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The Emperor Wears No Clothes, Part 4: Do You Prefer Open or Closed Architecture

The title asks a question with an obvious answer. Without having a clue what I’m actually talking about, the answer intuitively is obvious. Most people prefer their houses open, light and airy, not closed, dark and secretive. You now have been introduced to the marketing genius (or silliness to those who must overcome it) behind the use of the terms “open” and “closed” architecture in the investment industry.

Try mentioning at a cocktail party that you have some bucks to invest. You will be besieged by firms hawking their open architecture, while denigrating everyone else - their “closed” competitors. Here’s the pitch:

  •  We don’t sell any products (gasp! – another great marketing notion said in a tone of voice that suggests a money manager lurks in the dark wearing a cloak behind which he carries illicit items for sale);
  •  We screen the universe of managers and help you find the very best; and
  • Because the choice of manager doesn’t affect our fee, we are totally objective in our advice.

It’s pure marketing genius. With the intuitively simple “open” and “closed” terms, firms that don’t actually manage money sound better and nobler than those who do.

But, it’s not that simple, so let’s get behind the marketing hype.

What It Means

In the industry, an “open architecture” firm offers access to other managers and does not manage money in house. “Closed” means that the firm offers only its own management.

As an aside, many formerly “closed” firms that used to manage money in house scrapped that higher fee activity for the presumably lower margin consulting service.  Why did they make the change? Could it be because their investment performance wasn’t good enough to keep their clients? Remember the saying, “Those who can, do, those who can’t, consult…”

Any way, there are many firms that do both. They manage money in-house and they offer access to other managers. For them, a more descriptive phrase might be “open access,” because they offer access to the same universe of managers that the open architecture firms offer.

Whether open or closed architecture, or open access, many firms offer other important elements of investment advice, including strategic asset allocation. They also provide monitoring and consolidated reporting of all of your managers. There is nothing inherently wrong or evil about any of these firms.

The Key Question

The key question is the objectivity and integrity of the advice that you receive. There is a potential conflict of interest if the person/firm giving advice stands to benefit from the customer acting on the advice. For example, suppose I recommend that you invest in hedge funds because they can play an important role in a well-diversified portfolio. If it turns out that I get a bigger fee by selling you an in-house hedge fund management program than if I recommend another manager, there is an obvious conflict of interest. My advice should be suspect even though it may be correct and best for you.

However, “pure” open architecture firms may not be totally objective either. Why? They want to keep you as a customer so they can continue to collect your fee. Will they risk getting fired by admitting that they made a mistake in manager selection? Will they compare how your investment performance under their guidance measures up to what you could have gotten with another advisor? Will an open architecture firm admit that there is a provider who is better able to meet your needs even if the result may be that you don’t need its service? Will they admit that you might do better with index funds than with their manager selection program (and charge you less as a result)? If part of the sales message is that they negotiate discounts with managers (perhaps offsetting the fee they charge you), might they be more hesitant to fire a low-fee manager and replace him with a manager that offers no or lower discounts, but higher net return expectations?

The answers to these questions may be “yes,” but the bottom line is that you need to assess every advisor’s integrity and objectivity. Certainly, the less comfortable you are with your skill in doing that, the greater the burden you should place on your service provider to prove his characteristics and the appropriateness of his advice. And, the greater scrutiny you should give to potential conflicts of interest.

A (Higher) Middle Ground?

What if your architect figures out a way to create a better result for you if he does a bit of the construction himself? He can’t find any contractor or subcontractor that can do it cheaper, more efficiently or with better results. Would you automatically prohibit him from doing it? If he does that bit of construction, should he be disqualified from his primary architect role? Is he somehow less objective or suddenly not looking out for your interests because he takes on this additional responsibility? Of course not, although you obviously need to make sure that he is qualified, has done it successfully, is charging a fair price, and is fully disclosing what he is earning.

Indeed, there are a few organizations that fit the mold of open architecture firms (offering the same levels of objectivity and access to the universe of managers), but that do part of the construction because it is in fact in their clients’ best interests. And, those parts are not available elsewhere. It might be the high ground for you, but it’s hard to hear over the open vs. closed cocktail party din.

I firmly believe in the principles of my accounting profession – objectivity and integrity are paramount. But, understand that those qualities are not automatically available from anyone, regardless of the sales pitch’s appeal. There are tradeoffs to consider. You might benefit by looking beyond the superficial marketing terminology and thoughtfully assess all aspects of the story.

Ross Nager is Senior Managing
Director of Sentinel Trust Company of
Houston, Texas

 

 

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