Sunlight Disinfectant

Sunlight Is the Best Disinfectant:
Key Questions Every Investor Should Ask Their Financial Advisor

James W. Watkins, III, J.D., CFP®, AWMA®

CEO/Managing Member
InvestSense, LLC

“Sunlight is the best disinfectant.”
Justice Louis Brandeis

The recent bear markets of 2000-2002 and 2008-2009 have brought to light various unsavory practices in the financial services industry. In many cases, these practices were allowed to exist because of laws that do not hold all financial advisors to the same disclosure requirements regarding their business practices. 

Justice Brandeis’ quote was made in the early 1900’s to address the need for greater transparency and disclosure in government.  Most states and local governments have so called “sunshine” laws that require greater transparency and openness in conducting government affairs.

Sadly, in many cases, those regulating the financial services industry have failed to fully implement rules and regulations requiring full and complete disclosure by the financial services industry.  Even where rules and regulations requiring greater transparency have been enacted, history has shown repeated disregard and violation of such rules and regulations. One only needs to go to the “news” section of the web site of either the Financial Regulatory Agency web site ( or the Securities and Exchange Commission ( to see the continual stream of fines.

Two prime examples of the harm that can be caused by the failure to require greater transparency in the financial services industry can be seen with regard to 401k/403b plans and preferred provider/revenue sharing arrangements.  While the Employees’ Retirement Income Security Act (ERISA) was enacted to provide better treatment and protection for employees and their retirement, the law still does not require that all fees and expenses in 401k and 403b plans be disclosed separately. 

Without such information, employees cannot adequately assess the fairness of the fees being charged in their retirement plans. The harmful impact of such fees and expenses has been clearly documented, yet the lack of transparency is allowed to continue.

Financial service product providers naturally seek to improve sales of their products.   One of the most commonly used sales incentive techniques used by product providers has been revenue sharing arrangements with broker-dealers and financial advisors.  Under these revenue sharing agreements, the product providers would offer increased commissions for sales of their products and/or agree to direct brokerage transactions to broker-dealers, who would benefit from the commissions generated from such trades.

The problem with these revenue sharing agreements was that neither the agreements nor the actual or potential conflicts of interest created by such incentives were required to be disclosed to investors as long as the investment recommendations provided to a customer were “suitable” for that customer. Consequently, customers were allowed to falsely believe that the information and advice they were receiving was truly objective and based solely on their financial goals and needs. 

During 2004 and 2005, collectively, regulatory bodies fined over thirty firms more than $200 million dollars, collectively, for failing to disclose revenue sharing to their customers.  Chances are that very few investors were even aware of such violations and fines, as the regulatory bodies generally do not contact the victims of such practices and such actions generally go unreported in local newspapers. 

Questions Every Proactive Investor Should Ask Their Financial Advisor

If Congress and the financial service regulators are not going to require more disclosure and greater transparency from the financial services industry, then it is up to investors to take the initiative and protect themselves by requesting such disclosure from their financial advisor.  In some, perhaps many, cases, the financial service provider will refuse to make such disclosures since there are no laws that require them to do so.  Such refusals should serve as red flags to investors to assess their relationship with such advisors and question why the advisor refuses to make such seemingly harmless, yet important, disclosures and what they have to hide.

The continuing lack of transparency in the financial services industry denies investors with the information they need to educate and protect themselves and their financial security. Evidence of this fact can be seen in a 2008 Rand Corporation report, commissioned by the Securities and Exchange Commission, to study public perceptions of investment advisors, stockbrokers and other financial advisors and their business practices.

One of the most significant findings of the study was that fact that investors generally misunderstood the legal obligations of the various categories of financial advisors.  Investors overwhelmingly and mistakenly believed that stockbrokers, not investment advisors, were required to act as fiduciaries, disclose conflicts of interest and always act in a customer’s best interests.  This mistaken belief may have proved extremely costly to investors, who may have withheld action when action would have been prudent based upon their belief that their financial advisor was acting in a fiduciary capacity and was watching out for the financial interests.

The following questions are provided as suggestions for gaining a better understanding of the relationship between investors and their financial advisors, a clarification of the guidelines as to what both the investor and their financial advisor expect of each other.  A checklist with the questions is provided at the end of this paper.  Please keep in mind that the questions provided are not intended to be exhaustive, but rather are intended as a step in determining the nature of an investor’s relationship with their financial advisor and to inquire into areas where conflicts of interest may exist or develop.

Some investors have reportedly asked their financial advisors to initial their responses and sign the checklist as evidence of their commitment.  To date, reportedly none have done so.

1. Will you be acting in a fiduciary capacity in working with my account(s)?

This cuts strength to the chase.  Fiduciaries are required to always put a client’s interests first and to fully and completely disclose any and all actual or potential conflicts of interest.  Non-fiduciary financial advisors are not required to disclose actual or potential conflicts of interest and are allowed to put their personal interests ahead of their customer’s interests as long as the investment advice they provide is merely “suitable” for the customer, but not necessarily in the customer’s best interests.

2. If you will not be acting in a fiduciary capacity on my account(s), what standards/ guidelines will you be using to determine the suitability of your recommendations?

Most broker-dealers and financial advisors used some sort of questionnaire to assess a customer’s risk tolerance level.  Aside from the fact that such questionnaires are flawed and easily manipulated, sometimes deliberately, the questionnaires only address one part of the risk tolerance assessment process, an investor’s willingness to accept risk.

Studies have consistently shown that investors are prone to overestimate their risk tolerance level due to their lack of actual experience with suffering such losses and the impact of such losses.  Consequently, in assessing risk tolerance, a financial advisor is required to properly assess both an investor’s objective willingness to assume risk and an investor’s objective ability to bear investment risk.

It has been my experience that many financial advisors, and for that matter many compliance officers, are unaware of the objective prong of assessing a customer’s risk tolerance level.  Failure to consider both aspects of risk tolerance often results in an investor being potentially exposed to unnecessary investment risk.

3. Even if you will not be acting as a fiduciary on my account(s), would you be willing to agree to fully and completely disclose in writing any and all actual or potential conflicts of interest in connection with any advice or recommendations you provide?

4. Even if you will not be acting as a fiduciary on my account(s), would you be willing to agree that you will only make investment recommendations that are both suitable for me and in my best interests?

5. Would you be willing to disclose, in writing, both the nature and amount of any compensation, of any kind, that you receive in connection with any advice and any product recommendations you make, including commissions, fees, 12b-1 fees, referral fees, finder’s fees, trips and conferences?

The issue of 12b-1 fees is a sensitive topic in the financial services industry.  12b-1 fees are annual fees paid by financial service product providers to financial advisors as long as the advisor’s customers remain in the product provider’s products.

Theoretically, the fees are paid to advisors for continuing to provide service to the accounts on behalf of the product provider.  The reality is that in many cases the advisor does not provide any ongoing service to the customer and the fee simply acts as a potential or actual conflict of interest, as an incentive to leave a customer in a product, even if it might not be in the customer’s best interest.

6. What processes, theories and/or software do you rely on in determining your investment advice and recommendations?

Beware of “black box” financial planning!  Many advisors use software programs to generate their financial advice, blindly accepting whatever results the software program produces.  Most of these software programs rely on Modern Portfolio Theory (MPT) and/or Monte Carlo simulations in producing investment advice.

Without getting into technical explanations, investors should be aware that both processes have significant weaknesses and are highly unstable due to their dependency on the accuracy of the input data required in their calculations.  Interestingly enough, Dr. Harry Markowitz, the father of MPT, chose to simply split his retirement fund 50/50 between a stock index fund and a bond index fund, foregoing MPT calculations altogether.

For more information about the criticisms and dangers of “black box” financial planning, please read our white paper, “Dirty Little Secrets: Protecting Investors and Fiduciaries Against ‘Black Box’ Investment Fraud.”

7. Are you willing to disclose, in writing, any and all data and assumptions that you use in formulating investment advice and recommendations for my account(s)?

8. Are you willing to disclose, in writing, the advantages and disadvantages of each recommendation you make for my account(s)?

9. Are you willing to disclose, in writing, the terms of any and all revenue sharing arrangements that you, your firm, or your broker-dealer have with any other companies?

10.  In making investment recommendations for my account(s), are you willing to disclose to me when you are recommending proprietary products of your firm, your broker-dealer or an affiliated company?

11.  In cases when you do recommend proprietary products of your firm, your broker-dealer, or an affiliated company, would you be willing to provide me with a list of comparable no-load mutual funds and/or exchange traded funds?

Questions 9, 10 and 11 are designed to address potential or actual conflict of interest situations.  Advisors typically get a higher commission and other incentives if they sell their firm’s proprietary products.  Many financial advisors simply give a customer a prospectus for any products they may recommend without providing any more detail about the recommended product.

Very few people, financial advisors included, take the time to completely read a prospectus, At best, they may look for one or two specific items in the prospectus.  During my compliance days, there were numerous cases where I would not approve a trade because the information in a mutual fund’s prospectus made the trade unsuitable for the customer.  In most cases the stockbroker would admit that they had never read the prospectus, but had simply relied on representations from the mutual fund company’s representatives.

12. In making investment recommendations for my account(s), what criteria do you use in determining whether an actively managed mutual fund is a “closet indexer?”

13.  If you recommend actively managed mutual funds for my account(s), would you be willing to disclose, in writing, the effective “active expense ratio” for each such mutual fund recommended?

Questions 12 and 13 are designed to avoid losses due to overpayment of asset management fees for actively managed mutual funds whose performance is due primarily to the performance of some stock market index instead of the fund’s management team, i.e.,  “closet indexers.”

Investors can determine whether an actively managed mutual fund might be a closet indexer by looking at a mutual fund’s R2 rating.  The higher a fund’s R2 rating, the higher the correlation of the fund’s performance to its relevant stock market index.

Actively managed mutual funds charge significantly higher fees than index mutual funds.  Consequently, if a fund has a high R2 rating and charges a high management fee, an investor is effectively paying a much higher management fee for the active advice than the fund’s stated management fee.

One way to measure the effective cost of the active management portion of a closet indexer is to compute the fund’s “active expense ratio.”  The active expense ratio is calculated by using a fund’s R2 rating to determine the percentage of a fund’s performance due to a relevant index, deducting the management fee charged by a index mutual fund that  tracks the relevant index, and then calculating the effective cost of the active management as related to the fund’s total management fee.

Investors who are paying the higher management fees for closet index actively managed funds are simply throwing money away since similar, and often better, results could be obtained by simply investing in a comparative index mutual fund with much lower management fees.

14.  Which approach to asset allocation do you prefer, static or dynamic?

Static asset allocation believes that once you calculate an asset allocation plan for a customer, you basically never change the allocation percentages unless life changing events occur.  In most cases, the plan is reviewed periodically and assets are bought and sold in order to restore the original allocation percentages.

Dynamic asset allocation takes a more flexible approach by factoring in changes in the economy and the stock market and adjusting the original allocations or reallocating assets when appropriate in order to take advantage of such changes and to manage potential investment risks created by such changes.

Neither Dr. Markowitz not Dr. William F. Sharpe, both Nobel laureates for their work in the area of investment management and asset allocation, advocate a static approach to asset allocation.  In fact, Dr. Sharpe is on record as promoting the benefits of flexibility in asset management in order to manage investment risk.

15.  Will you be personally managing my account(s) or do you intend to recommend that I turn the actual management of my account(s) over to a third party money manager?

16.  If I agree to turn management of my account(s) over to a third party money manager, will you continue to monitor the performance of and the strategies used by the money manager and advise me when action needs to be taken to protect my financial interests?

17. If I agree to turn management of my account(s) over to a third party money manager that you recommend, will you agree to provide me with written documentation of the due diligence you conducted on the third party money manager prior to your recommendation, including the date such due diligence was done, by whom the due diligence was done, how many other money managers were evaluated in the due diligence process and the names of the other money managers evaluated, and the data found and relied on by you in deciding to recommend the third party money manager?

18.  If I agree to turn management of my account(s) over to a third party money manager that you recommend, will you provide me with a copy of any and all agreements that you, your firm and/or your broker-dealer have with the recommended third party money manager?

Third party money managers often attempt to limit their liability by including language in their contracts with broker-dealers and investment advisors that states that the broker-dealer or the financial advisor, not the third party money manager, will be responsible for determining both the initial and ongoing suitability of the money manager’s program and performance.

Many of today’s financial advisors see themselves as asset gathers and want nothing to do with the actual management of client assets.  Unfortunately, these asset gatherers sometimes are either unaware of or simply ignore their ongoing suitability obligations to their clients.  As a result, I have seen too many cases where investors have suffered significant losses simply because neither the third party money manager nor the financial advisor was protecting the investor’s interests by performing ongoing suitability analyses.

19.  Regardless of the eventual outcome, have you or your firm ever been the subject of a legal or a regulatory action?  If so, are you willing to provide, in writing, the date(s) of such proceeding(s), the parties involved in the proceeding, the court or regulatory body in which the complaint was filed, the nature of the claimed offense, the eventual outcome and the amount of any judgment or settlement paid?

Investors can and should always do periodic background checks on their financial advisors.  Fortunately, background checks can now be done quickly over the Internet through available resources at both the FINRA ( and the SEC ( web sites.

If your financial advisor recommends the purchase of a variable annuity, my advice would be to just say “no” and get up and leave.  If you are considering the purchase of a variable annuity, I would strongly recommend that you read our white paper “Variable Annuities,” as the paper discusses some of the key issues involved with these products.  There is a very legitimate reason for the saying that “annuities are sold, not purchased.”


While Congress and the regulatory bodies that oversee the financial services industry are considering new rules and regulations that would require greater transparency in the financial services industry, the fact remains that the industry, inexplicably, is still allowed to conduct much of their business in a manner that denies investors the information and fair treatment they deserve and need in order to properly protect their financial security.

Until changes are made requiring that such transparency and fair treatment are required, prudent investors must take the initiative to force their financial advisors to either acknowledge the value of their customers by becoming more transparent, allowing the “sunshine” into their client relationships, or risk losing their clients.