Here’s how to navigate conflicts of interest when you hire an investment professional

I’ve often written that conflicts of interest are the greatest risk you face as an investor. This idea seems to make sense to most of our subscribers and Inner Circle members, even if they never thought of it that way before. But when I mention it to experienced investment professionals, most react in one of three ways:

1. A blank look, as if I’ve referred to something that they know nothing about, or a sensitive issue they don’t want to talk about;
2. An aggrieved or defensive look, as if I’ve raised a sensitive issue and they expect me to follow up with criticism of something they’ve done;
3. A big smile, as if they know of an outrageous conflict of interest and are eager to share.

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Recently I got response #3—a big smile—from a fellow portfolio manager. He told me about a new client who had previously been investing through a discretionary portfolio-management arrangement with a broker. Previously this client owned a portfolio of mutual funds with an average MER (management expense ratio) of more than 2% of assets. The broker sold him on the switch to a portfolio-management arrangement, because it would only cost him 1% a year (plus “standard” brokerage commissions).

Unfortunately, this kind of arrangement with a broker exposes you to many conflicts of interest.

When my friend took over the management of the account, a big part of his new client’s portfolio consisted of shares of a small, little-known, thinly traded stock with a modestly above-average dividend yield and an uncertain outlook. Buying any amount of the stock seemed questionable. It was hard to imagine why the broker-portfolio manager chose to load the client up with it.

The holding was so large that it dominated the client’s portfolio; the stock was so thinly traded that if the client wanted to unload, it would take months to sell the position into the market without driving the price down. When my friend asked why the broker bought so much of the stock, the client said the broker told him it was a special deal: he was able to buy the stock without paying commission.

It turned out that this was because the stock was part of a secondary offering by the brokerage firm.

A secondary offering is a little like an IPO (Initial Public Offering). The main difference is that the stock in a secondary already trades publicly; the brokerage firm sells a block of the stock to its clients on behalf of the owner.

With a secondary offering, as with an IPO, the buyer pays no commission. But the seller pays a high commission, often 5% or more, to the selling broker. This creates a conflict of interest for the broker: buy stocks in the market for the client and generate a “standard” commission (paid by the client) of perhaps 1.5% to 2%; or, buy from the secondary offering (or an IPO) at no immediate cash cost to the client, and generate commission of 5% or more, paid by the seller.

When the broker-portfolio manager sold shares from the secondary offering to the client, he let his interest—generating more commission income—trump the client’s interest of building a stronger, more diversified portfolio.

As I started out saying, conflicts of interest are the greatest risk you face as an investor. The risk to you on any one day may be modest, but they are everywhere, and you run into them every day. In the course of an investing career, they add up.

The best way to protect yourself is to find out as much as you can about the business model of firms and individuals you deal with, especially those in or related to the financial industry.

Are you getting ready to hire a financial advisor? What do you look for?