The label on the shampoo I used this morning advised me to “lather, rinse, repeat.” This is a clear conflict of interest! The manufacturer gains if I double my consumption of its product. Is the label instruction for my benefit or the manufacturer’s profit? Why have I never seen a shampoo label say “lather, rinse, then go out and buy a competitor’s product for a second shampoo”?
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If this sounds too silly for a Bloomberg Opinion column, here is an academic paper making the same points about model portfolios published by asset managers, a $4.9 trillion branch of the U.S. asset management industry.
Large asset managers provide model portfolios for many purposes — as options in 401(k) plans, as blueprints for institutional clients and affiliated financial advisors, and as suggestions for unaffiliated investment advisors. These have the “lather, rinse, repeat” conflict of interest. On one hand, the asset manager wants happy clients, so it wants the model portfolios to perform well. On the other hand, it wants investment management fees, so it has incentives to recommend its own products, especially ones with the highest fees.
The same conflict exists in nearly every transaction. The seller wants satisfied customers — for repeat business and good word of mouth if nothing else — but also wants to get the most money for the least costly goods and services. Conflicts of interest are not evil. What matters is whether they are disclosed and how they are managed.
Model portfolios come with an explicit disclosure of the conflict. Moreover, any financial adviser who doesn’t understand without specific disclosure that asset managers profit when investors use their products should find another profession. There are strategists not affiliated with investment managers who provide model portfolios, and they charge for the service. Financial advisers have to know that investment managers giving away model portfolios free are making money from it in other ways. To manage conflicts, large asset managers monitor recommendations to ensure quality. Skeptical readers may question how carefully disclosures are read, and how sincere oversight is, but there’s nothing inherently dishonest about a producer recommending its own products.
The first problem with the paper is it analyzes model portfolios investment-by-investment. This defeats the purpose. Model portfolios are not intended to be lists of the best individual investments, but carefully balanced combinations of investments with the best portfolio characteristics, including risk, return, income, tax and other features. This is like criticizing the recipes that come on Philadelphia Cream Cheese packages (back when any was available) for recommending too many ingredients manufactured by parent company KraftHeinz. A recipe is not good or bad based on who makes its ingredients, but on how the result tastes.
Read the full article here by Aaron Brown, Advisor Perspectives
