Asset Management Expert: A Simple Approach to Conflicts of Interest

Conflicts of interest are inherent throughout the investment management industry. If you have your assets managed professionally by an investment adviser or are responsible for the oversight of other people's hard-earned money, you need to be cognizant of existing conflicts and take any corresponding risks into consideration.

First, let's define a conflict of interest. Merriam-Webster defines a conflict of interest as "a conflict between the private interests and the official responsibilities of a person in a position of trust." These conflicts can exist within the day-to-day core activities of any investment adviser. From dealings with affiliated entities to the timing and selection of investments for different client accounts, to the possible preferential treatment of one account over another due to the difference in fees charged, potential conflicts should be considered by every investor prior to handing them assets to manage on your behalf.

Now that you have a simple understanding of what constitutes a conflict of interest, what actions should you take before signing over a check to an adviser? Well, I'd like to suggest a basic three-step method that should get you comfortable.

Identification

First, you need to get comfortable with any disclosed conflicts. Some of the disclosures that each adviser is required to make available to the public include:

Form CRS: this simple two-page document is designed to provide individual investors with basic answers to some key points about the firm you are considering and hand you some questions that you can use as "conversation starters" if you want additional detail from the firm. An example of a Form CRS can be found here. This form should be available on the adviser's website.

Form ADV Part 2a: this document provides a much more in-depth description of many key aspects of the firm. An example of a Form ADV Part 2a can be found here. This form is publicly available on the U.S. Securities and Exchange Commission's website.

Form ADV Part 1: While this one can be intimidating to flip through, there are some items within it that provide valuable information. In particular, you should focus on the following items within this disclosure in order to gain more information on the firm's conflicts of interest:

• Item 6 - requires the adviser to disclose Other Business Activities (i.e., the existence of an affiliated broker / dealer through which they may execute some of your trading activity). If the adviser does have an affiliated broker / dealer, it would be a good idea to get your hands around just how often your trades may be directed to this affiliate (if ever), and at what commission rate.
• Item 8 - discloses its interest (if any) in client transactions. Basically, this section asks the adviser to describe to what extent they could possibly benefit from the management of your assets, above and beyond the fee they charge to manage your account.
• Schedule D - provides the adviser with a location to disclose any item they consider material enough to warrant public disclosure.

Evaluation

Once you've reviewed these disclosure documents, you'll have a slightly better idea of who the firm is and how they are structured. If you are an individual investor who is depositing assets into a mutual fund, know that the mutual fund's Board of Trustees is responsible for evaluating the significance of these potential conflicts of interest prior to hiring the adviser to manage the fund's assets. So the Trustees typically do a level of due diligence above and beyond what you read in public disclosures.

Mitigation / Elimination

Now let's say you are someone who's responsible for overseeing other people's assets, and part of your job is to select the right adviser to professionally manage and grow it. I would recommend that, during your due diligence process, you ask how the adviser identifies, evaluates and mitigates its conflicts of interest. The most effective way to accomplish this is by adding detailed questions pertaining to conflicts within your due diligence questionnaire. In addition, make sure that controls surrounding conflicts of interest evaluation are discussed in any final in-person interview you may conduct before making your decision.

While conflicts of interest are inherent within the investment management industry, they are not truly a negative thing as it pertains to the professional management and growth of your assets. What truly matters is the way by which advisers identify them, evaluate them and then mitigate (or completely eliminate) them.