PART I: FINANCIAL PLANNING

On an average Monday evening, Bobby Van's steakhouse on West 50th Street in Manhattan, New York, would have been buzzing with the cheerful chatter of bankers blowing off steam after a day's work. But on the evening of 15 September last year the mood in the favourite hangout of Lehman Brothers' staff was one of deep gloom. The company had filed for Chapter 11 bankruptcy that day.

A Forbes journalist likened the scene of sweaty, glazed-eyed men in wrinkled shirts to the end of a family wedding or a wake, as she observed them drowning their sorrows over lost jobs in depressingly cheerful looking cocktails. The financial crisis was already in full swing when Lehman went under, but the day the investment bank collapsed was the day the crisis got out of hand.

Sitting there, in the steakhouse, few Lehman staff could believe the curtain had really fallen for the Wall Street giant that had been around for more than a century and a half and had survived the 1930 crash. The feeling of disbelief was shared by many in the financial services industry around the world.

In Australia, MLC was holding its annual Implemented Consulting conference and MLC head of capital markets research Susan Gosling was in the middle of a presentation when the room erupted in a cacophony of Blackberries, announcing the bank's demise. "I looked at a sea of gobsmacked faces," Gosling recalled a year later at the same conference.

Australia did not escape the impact of the crisis, with former stock market favourites such as Babcock & Brown and Centro hovering on the brink of collapse, while at the same time whole sectors disappeared, as was the case with the non-bank mortgage providers.

Revenues dwindle

As stock prices collapsed, the financial planning industry was confronted with a drop in funds under advice (FUA). And as most planners are remunerated as a percentage of FUA, firms experienced falls in revenues averaging around 30 per cent. Planning business went into damage control and started informing their clients about the situation, and explaining the options they had.

The shock of losing large amounts of money in a matter of months gave rise to a feeling of disappointment among some planners' clients. It became painfully clear many clients held their adviser responsible for investment returns, rather than seeing them as strategy consultants.

In this environment of simmering dissatisfaction the collapse of Storm Financial had maximum impact. Submissions to the Parliamentary Joint Committee (PJC) on Corporations and Financial Services Inquiry into Financial Products and Services in Australia paint a picture of unscrupulous money-grabbing methods at the firm in which risks were downplayed, while the potential rewards were magnified. Margin lending strategies were allegedly abused to such an extent that clients living on Centrelink benefits were issued loans amounting to hundreds of thousands of dollars.

The debacle surrounding providers of managed investment schemes, such as Timbercorp and Great Southern, only added to the unease among clients. The committee has now to answer the question of whether these practices were an aberration in an otherwise diligent industry or whether such methods are more widely used. However, regardless of the outcome, the industry's reputation has been dented and this has sparked a broader discussion about managing conflicts of interests.

Conflicts of interest

The issues surrounding conflicts can be brought back to a single question: did financial planners have the best interest of their customers in mind when recommending investment products or were they driven by the compensation they would receive for the advice?

To answer this question it is helpful to start with the legal obligations financial planning practices have in Australia. ASIC lays out the regulatory framework for managing conflicts of interest in its Regulatory Guide 181, published in August 2004. This guide makes it clear the corporate regulator expects the industry to take the reins largely in its own hands, as long as conflicts are adequately disclosed.

"We do not think that we can, or should, provide exhaustive guidance on what licensees need to do to comply with the law," the regulator says.

"Licensees must determine, on an ongoing basis, what arrangements they need to have in place to ensure they maintain adequate conflicts management arrangements."

The FPA has issued additional guidelines to its members, which are aimed at assisting them in meeting the requirements described in the regulatory guide. It comprises four principles, which emphasise the need to disclose planning fees separately, carefully match the recommendation of products to a client's needs, ensure remuneration arrangements are not biased against the client and have arrangements in place that enable the interests of the client to be considered independently of wider group interests.

There is also a case for arguing financial planners have fiduciary obligations to their clients under common law, as their profession requires them to enter into a relationship of trust with their clients. But opinions about this interpretation of the law vary, judging by the request a financial planner made to the PJC inquiry to give practitioners explicit statutory fiduciary duties.

Regulatory Guide 175 is more outspoken on this topic and provides financial planners with rules for minimum requirements on the advice they provide. If planners provide clients with personal advice, they have to ensure the advice is appropriate considering the client's circumstances. This guide explicitly says a planner does not have to provide a client with the best advice possible, which is unsurprising as the 'best' advice is arguably a subjective 'quicksand'.

The regulatory system clearly identifies the need to put clients' interests first, but at the same time it does not monitor compliance to this principle for various practical reasons. One of the questions the inquiry now has to answer is whether the current model of self-regulation has worked or whether structural reforms are necessary.

Restoring confidence

Regardless of the question of whether regulations have been strict enough, the financial planning industry quickly realised it needed to restore confidence in its advisers, and the FPA took the lead by proposing to phase out commissions by 2012. "A move away from commission-based remuneration is key to protecting both consumers and the reputations of financial planners," FPA chief executive Jo-Anne Bloch said in May this year, when the association announced its plans.

"While people should be free to choose how to pay a financial planner, removing commissions will dispel accusations of conflict of interest."

The Investment and Financial Services Association has made similar recommendations on fees for the superannuation industry.

However, some critics have argued the move away from commissions will do little to safeguard a client's interest. The way a financial adviser is paid is of less importance than the practice of setting planners' business objectives, or as the critics have called them, sales targets. Critics say aggressive sales targets prevent advisers from giving appropriate advice. To make the targets, planners need to sell products with high upfront fees or commissions, or use questionable practices, such as switching clients between products in order to capture a sales commission.

In response to the criticism, the FPA has said every healthy business works with targets and these targets do not affect the quality of advice. "That is a completely ridiculous assertion that having targets leads to bad advice," Bloch has said.

"It is a pathetic attack on financial planners, which is completely unsubstantiated."

Targets are necessary

Setting aggressive targets in itself is not necessarily a bad thing and certainly does not have to lead to bad advice, Eureka Financial Services managing director Greg Cook says. "If you are targeting aggressive growth, I would like to see that it is a well-balanced growth; you're not suddenly doing trice as much gearing business this year as you did last year. Those things should set off alarm bells," Cook says.

"[But] if an adviser is underperforming and they need to double their production in the coming year, they might think that is an aggressive target, but there is nothing wrong with it."

He argues that revenue targets should be combined with targets that ensure quality of service. For example, practices should measure if they have conducted enough client satisfaction surveys and whether these were finalised in time.

"Sales and revenues targets need to be a part of targets, but they shouldn't be the be-all and end-all. The days of saying 'between now and June 30 we are going to sell so much of this tax-effective product' are gone. But there are some purists out there that say you shouldn't have any targets for how much insurance premiums you are going to sell in a year," Cook says.

He points out Australia has a severe underinsurance problem. "Even amongst my own clients there are many people that for whatever reason are underinsured. I don't see any problem in saying 'this year we're going to focus on adding trauma insurance to clients' portfolios', and having a target for that," he says.

But the federal Treasury Department does raise some questions in its submission to the PJC inquiry about financial planners' independence.

"In Australia, we are aware that there are significant links between product manufacturers, financial planners and platform providers," Treasury says in the submission.

"Most large financial planning firms (ie, dealer groups) are owned by diversified financial services groups that also include funds management entities (ie, product manufacturers). It is common practice for financial planning firms in these groups to receive a significant proportion of their revenue in the form of fees and commissions from related product manufacturers."

It then refers to the ASIC shadow shopping survey on superannuation advice conducted in 2006 and says that there is some evidence that remuneration and association-based conflicts are inappropriately influencing advice. "Concerns are being raised that advice has the flavour of selling rather than the giving of impartial advice," Treasury says.

A number of the largest planning groups have addressed this issue by proposing a better distinction between sales and advice roles. MLC has probably submitted the most comprehensive framework as to how this can be done. In its submission to the inquiry, it proposes a separation between businesses providing 'affiliated advice' and 'independent advice'. "The independent model separates advice from manufacturing and is 'indifferent' as to where monies are placed," MLC says in the submission.

Both types of businesses should have separate licenses, it says.

AMP makes a case that financial planning firms backed by a large organisation with a strong brand protect consumers against malpractice. "Because our brand is so important to us we would make sure clients wouldn't lose their money," AMP Financial Services managing director Craig Meller says.

Commonwealth Bank of Australia says in its submission that the current legal and professional obligations already ensure advisers will not deliver inappropriate advice. The focus, therefore, should be placed on monitoring practices by the regulator. "We recommend licensees be required to report a standard set of information periodically, say annually, about their respective business models," the bank says.

Such reports should include the number of statements of advice produced, list of approved products and advice strategies recommended.

Solutions

Part of the industry's problems with conflicts of interest comes from the absence of uniform quality standards in the financial planning industry, which is largely the result of the lack of restrictions on the use of the terms financial planner and adviser. This means the services of a planner can range from mere product advice to sophisticated financial consultancy services.

In its submission to the inquiry, the FPA has asked for restrictions on the use of the term and made a case for stricter qualifications for those who should be allowed to use the term. "The minimum standards required under RG146 are inadequate for the delivery of quality advice and therefore create a risk of consumers acting on information provided by providers that are not appropriately or professionally qualified," the association says in its submission.

The association's certified financial planner (CFP) certification ensures a high level of skill, but still many planners are not qualified under this system. AMP has the highest level of CFPs in the industry, but out of 1360 planners still only 454 have received the designation. Meller says this does not mean the firm's planners that have not sat the exam are any less qualified.

"Our compliance requirements call for a higher level of quality than the legal requirements," Meller says.

"All of our planners would be operating at a higher standard irrespective of whether they have been through the CFP process and taken the exam or not.

"Clearly at the moment it is a voluntary qualification. Some planners just look at the effort that they have to put in to take the exams and say: 'I'm already operating at a similar standard. I don't want to spend my time taking more exams'."

But he welcomes the FPA's initiatives and says that if legislation for a CFP-equivalent threshold is passed it would not create any problems for the firm. "We don't think we have a significant issue in ensuring that the vast majority of our planners could be compliant in a short space of time," he says.

PART II: FUNDS MANAGEMENT

Funds management: are the fundamentals still in place?

The impact of the financial crisis on investment managers has been profound. Not only did they face the wrath of clients as the returns on investments became execrable, but the very foundations on which their portfolio management practices were based have been shaken to the core.

Modern economic theory is based on the efficient-market hypothesis, which assumes all available information about companies is reflected in the price of a stock and, therefore, stocks are valued at a fair price. Although most fund managers would argue markets are not highly efficient and there are considerable periods during which securities are undervalued, most would agree that over time markets will recognise discounts and prices will adjust accordingly. After all, there would be no point in buying inexpensive stocks if they always stayed cheap.

But the financial crisis has cast considerable doubt over the efficient-market theory. The fact highly complex financial products, such as collateral debt obligations, had almost no value was not recognised until it was too late and the system had come crashing down. Not even rating agencies recognised the systematic deferring of risk would not turn lead into gold.

Proponents of the efficient-market theory would say the market did not adjust, because the information was not readily available. But former GMO head of strategy Jack Gray, who is currently working for the Paul Woolley Centre for Capital Market Dysfunctionality as its investment roundtable director, argues several market commentators had predicted the financial crisis, including old colleague GMO director Jeremy Grantham, PIMCO managing director Bill Gross and the Bank of International Settlements.

Why we froze

The question is why nobody acted on these warnings. Gray argues there are two main reasons for this. The first question is one of timing: you do not want to act too early, because you will miss out on high returns and lose your customers. Gray experienced this first hand during the technology bubble when he was still with GMO. Recognising the bubble for what it was, he did not participate in the frantic buying of technology stocks, a strategy the firm's clients did not agree with. "We lost during the tech bubble two-thirds of our business, just walked out of the door, because we thought this is just nonsense and it is going to end," Gray said at the MLC Implemented Consulting conference held in September this year.

When the bubble burst, however, his clients returned.

A more fundamental reason can be found in the caverns of the human mind, Gray argued. "We are seriously limited in what we can imagine. We can't see the future very much," he said.

This lack of imagination extends to financial markets, as people simply could not picture a collapse of the system.

This is the main problem with modern economic theories: they do not take into account the practical implications of human behaviour, Gray said.

"The [economic] models are still primitive in the sense they assume that if I want to transact in the market, I just go out there," he said.

"There are no agents, there are no brokers, there are no custodians, no managers, no consultants . yet those institutions have played an enormous role in what goes on in the markets."

Critics, like Gray, are looking to bring back a human dimension to economic theories and to the assumptions that are based on them. This has sparked a renewed interest in unorthodox theories, such as the Austrian School of Economics, while others have pleaded to bring back more government intervention in a renewed appreciation for the Keynesian model.

Practical implications

MLC head of capital markets research Susan Gosling is likely to agree, at least to some extent, with Gray when he argues that many economic models are still somewhat rudimentary. Gosling says one of the lessons that can be learned from the crisis is that the dominant approach to risk is too narrowly focused on mathematical equations.

"Traditional models are too simple. We need a model that makes the most of information about what the future might look like. It needs to provide us with information about the sources of uncertainty," she says.

In response, MLC has introduced a strategic overlay, which affects the asset allocation process of both its institutional and retail funds.

Most asset allocation models used today are based on the modern portfolio theory of United States ecomomist Harry Markowitz, for which he received the Nobel Prize in Economics in 1990. Markowitz developed an algorithm, called the critical line algorithm, which seeks to identify all portfolios that minimise risk for a given level of return and maximise expected return for a given level of risk.

But Gosling says the financial crisis has shown the shortcomings of this model. "It's a nice, neat model . but it just doesn't fit reality," she says.

 One of the main problems she has with it is that it considers risk as a constant, while she argues there are many different types of risks and they are constantly fluctuating. For investors the main risk is that markets do not deliver the returns they need to achieve their objectives. "That is a risk we need to manage more effectively as an industry," Gosling says.

MLC is currently implementing the use of this strategic overlay in all of its funds, but it allows for deviations from the strategy in terms of allocation to growth assets of plus and minus 5 per cent to accommodate the investment objective of the fund. At the moment, determining the level of growth assets in a portfolio is difficult, Gosling says. "There are no strong indicators on whether you want to put risk back on the tables," she says.

"We have seen some risk coming off asset prices, but we are on a trajectory that is unclear and it retains some significant risks. We are really in many senses in uncharted territory."

Investors demand simplicity

Fund managers are presented with the dilemma of on the one hand the need for more comprehensive investment models to better anticipate falls in the market, while on the other hand they have to respond to a renewed aversion to risk among investors that has brought with it an appetite for simplicity. As investors are slowly regaining the courage to get back into the market, they are demanding easy-to-understand products to invest their funds in. This development has sparked a renewed interest in low-cost, no-frills indexing strategies, Vanguard principal and head of retail Robin Bowerman says. "A lot of financial planners are disillusioned with what they saw as what active management was promising to do. One of the lessons that comes out of the financial crisis is that it's the power of the markets that really drives returns, much less the impact of any manager, how good or how bad that might be," Bowerman says.

The crisis has also silenced some of the criticism Vanguard has received about its products, he says. "We were criticised for being too conservative in fixed interest, but nobody is asking those questions now," he says.

Most of Vanguard's inflows go into Australian, international and fixed interest products, he says, and to a lesser degree listed property. Vanguard has expanded its product range with exchange-traded funds (ETF). "The most exciting aspect of ETFs is it gives planners the opportunity to grow in the direct equity space," Bowerman says.

Northward Capital chief executive Darren Thompson says although active management might have struggled a bit internationally, in Australia it has followed a different trajectory. "Obviously we have a vested interest [to say this], but the history in the Australian market is that the median active manager has outperformed the market over the last 20 to 25 years," Thompson says.

This is partly the result of a difference in corporate culture. "There is perhaps better access to company management and a better understanding of business models that are implicit in this market; it's a smaller and easier market to understand. That is perhaps where the opportunity arises to add value," Thompson says.

"In the last 18 months, if you owned the index you would own stocks like Babcock & Brown, Allco and a number of companies where you'd hope through fundamental research of business models you would identify fundamental risks."

Tyndall managing director Brett Himbury says it is important to keep the Australian context in mind when drawing conclusions about the efficiency of existing investment methods based on the developments in the past 12 months. "Let's not overreact. Australia has done well because of our competitive environment [and] legislative system, and [because] our regulators, like APRA (Australian Prudential Regulation Authority), have generally speaking done a reasonable job," Himbury says.

He says this extends to the funds management industry, where managers have added more value in the past 12 months than they have for a long period of time. "The average manager has consistently added value compared to the benchmark and in the last 12 months that has gone up considerably," he says.

"Markets have recovered and managers have demonstrated significant skill, which has added to the wealth of Australians."