With securities regulators contemplating whether disclosure is enough or if they need to pursue more interventionist investor-protection strategies – such as banning trailer fees and imposing a statutory fiduciary duty upon financial advisors – new research suggests that there are ways in which disclosure can actually be harmful to clients.
Historically, securities regulators have favoured disclosure as their primary strategy to ensure investor protection. The assumption is that if all the salient facts and the attendant risks in a company’s business or an investment product’s strategy are disclosed, then clients can make an informed decision. Similarly, when it comes to investment dealers and financial advisors, regulators typically have turned to disclosure as a way to make certain that clients know what they are getting into when they open an account or make a trade.
In the regulators’ efforts to beef up investor protection, disclosure has been favoured rather than banning certain products, business structures or compensation arrangements. For example, the client relationship model reforms aim to improve the transparency of the client/advisor relationship, conflicts of interest, costs and investment performance.
However, new research from Sunita Sah, assistant professor of strategy, economics, ethics and public policy with Georgetown University in Washington, D.C., points out that disclosure can have unintended consequences and can also lead to perverse outcomes.
Speaking at an investment industry conference in Toronto in late October, Sah detailed the results of her recent research, which reveals that the disclosure of conflicts of interest can be potentially harmful to investors.
In a series of experiments, Sah and her colleagues examined the impact of disclosing a conflict of interest in a scenario involving a choice between two options in which one option is clearly preferable for the client.
People off the street were randomly assigned to serve as either “advisors” or “clients” in these experiments. The research found that in situations with no conflict of interest, 93% of “advisors” recommended the superior option and a similar percentage of “clients” chose that option.
However, when a conflict of interest was introduced, whereby the advisor would benefit if the client chooses the less appealing option, then about 80% of the “advisors” recommended the inferior option. More surprising, in the scenario involving a conflict of interest, 57% of clients chose the inferior option.
In cases in which the conflict of interest was not disclosed, 42% of clients chose the inferior alternative – but this jumped to 76% of clients in cases in which the conflict of interest was disclosed.
Therefore, Sah’s research found that most clients chose against their own best interests even when they were told that the advice they received was biased. In fact, clients were more likely to choose against their own best interests when receiving advice that they knew involved a conflict of interest.
The study found that disclosing the conflict of interest did help to warn clients, in that they reported putting less trust in the advice they received. And, yet, the likelihood of following that tainted advice went up.
The researchers attribute this finding to an effect they call “the burden of disclosure,” which means that when clients are warned that advice is biased, they nevertheless feel more compelled to follow it.
The researchers theorize that in this context, disclosure functions as an implicit request for help. By disclosing a conflict of interest, the advisor effectively is asking the client to go along with something that benefits the advisor; and, as most people are naturally co-operative, the client feels compelled to help.
“Instead of [being] a warning, disclosure can become a burdensome request to comply with distrusted advice,” according to the paper detailing the results of these experiments. At the same time, the paper continues, clients also may feel that rejecting advice pertaining to a conflict of interest indicates that they don’t trust the advisor and that they are reluctant to display this distrust openly.
Despite these results – and given that disclosure is not likely to be abandoned as a way of dealing with conflicts of interest – the researchers also examined ways to enhance the protective effect of disclosure and diminish the burden.
After conducting followup experiments that adjusted the timing and source of disclosure, the conclusion is that clients are better served if the disclosure comes from an external source and if clients aren’t in the presence of their advisor when they make their decision. This way, clients feel less compelled to go along with advice they don’t trust.
“Disclosure is especially likely to produce perverse effects when it happens in person, establishing mutual awareness of the advisor’s interests,” the paper says. So, the paper concludes, the disclosure of an advisor’s conflict should not come from the advisor; rather, from some external source instead.
In addition, the research suggests, providing greater distance between client and advisor, such as a cooling-off period, also can help clients to act in their own best interests when faced with advice involving a conflict of interest.
Ultimately though, the paper’s advice for policy-makers is that it’s better to eliminate conflicts of interest than to hope that disclosure can solve the problem: “We believe that transparency is often insufficient to deal with the problems caused by [conflicts of interest] and, in some cases, can lead to perverse effects, so more fundamental interventions are needed. As many others have advocated, the optimal solution to [conflicts] is to eliminate them wherever possible, or at least to increase the availability of unbiased advice.”
These findings offer much food for thought for regulators as they ponder the need for more invasive reforms in the retail investment business.
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