x Abu Dhabi, UAEThursday 18 January 2018

The case for investment ethics

The pursuit of profit is essential in free enterprise, but fair play and trust are indispensable, and if those are promoted in the financial world success will follow.

Kit Kat recently started sporting the Fairtrade logo, an increasingly popular symbol of ethical production, in the UK.
Kit Kat recently started sporting the Fairtrade logo, an increasingly popular symbol of ethical production, in the UK.

After I delivered a speech at the recent Hedge Funds World Middle East conference in Dubai, I was asked for a message to the sell-side investment professionals in the room. My advice is simple but not easy: manage investor expectations ethically, promise only what is deliverable, and prepare clients for the whole range of outcomes, even the uncomfortably negative ones.

In much of the past decade, many in my industry promised more than could be reliably delivered and buried the bear scenarios, leaving clients woefully unprepared when the credit crisis struck in 2008. In my asset allocator role, I get to play down the middle of the vast industry, since I am neither a buyer nor a seller but one who matches the needs of his clients with the thousands of investment instruments in the marketplace, cued by global investment research, constrained by clients' risk tolerance and compensated ultimately on portfolio performance.

So I enjoy a luxury that sell-side professionals do not: I don't have to push clients to buy anything. But much of the finance industry, especially the better-paid jobs, require pushy sales that are often cloaked as objective advice. How does one strike a balance between objectivity and revenue? The general issue is whether business ethics pay. Clearly, trust is the bedrock of the adviser-client relationship. While the profit motive will always run strong, as it rightly should to promote efficient capital allocation - which is the essence of capitalism - it is also essential that rules of engagement be respected.

As the economist Milton Friedman wrote in his book Capitalism and Freedom, "there is one and only one social responsibility of business - to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud". One industry in which ethical conduct is admirably upheld is health care. The Hippocratic oath holds more often than not. Can we replicate that fidelity in business or government?

Last year, for the first time, Harvard MBA graduates had the option to take an oath of ethical behaviour. Surprisingly, more than half chose not to. In the investment world, the oath of the CFA Institute commendably proclaims, "I will place the integrity of the investment profession and the interests of clients above my own personal interests". But how many live up to it? Most banks have good training programs in sales, markets and compliance but I see no dedicated ethics training. If instituted, it would boost trust and lifetime customer value.

The more complex the client situation, the more important the role of trust. A study in the healthcare industry showed only 15 per cent of patients felt comfortable making a difficult healthcare choice themselves, yet 61 per cent said they would be comfortable with their physician's decision. In the investment advisory business, trust was cited as the foremost factor by 69 per cent in a study done at the University of Pennsylvania's Wharton School.

Another dimension to trust is disclosure of fees. Unlike health care, where the price list is clearly published and seldom abused, fees are often fuzzy in some segments of the investment industry. In a survey by the Institute for Private Investors, a large majority felt transparency on fees was lacking. Fewer than half of the respondents completely or strongly agreed that their adviser's counsel was objective, and 70 per cent of clients reported they had not been asked how their adviser might improve the relationship.

To regain trust, the "wealth care" industry must catch up to the healthcare industry on objectivity and transparency. There is a business case for doing so. A more transparent and objective industry will eventually be more profitable. In a research study by the Harvard and Michigan business schools, 80 cases drawn from a period of more than 30 years were analysed to evaluate whether corporate social performance contributed to corporate financial performance. In 53 per cent it did, which is a high outcome for a study of this nature.

It is tautological that prioritising the client's interest will eventually result in better investment performance and greater wallet share, which is easier said than done given the pressures of quarterly earnings management and the annual bonus grab. So, given clear business benefits to ethics, how does one promote ethics in an investment organisation? First, ethics cannot be compartmentalised; they have to be at the core and permeate all organisational cavities.

Start with the hiring process. Inquire what ethical situations candidates faced, how they handled those and what should have been done differently. If they are clients facing staff, perhaps they need a "moral sense test", such as the famous one by the bioethicist Marc Hauser. For large companies, hire an ethics officer to supplement the requisite compliance manager. Instead of a dedicated hiring, one US corporation smartly rotates business leaders into that role to promote ethical sensitivities throughout the management team. Encourage whistle-blowing, preferably to an anonymous hotline or in-box, and adjust the incentive structure to reward ethical behaviour.

When it comes to ethically setting client expectations, design a management mechanism to cross-check whether sales staff promise too much. If a salesperson sells more product for a higher fee in a shorter time than is normal, pat the person on the back but also meet the client to understand that the expectations set are appropriate. Finally, build a brand around your ethical policy. For example, my preferred candy bar, Kit Kat, recently started sporting the Fairtrade logo in the UK, an increasingly popular symbol of ethical production, which boosts my brand loyalty. As your clients come to appreciate your ethical advantage, your profits will eventually be enhanced.

The investment industry has many personality types working in it, from good-intentioned value enhancers to bonus-obsessed, self-dealing piranhas. While a competitive spirit is essential to excelling, success need not come at the expense of client satisfaction. The predators pillaged the industry in the past decade, putting profits before principles. But before we regenerate the industry, we must re-examine who we are at our very core.

I turn to the esteemed bioethicist Peter Singer. In his view, "We must reinstate the idea of living an ethical life as a realistic and viable alternative to the present dominance of materialist self-interest. "If a critical mass of people with new priorities were to emerge, and if these people were seen to do well, in every sense of the term - if their co-operation with each other brings reciprocal benefits, if they find joy and fulfilment in their lives - then the ethical attitude will spread, and the conflict between ethics and self-interest will have been shown to be overcome."

At the risk of insipid idealism, I wish that approximates the future of the finance industry. Rehan Syed is the head of portfolio management at ABN AMRO Private Banking in Dubai. The opinions expressed are personal and not necessarily those of his employer.