5 Warning Signs to Recognize Conflicts of Interest
In the United States, about half of all medical doctors accept some form of payment or gifts from pharmaceutical or medical device companies.[1] You are correct if you suspect these payments influence doctors’ recommendations to patients. The results of 36 individual studies showed the same outcome: “Industry cash influences how doctors treat their patients.” The same type of influence affects politics (through lobbying), magazines and newspapers (through sponsored content), and social media influencers (through paid sponsorships). It also, unfortunately, affects the financial industry.
When financial advisors are offered incentives—commissions, bonuses, paid vacations—in exchange for promoting a specific product, their lens becomes clouded. Even if they don’t intend to, they will likely be swayed by those incentives. That was also the case for me years ago when I worked for a commission-based brokerage company. Even though I tried to act in my clients’ best interests, there was always company-wide pressure to push certain investment products. And that creates an inherent conflict of interest.
How can you recognize potential conflicts of interest?
For the average investor, the signs may not be obvious. Companies might expertly conceal fees or obfuscate their sponsors. What, then, is the everyday investor to do? I recommend taking the following five warning signs into consideration:
1. Unclear Sources of Revenue
How does a company make its money? What are the sources of compensation? With fee-only wealth management firms, income is generated through its clients’ fees — often charged by the hour or taken as a percentage of the client’s assets under management. The answer isn’t always so simple for other financial companies. Some companies generate income through commissions, by charging fees for buying or selling securities, or by earning interest on clients’ uninvested cash.
The investing app Robinhood has gained popularity as a commission-free service with no minimums for investing. While that might be true, it must make its money somehow, right? After all, it is a publicly traded company and beholden to its investors who are counting on its continued growth. So, how does it do it? Mainly, it sells customers’ orders to high-frequency trading firms. This controversial practice relies on sophisticated computers and complex algorithms, which can edge out the average trader or cause extreme fluctuations in the market if an algorithm is triggered. The practice itself is not illegal, but removing humans from trading and relying solely on machines can cause plenty of trouble. For Robinhood, that trouble culminated in the Financial Industry Regulatory Authority (FINRA slapping it with a $57 million fine and order to pay $13 million in restitution because thousands of customers were approved for options trading when they weren’t eligible and other misleading communications and trading practices. This was a clear sign that Robinhood was not acting within the best interest of its customers. The lesson here is to be cautious with companies whose revenue sources are unclear.