“I wouldn’t give you two cents for all your fancy rules if, behind them, they didn’t have a little bit of plain, ordinary, everyday kindness and a little looking out for the other fella, too.”
Jefferson Smith in Mr. Smith Goes To Washington
Jefferson Smith was referring, of course, to Congress in that line but another Mr. Smith – Greg – this week came to the shocking revelation that Wall Street – of all places – has a similar disregard for the “other fella”. The modern Mr. Smith went to London to work in Goldman Sachs’ derivatives division and after 12 years of, presumably, highly remunerated toil, discovered that the company’s moral compass has been pointing in a rather more southerly direction of late. Mr. Smith pins the blame for this course correction on Lloyd Blankfein who, according to Mr. Smith, managed to alter the culture of the firm from the charitable organization that existed when he joined to the vampire squid it is today. I am sure Mr. Smith had only the public’s best interests in mind when he took to the pages of the New York Times to announce his transformation from naif to idealistic cynic.
I have worked in the financial services industry for over 20 years and it didn’t take me 12 of them to discover that the firms I worked for didn’t always have my clients best interests at heart. I’m sure Mr. Smith is quite a bit smarter than I am – he was a Rhodes scholar candidate – so I find his claim of extended naivete a bit hard to swallow. His newfound idealism is nevertheless admirable and I wish him the best on the lecture circuit and with the inevitable book that will surely follow soon. Self interest is the beating heart of capitalism and I’m sure Mr. Smith’s pursuit of it will have a positive effect in helping to reveal the conflicts of interest that continue to exist on Wall Street.
Goldman Sachs, it should be stressed, is hardly unique on Wall Street. Most investment firms have conflicts of interest that are hard or impossible to overcome. An investment bank that represents a client raising capital will always have a conflict of interest with its other clients who are providing that capital. The firm must try to strike a balance between the interests of the investment banking client, its brokerage clients and the firm’s bottom line. It is a nearly impossible task to keep all those constituencies happy. The same is true for other lines of business pursued by Wall Street. In Mr. Smith’s case, pricing illiquid derivatives in an opaque market, the firm has a distinct informational advantage that he believes Goldman Sachs exploited for the benefit of its bottom line. That may or may not be true, but Mr. Smith likely doesn’t have all the necessary information to make that judgment. Upper management, with knowledge of all Goldman’s lines of business, may have been using Mr. Smith’s division to balance out other transactions with the same client. That Goldman Sachs has been able to retain its client base over many years – even during Lloyd Blankfein’s tenure – is testament to its ability to strike the right balance.
From the perspective of the individual investor, the conflicts of interest inherent in the Wall Street model make investing a more difficult task than it should be. Your representative down at the local brokerage office is often as much in the dark as the clients he is attempting to help. And yes, most – not all – are doing their best to help their clients make sense of the extremely confusing task of creating and preserving wealth. Is the analyst putting out a buy recommendation being pressured to keep an investment banking client happy? Does the firm have too much inventory of that bond with the large broker credit? Is the mutual fund the wholesaler is hyping in the branch conference room a good buy or is the manager just on a lucky streak? Should I sell that stock that has gone up a lot or is my analysis clouded by the need to generate a commission and make the mortgage payment? Has the firm vetted the new hedge fund sufficiently or is it a ponzi scheme in disguise?
At Alhambra, we’re organized as an investment adviser and we have attempted to eliminate the conflicts of interest. We aren’t involved in investment banking and so don’t have to balance the interests of different clients. We don’t generally use actively managed mutual funds – we use ETFs and index funds with few exceptions – so we don’t have to judge the talent of other portfolio managers. We don’t invest in hedge funds specifically because of their opaque nature. We never act as a principal in a transaction; we aren’t on the other side of the trade. We don’t collect commissions on investment products or trades so when we do a transaction it is only because we believe it is necessary and prudent. And unlike the brokerage industry, we are held to a fiduciary standard so we have a legal mandate to consider only the best interests of our clients.
Yet, even we have conflicts we must overcome. While we offer passive investment strategies we also offer actively managed portfolios. Active management brings with it a pressure to perform. It should go without saying that high returns in these active management programs are good for our firm’s bottom line and poor performance is bad. Will we subconsciously take more risk than we should in our attempts to generate returns that will increase our bottom line? Will we be tempted take less risk due to fear of losses that would reduce our fee revenue? I know of no way to eliminate these conflicts and also pursue the active strategies that I believe are in the best interests of our clients but we do discuss them and are always vigilant about fulfilling our fiduciary responsibilities.
There is no perfect business model in the investment industry but I believe the adviser model is superior to the brokerage model. That’s why I organized the firm that way when I founded it and why I only hire advisers with the same dedication to their client’s interests. I can’t change human nature – we are all self interested – but I can provide an environment where our interests are aligned – as much as possible – with our client’s. There are a lot of industry people who read this weekly missive and to them I extend an invitation. If you are still operating in the brokerage model and have tired of trying to determine where the interests of your clients and your firm intersect, call me. You won’t ever have to wonder about our motives as a firm. We always stand on the side of the client. And Mr. Smith, if you’re reading this, the invitation applies to you as well.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: email@example.com or 786-249-3773.
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