William J. Bernstein
Open Letter to the New SEC ChairmanDear Mr. Donaldson:
First, the investment world wishes you Godspeed in what may well be the most thankless job in the federal government. You are made of stern stuff indeed for bearing up so well under a confirmation process that has become exponentially more humiliating and partisan with each year and for accepting a substantial pay cut in the process. I salute your stout heart and clear eyes.
You certainly have your work cut out for you. Your predecessor, in spite of his background as a spear-carrier for the securities industry, bent over backwards in the interest of impartiality. Mr. Pitts’ downfall related more to a political tin ear than to any deficit of attention, knowledge, or fairness. His years of expertise were both a blessing and a curse. His command of the minutiae of securities law, while nonpareil, blinded him to the larger issues that plague the industry. Mr. Pitt did not simply miss the forest for the trees; he was obsessed with the pinecones.
What ails the industry is not IPO spinning, accounting irregularities, or even the inherent conflict of interest between investment banking and retail brokerage. Rather, the problem is the nature of the industry itself.
The best way to expose the rot at the core of this business is to lay it alongside three other professions: accounting, law, and medicine. All three have rigorous educational requirements, and all three have an ethical core that you can cut with a knife. The securities industry has neither.
Consider accounting. The profession reacted swiftly to the Enron and WorldCom scandals. The mere mention of their names was enough to make most CPAs wince, and accounting organizations reiterated and clarified their strict standards faster than you could say "Arthur Anderson."
More to the point, while it is true that an incompetent or dishonest accountant can substantially damage a client, a wayward broker can devastate a customer with much greater dispatch. Yet the educational requirements in accounting are far more stringent than for brokerage. This is not saying much, since in brokerage, there are none at all. While the equivalent of a graduate degree is required to certify a tax return, not even a high school diploma is needed to manage a client’s life savings.
Consider law. Whatever one thinks of attorneys in general, those admitted to the bar are considered officers of the court, and even a trivial ethical lapse can result in disbarment. This is accomplished almost entirely without government regulation—attorneys have always zealously regulated the behavior of their peers and have also fiercely guarded the privilege of doing so. The history of the brokerage industry, on the other hand, is of steadily increasing government regulation necessitated by the industry’s chronically blind eye towards its chronically miscreant members.
Finally, consider medicine. The academic requirements are exceedingly rigorous—biochemistry, anatomy, physiology, histology, pathology, pharmacology, and epidemiology. All this before one ventures onto the wards to learn the disciplines of medicine itself: surgery, internal medicine, pediatrics, orthopedics, and the like. The bad news is that once you’ve mastered these areas, several more years of backbreaking general and specialty training lie ahead before you are certified. Even then, you’re not home free; if you don’t assiduously keep up with the torrent of journals crossing your desk, both you and your patients will suffer. A very old joke involves a pre-med taking Physics 101 and repeatedly challenging his instructor about its relevance to a medical education. Each time, his professor replies, "Physics saves lives." Exasperated after half a dozen such exchanges, the student finally asks, "Professor, just how does physics save lives?" "Why, by keeping the morons out of medical school!"
Manifestly, there are many brokers and advisors who simply do not have the intellectual horsepower to be managing money. Mathematics is the language of investing, and many will never speak it, no matter how hard they try. These individuals, along with the hordes of moral cripples who are attracted to a financial career, should not be allowed past the starting line. The sad fact is that today, the average broker is completely ignorant of the most basic principles of modern finance: marketplace efficiency, the nature of systematic and nonsystematic risks, how to estimate expected returns, the critical role and sources of investment expense, and the mechanics of proper diversification.
There was a time when the accounting, legal, and medical professions were not as solidly grounded as they are today. The state of medical education in particular was so bad in the early twentieth century that the profession commissioned a study—the Flexner Report—that transformed undergraduate and postgraduate medical education into its modern university-based format.
If you think that attacking the peripheral issues surrounding the current crisis—accounting and analyst standards, 401(k) reform, primary offering procedures, and the like—will improve public trust in the capital markets, you will fail just as ignominiously as Mr. Pitt. What is needed is a Flexnerian process that will transform brokerage from a den of incompetence and deceit into an honored profession. At a bare minimum, the following must be accomplished:
Solid educational and licensing requirements must be defined for brokers and investment advisors. Anyone who cannot grasp and apply the foundations of financial economics should not be allowed to manage other people’s money. Minimum standards of practice must be established, and deviations below it should not be tolerated. Brokers or advisors who put most of a client’s assets into a small number of securities or into one or two sectors, or who invest funds needed in less than several years in risky assets, cannot be tolerated.
Returns and expenses must be made transparent. Just as the nutritional composition of a can of tuna is available on the package label, so too must a brokerage’s average total expenses, inclusive of all fees, spreads, and impact costs, be available to each investor. In addition, each individual account’s expenses, return, and standard deviation should be reported with every statement and compared against well-matched and well-defined benchmarks.
Effective federal licensing of brokerages themselves should be undertaken. A hospital whose physicians systematically fail to meet minimal standards risks severe sanction; so too should firms whose brokers routinely fail to curb expenses and diversify properly.
Mr. Donaldson, you are charged with overseeing a profession, if it can be called a profession at all, that operates at a medieval level of competence and honesty. Only by bringing its educational, ethical, and reporting requirements into the modern era can public trust be restored.
Copyright © 2003, William J. Bernstein. All rights reserved.
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