One Sure Way to Blow Up Your Portfolio

Instead of thinking about what to do in order to succeed, it’s often easier to think about how to fail, and then avoid doing those things that would guarantee your failure. Want to bomb that math test? Then don't even bother studying. That's the wisdom behind the words of legendary investor Charlie Munger when he says, "Invert. Always invert."

For investors, Munger's advice means avoiding companies that engage in business practices that will ultimately cause them to fail. And one of the surest methods for a company, or even an industry, to fail is to build itself on conflicts of interest (COIs). Just look at how rife such conflicts are in the financial industry, especially in the lead-up to the 2008 financial meltdown.

COIs in asset management firms
According to a recent report by the U.K.'s Financial Services Authority (FSA), many U.K. asset managers have inadequate procedures in place for preventing conflicts of interest. Because the FSA's report didn't name names, it's unclear which (if any) public U.K. companies the report criticizes, but investors would do well to pay close attention to any enforcement news, as COIs can serve as a ticking time bomb for both clients and investors of the companies that perpetuate them.

According to Carlo V. di Florio, Director of the SEC's Office of Compliance Inspections and Examinations, "[C]onflicts of interest, when not eliminated or properly mitigated, are a leading indicator of significant regulatory issues for individual firms, and sometimes even systemic risk for the entire financial system."

The FSA claims that the procedural shortcomings it found harm clients by allowing asset managers to engage in several unsavory activities, including:

  • Imposing unnecessary costs upon their clients.
  • Accepting gifts that that may limit asset managers' objectivity when making decisions on behalf of clients.
  • Cross-trading between clients in ways that aren't mutually beneficial to all customers.
  • Failing to report errors to clients, and forcing them to bear the costs of those errors.

And if di Florio is right, this widespread problem shouldn't just concern these business' clients. It should also concern their investors, who risk losses associated with legal and reputational costs of this behavior. If businesses fail to limit COIs with their clients, you should be skeptical of their willingness and ability to limit COIs with their investors.

Legal and reputational costs
Investors don't have to look far to see the legal and reputational costs associated with a failure to limit COIs. The FSA and SEC have already taken enforcement action against Martin Currie, for allegedly sacrificing one client's interests to benefit another client. The FSA is also considering enforcement action against other companies discussed in the report.

We've also seen how American companies involved in asset management have paid the price for conflicts of interest. For example, Goldman Sachs (NYSE: GS  ) is infamous for misleading investors via its marketing materials for a collateralized debt obligation (CDO) before the financial collapse of 2008. In 2010, the SEC announced that Goldman would pay a $550 million fine for that misstep.

Also, as I've argued previously, JPMorgan Chase's (NYSE: JPM  ) London Whale debacle can be partially explained by the fact that the internal control group faced a conflict between the interests of the Chief Investment Office, which wanted inflated valuations so they could continue the trades, and JPMorgan's investors and other stakeholders, who wanted accurate valuations for the purpose of monitoring risk. This not only cost the company trading losses of more than $6 billion; it's also imposing ongoing costs associated with internal and government investigations.

And government investigations and settlements can be only the beginning of the external consequences associated with COIs. These costs can grow as the results of those investigations give investors fodder for filing civil lawsuits -- the costs of which are passed on to current investors.

Conflicts with investors
Di Florio opines that one of the best ways to minimize COIs is to establish a process for addressing them that "is fully integrated in the firm's overall risk governance structure," and that engages senior management and the board in the process.

I agree. I also think that the failure to minimize COIs involving clients should make investors wary. After all, if the company's leadership doesn't recognize or care about COIs that pit their interests against those of their clients, why should we think it will recognize or care about COIs that pit their interests against those of their investors?

The FSA report noted that some companies consistently fail to disclose mistakes made by their employees, and had processes that forced clients to bear the costs of these mistakes.

As investors, if we see that a company fails to recognize how this scenario constitutes a conflict, or for some other reason fails to eliminate that COI, that should raise a red flag. In such a situation, we should think carefully about whether management will tolerate COIs that sacrifice investor interests, including compensation plans that fail to align management interests.

Investors beware
As the enforcement news comes to light, investors would do well to think not only about how possible legal penalties will affect their investments, but also about how the business' approach to conflicts of interest can create new scandals that might compromise their investments. So if you want to have a good chance of blowing up your portfolio, make sure to buy companies founded on conflicts of interest.


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