A Case Study in Financial Services Malpractice
Financial services is the perfect example of an industry where enormous information asymmetry between businesses and consumers means that consumers are easily duped by those who might try to take advantage of them. This information asymmetry is reinforced by a vast array of bewildering technical jargon that ensures that non-specialists will have trouble understanding what is happening to their money. Unfortunately, it’s also an industry that folks are all but compelled to interact with; after all, we all must prepare for retirement, and given public and private pensions simply don’t cut it anymore, everyone has to become an investor.
These facts were made painfully evident to me, recently, as I heard the story of someone who was duped by an FS Financial employee to engage in a dubious investment strategy that is likely to cost them thousands of dollars or more while enriching that employee.
So, below, I’m going to try and cut through a bit of the bullshit and explain what happened in this particular case and, along the way, hopefully illustrate some of the obvious ways that folks might get screwed by unscrupulous investment advisers.
Note, everything below applies to the Canadian marketplace. I believe there’s important lessons to be learned here, regardless, but the particulars almost certainly don’t apply to other countries.
Mutual funds and deferred-sale charges
Have you ever wondered why the investment adviser exists? Why do these people do this job? How do they get paid?
Well, let’s start with the basic idea of mutual fund, one of the most common investment vehicles folks buy and sell. A mutual fund is an investment program where investors buy shares in the fund, and the fund then trades in various stocks, bonds, or other investment vehicles, with the shareholders sharing in the gains or losses of those investments.
In order to invest in a mutual fund, you simply buy shares in that fund. These days that can easily be done using an online trading platform or other self-directed investment program, but often people do this through an intermediary: the investment adviser.
Of course, an investment adviser must make their money somehow, and this is done by collecting some sort of commission.
When it comes to mutual funds in particular, these commissions can be taken as a percentage of the invested amount up-front, often up to 5% of the invested amount. But in Canada, far more common is something called a “deferred-sale charge”. In a DSC arrangement, the mutual fund provider pays the commission to the investment adviser instead of taking it out of the amount of money being invested.
Sounds great, right?
Well, there’s a kicker: If you, the investor, try to sell your shares in the fund too soon, there’s a penalty! In the first year, that fee can be as much as 6, 7, or even 8% of the amount being withdrawn. This fee then declines each year the shares are held until the fee reaches zero, typically 6–8 years out.
Now, if you’re investing long-term and can tolerate some risk of the fund doing poorly, this is fine. But if, for any reason, you need to liquidate your holdings (say, to put a down payment on a home or to free up funds to deal with an emergency), this can turn into many thousands of dollars in penalties.
Unfortunately, many consumer investors have no idea how deferred-sales charges work or that they might be subject to them.
Of course, this ain’t news. The DSC is a scourge on the Canadian investor community and has been reported on in many places and at many times.
But it gets interesting when you add something else to the mix…
Leveraged investment
Woah, wait, “leveraged”? What the hell does that mean?
Well, it’s more needless technical jargon. All it means is “borrowing money and then investing it”.
The term comes from the idea of a physical lever. The lever is a simple machine that multiplies the force applied to it. Similarly, leverage involves borrowing a large sum of money against some collateral, and investing that borrowed sum, multiplying the potential gains that would’ve been had if one had simply invested the collateral.
That should immediately make anyone a bit nervous. Unfortunately, I suspect that the mortgage industry has trained people to think this is normal. How so?
Well, for better or worse, many folks think of a house as an investment. Viewed this way, a mortgage is actually a leveraged investment, as opposed to a lifestyle purchase decision like a car or a boat.
Now, in the case of leveraged investing, the basic idea is incredibly simple and looks a lot like an interest-only mortgage (and we all know how great an idea those are):
- Borrow money using an investment loan.
- Invest that borrowed money in the market in a non-registered account.
- Pay only the interest on the investment loan.
- Realize gains through the investment that (hopefully) amount to more than the interest paid on the loan.
Note, there are a couple of other ways this can be arranged (one of which I discuss later on), but this is one of the more common methods.
There’s a couple of reasons why this might be appealing.
First, in Canada, the interest paid on the investment loan is tax deductible. For investors who’ve hit their RRSP contribution limit, leveraging this way can allow the them to continue to purchase shares in a non-registered account while realizing some of the tax advantages of an RRSP.
Second, lump sum investing typically out-performs traditional investing for obvious reasons: there’s more time for compound interest to apply to the full amount.
Combine these advantages with due to rock bottom interest rates, which makes borrowing a lot cheaper, and a lot of folks are looking at leverage as a way to increase their investment gains.
On its face this looks like a pretty great idea!
Well, leveraged investing and mortgages share another important trait: in both cases, if the value of the asset purchased with debt drops lower than the borrowed amount, the borrower finds themselves “under water”. And if the investor can’t afford the payments on the loan, they can find themselves trapped.
We witnessed this in the 2008 crash, when millions of people found that the value of their home dropped below the value of the mortgage. If you were a house flipper, this suddenly meant you were forced to default on your loan due to the inability to pay it back upon sale of the home. The result was a rash of bankruptcy filings and mortgage defaults.
When it comes to leveraged investing, this means that if the value of the investment drops below the amount of the loan and the investor then finds themselves in the position where they need to liquidate their holdings — for example, if they lose their job and can no longer afford the interest payments on the loan — they’ll find themselves unable to pay back the loan.
As a result, leveraged investing carries with it a great deal of risk, and is absolutely not something for the faint of heart.
FS Financial — Worst of both worlds
So, what happened to this person I know?
Well, they were sold on the idea of borrowing a significant amount of money and purchasing shares in a mutual fund with, yup, you guessed it, a deferred-sales charge. Unfortunately, this greatly compounds their risk, a fact the financial “adviser” failed to make clear.
Remember, in the next 6–8 years, if they need to liquidate their holdings because they’re under water or can no longer support the interest payments, they’ll have to pay a significant penalty, exactly when they likely can’t afford it.
Contrast this with a traditional RRSP where the investor can simply choose to stop paying into the fund.
Moreover, the investment “adviser” who recommended this strategy did so at a time when markets are at an all time high and starting to look shaky (leveraging is typically a strategy you employ after a correction, not before, to take advantage of market gains when money is cheap). The result may be a weak job market and poor fund performance, a perfect storm for the leveraged investor.
But it gets worse.
Naturally, this person asked the investment adviser if there would be any risk associated with the value of the investment dropping below the value of the loan, to which the adviser told them that no, they would not be responsible for those losses.
On it’s face this appears to be a lie, but it turns out it may not be. They might’ve simply been answering a different question.
A detour into margin loans
Oh god, more terminology. Don’t worry, this won’t hurt a bit!
Remember when I mentioned an “investment loan” earlier? Well, there’s another kind of loan out there that can be used for leveraged investment and it’s called a “margin loan”.
A margin loan is designed to reduce the bank’s risk that the investor could find themselves under water. Part of the loan’s terms is the loan-to-value (LTV) ratio, which is the ratio of the value of the loan to the value of the investment.
If that ratio drops below the LTV specified in the loan contract (due to the investment losing value), the investor will be required to sell some of their investment to pay back part of the loan and cover their position.
This is referred to as a “margin call”.
So if you’re a leveraged investor with a margin loan and things go bad, you may be forced to sell some of your position and realize immediate losses. This adds to the investor risk of leveraging but it means the bank doesn’t take on as much risk of the investor defaulting.
Back to FS Financial
So what our investment “adviser” was actually saying was that our investor would not be subject to a margin call if the investment declines in value.
This is technically true because the loan was a regular ol’ interest-only investment loan and not a margin loan.
But that wasn’t the question.
This does not mean that the investor isn’t responsible for paying back the loan and realizing losses if they can’t repay by selling off their investment. They absolutely are.
So was the adviser being intentionally misleading or just stupid? I have to assume the former.
One more thing
Looking at the communication between the subject of this blog post and their FS Financial investment “advisor”, I noticed something very interesting: they kept referring to the investor’s “contributions”. This is an extremely loaded term, implying money flowing into an investment vehicle of some kind (which is why RRSPs have an “contribution limit”).
But the investor wasn’t making contributions to an account.
Remember, when leveraging to invest, you have a loan. In this particular structure, the investor then pays just the interest on that loan on some regular schedule. But the “contribution”, that is the purchase of the mutual fund shares themselves, is done at the time the loan is granted and the purchase executed.
Every payment after that is just servicing the loan.
So when, later, this person, thinking like a regular investor, indicated they wanted to “increase their contributions”, the FS Financial “adviser” had no trouble complying! They simply took the amount that the “contribution” was to be increased (say, $100), calculated how big the loan would need to be to require an interest payment of that size, and then set up a new loan of that size that the borrower then approved.
It’s a clever little twist of language designed to do one thing: confuse the investor so they forget that what they were actually doing was just borrowing more money, thus increasing their leveraged position and their associated risk.
Meanwhile, the financial services guy earned a fat commission for a big up-front purchase of shares in the mutual fund. No conflict of interest there at all.
The Upshot
When you consider what actually happened here — the investor got a loan and bought an investment with that borrowed money, then paid interest while being subject to fees on early exit — it’s all actually incredibly simple. The complexity is all in the jargon.
So when thinking about this stuff, always try to peel away the language and get down to the nuts and bolts of what’s going on: What are you paying? What are you gaining? What are your obligations? Can you get out, and if so, what penalties might be applied if you do?
These are basic questions that a shady financial guy might not want to answer. The job of the investor is to cut through the BS to get the answers they need.
And worst case you can always walk away. If your financial services guy seems to be dazzling you with jargon or giving you the run around, leave.
Remember: you’re not stupid because you don’t understand their lingo.
A good, smart adviser will know how to explain these concepts in a way you’ll understand, because ultimately, this stuff ain’t that complicated. If they don’t do that, or can’t, they’re not worth your time.