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Open vs. Closed Architecture Investment Platforms

The Pros and Cons of Each

Written by Briton Ryle
Posted November 24, 2014 at 2:02PM

Investors contributing to their employment retirement plans, or who prefer to hold investment accounts with private banking, mutual fund houses or specialty investment firms, may be taking on more risk than they realize.

The risk is not necessarily that you end up getting stuck with investment funds that lose you money, but is more along the line of not ending up with better investment funds that could be generating greater returns than you are currently earning.

Even if you actively and diligently scour through all the investment brochures and prospectuses that the firm neatly tucked inside your glossy multi-pouched folder, you could still be missing out on much higher returns simply because of the brochures and prospectuses that were NOT tucked inside your folder.

Banks and investment firms generally offer one of two main types of investment platforms, referred to as “open architecture” and “closed architecture”. Over recent years numerous lawsuits have been filed against investment banks and firms for fiduciary negligence in favoring one type of investment over another. Might your investment firm be letting you down as well?

Closed Architecture vs. Open Architecture

One of the first things an investor visiting with an investment advisor, whether at a bank or investment firm, should consider is: Whose funds are you gaining access to? Are the bank’s or investment firm’s own proprietary funds the only funds you have to choose from? Or do you have access to investment funds from other institutions and investment companies?

If their platform is closed, they will carry funds and investment products offered by their own bank or firm only, limiting your choices. An open platform, on the other hand, is one where investors can choose to invest in other funds and vehicles offered by competitor institutions and companies.

There are pros and cons to either platform that need to be considered, as explained by Pensions and Investments:

• “Proponents of closed architecture say the use of in-house investment managers reduces costs and gives fund company executives more control over the investment approaches. Closed architecture is good for the fund company because it doesn't have to share management fees with subadvisers or track the trading and compliance behavior of outsiders.”

Hence, investors dealing with closed architecture investment platforms will generally pay lower fees and management expenses. On the other hand:

• “Critics say closed architecture raises conflict-of-interest risks, enabling the fund company to bulk up on certain asset categories to raise profits. They say plan participants face considerable single-firm risk, especially if participants put all of their retirement assets in a single target-date fund.”

If all you have to choose from are mutual funds, bonds and ETFs that are structured and managed by just that one bank or investment firm, even if you spread your investments across multiple funds you are still technically putting all of your eggs in just one basket.

What is more, who is to say you are even getting a superior list to choose from? Many better performing funds managed by other firms are not even on the list in front of you.

Similarly, open architecture platforms have some pros and cons of their own:

• “Proponents of open architecture say their approach is best because it enables a provider to search for the best fund managers, rather than rely on a relatively narrow group of in-house investment managers. Casting a wider net offers a chance to find better returns and more diversification.”

Indeed, the open platform will give investors a much more diverse universe of investment vehicles to choose from. But the convenience doesn’t come cheap:

• “Critics say the search for multiple outsiders can be difficult, time-consuming and expensive.”

Not only does your investment firm incur additional expenses in locating and negotiating with outside funds to sell to their clients, but those expenses are ultimately passed onto their clients through higher fees. And let’s not forget the involvement of a third party in the arrangement means one more finger in the pie taking a cut of your investment returns.

But there is one more important consideration investors need to make: the lack of regulation which increases the risk to you as an investor all the more.

Open Architecture Abuses Trigger Law Suits

“Investors have to be ever careful looking for conflicts of interest with all of their investment providers,” advises Chris Tobe, Senior Investment Consultant with the Hackett Group. “Open architecture was intended to give clients best-in-class investments by offering more choices through third-party platforms in an independent, non-conflicted manner. However, open architecture has no legal definition and there is no regulation around it, so it is ripe for abuse.”

Even when an investment bank or firm provides an open platform where investors can select outside funds from other institutions, the vendor often increases the fees associated with those outside funds to make their own in-house funds more appealing. In so doing, the vendor actually redirects investments into their own proprietary funds under the guise of offering an open platform where all outside funds are treated equally alongside their own.

The practice of redirecting fund flows into their own in-house funds is so prevalent it has been given its own name: “guided architecture”, which means simply that… the vendor guiding clients’ investments into their own house-brand funds by tweaking the fees and expenses making outside funds less profitable and thus less appealing.

The unscrupulous and self-serving practice of guided architecture generally goes unnoticed; you really have to dig deep into the numbers and compare all the products involved to spot the tweaking. But it is quite prevalent none-the-less, and has even resulted in some lawsuits.

“The hybrid kind of open architecture comes with its own set of potential conflicts,” Barron’s reported in September of 2012. “Firms with in-house products have been known to push their proprietary products even if not in the best interest of clients. Last year [2011], JPMorgan Chase had to pay $373 million to American Century for pushing its own products in violation of an agreement to promote the mutual-fund firm's products. The case involved JPMorgan Retirement Plan Services, not its private bank, but it is worth noting that the troubles grew directly out of the model mixing proprietary and third-party products.”

Another suit against JP Morgan Chase filed in August of this year claims that “millions of dollars were wasted on bad investments and exorbitant fees because of JPMorgan Chase and Co.'s self-dealing and mismanagement of two Christ Church Cathedral trust funds endowed by the late Eli Lilly Jr.,” reported IndyStar.

The suit claims the losses were incurred from JP Morgan's decisions as independent trustee “to purchase over 177 different investment products, mostly from itself, ... because they produced the highest revenues to JPMorgan, to the detriment of Christ Church”. The investment products were “structured in a manner that would ensure that JPMorgan and its subsidiaries would receive substantial fees, oftentimes receiving more in fees than its clients including Christ Church received in returns from the investment”.

Know the Platform

Investors, therefore, need to ask more questions about the investment plans they are contributing to. This includes not just plans structured by the bank or mutual fund company you have an account with, but also retirement plans offered at your workplace.

Where are your contributions going? What investment funds are your matching contributions going into? What investment companies are your fees going to? Do you have a say in selecting which funds to invested in? If so, can you choose third-party investment funds offered on an open platform? Or are you limited to just the in-house vehicles of a closed platform?

Remember that while open platforms do give you more choices, they may come with higher fees. And while closed platforms may be cheaper, they may not give you enough to choose from to be properly diversified.

You now have a few more things to talk about the next time you visit with your investment planner.

Joseph Cafariello

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