This story begins with an illusionist — but one whose audience would be none too pleased to unravel the secret behind his act.
The deceiver in question (we liked to call him Hunter Simpson) was a high-flying producer at a regional firm where I worked as manager of various wrap programs. Simpson was a known rule bender to those of us who managed and policed at the firm, and when his name came up in one of our weekly meetings, we braced ourselves for the worst.
Turns out he had requested a change in the benchmark — from the S&P 500 to Treasury Bills — used to measure performance in one of his accounts. Ordinarily such a request would be handled by the operations department, but short-staffing there pushed the call to the desk of one of my co-managers, Tyler. Because of its source, this innocuous-sounding request smelled vaguely sinister, and Tyler pushed Simpson for details about why he wanted to make such a change. The glowing response was vintage Simpson: “I want the client to think I did a spectacular job picking stocks!”
Grudgingly, Tyler made the necessary changes to the statement.
Under the Cloak
After hearing this story, our staff decided to examine this issue more closely to see if there were other members of the “benchmark gang.” It didn't take long to confirm that a number of brokers were indeed requesting copious changes to their clients' benchmarks. Considering that the market was making a comeback, we hoped these actions were necessary adjustments to the new market realities and that the brokers were consulting with their clients about the changes. After all, such alterations can be appropriate, particularly when clients' investment allocations are changing.
Regrettably, further examination confirmed our fears about the benchmark changes — many of them were not appropriate to the allocation in the account. What's more, some of the “benchmark gang” were requesting changes with increasing frequency, galloping from one benchmark to the next, in an effort to select the one performing the poorest for that particular period.
But identifying abusers in a definitive way was more difficult than we imagined it would be. Even in cases where smoke was in clear evidence, it was always possible that the client had lit the fire, so to speak. Brokerage clients, after all, do not always behave rationally, and some seemingly dastardly benchmark shifts could indeed be in compliance with customer requests. Indeed, one of the brokers we suspected of unethical switching actually had acted on the request of his client. The broker had been using a mix of several different benchmarks that appropriately reflected the client's portfolio allocation, but the client preferred a simple comparison to the bond index.
This drives home a tough point: Sensing a broker is abusing the benchmarking rules and proving the abuse are two very different things. Still, proof or no proof, something needed to be changed to protect the client from misleading portfolio performances.
This was a touchy situation indeed. On the one hand, the firm needed to allow brokers the flexibility to change the benchmark to meet the requests of the client, but, on the other, the abuse of changing benchmarks needed to be squelched. The firm's solution was to change its policy to limit the number of benchmark changes allowed to four per account, per year. Even with this policy, clients are not fully protected, but the most gratuitous problems are at least curtailed.
Fortunately, the firm never had a client file a benchmarking complaint. Still, I am certain that several clients were misled into believing their investments were performing better than they actually were. The lesson, then, has yet to be learned the hard way. But that shouldn't keep us from stating it: Deceptions and illusions are the domain of magicians, not brokers. For those in the financial realm who decline to heed this, I have a warning: A magician's audience delights in exposing his deception, but if your “audience” finds out it has been duped, don't expect a rousing ovation.
Writer's BIO: Jeff Quaid is the pen name of a former manager of various wrap programs at a large investment house. He is currently pursuing a career in consulting.