. the separation of duties to different parties. In such a scenario, each group is compensated to provide investors with the most effective solutions available at a reasonable cost and has no financial ties to the others. 



The four components of an investment solution are:
 
  • Brokers – These firms place trades for money managers and should be autonomous from those managers. Brokers should charge a commission that is fully disclosed and subject to regulatory “Best Execution” practices.
     
  • Consultant – The consultant is the quarterback of these players, providing leadership to the investor and transparent reporting on a portfolio’s performance and the risk taken to achieve that return. The consultant should have no reason other than the client’s best interests to change or maintain any of these relationships.
     
  • Custodian – This is the safe keeper and main accountant of the assets. An independent custodian collects, holds and reports on the assets under its care. There should be strict controls required by the custodian on moving assets amongst accounts with sufficient insurances behind those controls.
     
  • Money Manager/Mutual Fund/ETF – This is the group that is selecting the instruments into which clients invest and likely choosing which brokers through which to place those orders. Managers often get the most attention as the most impactful part of a client’s portfolio, but this is only true if the rest of the platform is properly designed.
The pitfalls of a lack of separation of duties was outlined by The Wall Street Journal on July 27, 2018 in an article entitled “Whistleblowers Detail Wells Fargo Wealth Management Woes.” This article describes allegations that advisors were more highly compensated by the bank if they steered their clientele to costlier proprietary products. In a properly managed solution, as described above, an advisor would not benefit and likely would suffer from making decisions that are not in the best interest of its clients.

When confronted with hubris or greed, investors should understand that the structure and separation of duties can go a long way to avoiding becoming another tale of woe. Hiring professionals whose only financial relationship is with the investor is a time-tested way to trust but verify.
 

[1] Prior to reading the book, I had the opportunity to hear Ms. Millard speak at the John Van Horne Lecture Series sponsored by the Library Company of Philadelphia, the oldest public library in the nation. History buffs receiving this Independent Insightsshould consider attending next year.
[2] Garfield’s lead doctor banished others from treating the President, while the interest rate traders worked within a lightly regulated system where prices could be manipulated by a few bad actors.

Kevin Karpuk, CFA Chief Investment Officer

Kevin is Cornerstone’s Chief Investment Officer and is involved with the firm’s Investment Policy and Strategic Planning committees. Kevin joined the company in 2000 after graduating from Lehigh University with a B.S. and M.S. in Economics and earned his CFA charter in 2005. Kevin and his wife Kat support many charitable causes and have established a donor advised fund to propagate their philanthropic interests. They live in Bethlehem with their two cats: Zola and Charlyne, enjoy woodworking, gardening, reading and travel. Kevin is the proud uncle to many nieces and nephews and loves spending time with and spoiling them.

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