When most people hear about fraudulent investment advice, they think of Bernie Madoff and other scam artists who take your money and spend it on themselves. This type of blatant fraud is surprisingly common. This week, the SEC announced that it had obtained a court order freezing the assets of a Georgia-based investment adviser who had apparently gone into hiding after orchestrating a $40 million investment fraud. The adviser, Aubrey Lee Price, allegedly concealed investment losses by creating bogus account statements with false account balances and returns.
Most investors dont have to worry about that kind of fraud. In this post-Madoff era, investors are more cautious about promises that seem too good to be true. However, there is far more pervasive conduct that takes place daily in almost every brokerage firm in this country, which can have devastating consequences to investors. In my view, it is a variant of fraud that few investors understand.
A fraudulent misrepresentation is legally defined as a false statement where (1) the party making the statement is aware that it is false or disregards the possibility of it being false, (2) the party making the statement does so to induce another party to enter into a contract, and (3) the other party enters the contract as a result of the statement and consequently suffers a loss.
Lets apply this definition to the advice given by most brokers and advisers to both individuals and to plan sponsors of 401(k) plans who are required to decide what investment options to include in their plans. Typically, the advice is to buy actively managed funds (where the fund manager attempts to beat a designated benchmark, like the Samp;P 500 index). Its highly unlikely that your broker has ever told you to limit your investments to a globally diversified mix of low management fee stock and bond index funds.
Brokers will frequently support their recommendation of actively managed funds with data showing excellent past performance or a Morningstar 5-star rating. The message is clear: He is recommending these funds because he believes they are likely to outperform their benchmark.
However, as I explained in a recent blog, there is compelling evidence that 97 percent of actively-managed funds could not be expected to beat a risk-adjusted benchmark. There is no credible, peer-reviewed data indicating your broker or anyone else can identify who the members of this elite club of outperforming fund managers will be in the future.
Most investors are not aware of this data. If they were, there would reject recommendations for actively managed funds and invest only in index funds.
Is the conduct of brokers who recommend actively managed funds fraudulent? Lets go back to the definition of a fraudulent misrepresentation. A statement that you should buy an actively managed fund because it is likely to beat its benchmark over the long term clearly is a false statement. The broker who makes this statement either knows it is false or ignores the possibility of it being false. He makes this statement to induce you to buy an actively managed mutual fund. You rely on his statement and buy the actively managed fund. You are likely to incur a loss compared to the returns of a low management fee index fund of comparable risk. You decide.
To me, if it looks like a duck and quacks, its a duck.
Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book Youll Ever Read, The Smartest 401(k) Book Youll Ever Read, The Smartest Retirement Book Youll Ever Read, and The Smartest Portfolio Youll Ever Own. His new book, The Smartest Money Book Youll Ever Read, was published on December 27, 2011.
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