Many securities attorneys may be eagerly awaiting the implementation of the Department of Labor’s new Fiduciary Rule, which will require that financial advisors act as fiduciaries for their clients. The rule is causing considerable consternation among financial advisors since many of them are able to charge clients minimal fees, with the advisor generating their income via sales commissions on various financial products.
Even as the market sits near all-time highs, the threat of the DOL’s new Fiduciary Rule threatens to upend the industry, and in the extreme, perhaps destroy many advisors’ businesses. The Fiduciary Rule is the burning platform issue of many investment firms right now, and it is time advisors came up with a plan to put out that fire.
The fundamental issue with the new DOL rule is that it forces advisors to act as fiduciaries, which in turn will lead many advisors to try and play it safe by recommending only the lowest-cost investment products, such as basic, plain vanilla index funds. That could lead overeager attorneys to pounce on any advisor that puts a client into even a moderately more expensive investment product, even though that additional expense might be money well spent.
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There is nothing wrong with being cheap and trying to save a buck, but the problem is that choosing only the lowest-cost investment vehicles forces investors to give up slightly more expensive investment options that are still very much worthwhile.
For instance, international stock ETFs are almost always more expensive than domestic equity ETFs. That’s understandable because international stocks are more expensive to trade. Yet advisors concerned about mitigating lawsuit risk and meeting a fiduciary obligation might give up the value of diversification and higher returns associated with international stocks in exchange for the safety of a defensible holding in pure U.S. equities. That would be costly long-run error for the investor, though – at the end of the day, while international stocks can be volatile, they still serve a valuable diversification purpose in one’s portfolio.
Factor investing or Smart Beta investing is another area that investors are likely to overlook if they hew to a simple lowest cost approach. There is unambiguous scientific evidence that factor investing leads to significantly higher returns than simple market indexing. That evidence was the basis for a Nobel Prize in economics a few years ago. Giving up that extra return for a few basis points of upfront savings would be the epitome of penny-wise pound-foolish.
Investment management firms in the factor-investing space are saying this to clients as loudly as they can. According to Patrick Sweeny, Principal and Co-Found of Symmetry Partners, one of the largest factor-investing firms out there:
The DOL Rule does not require advisors to choose the lowest cost investment option for their clients. However, being required to prove as a fiduciary that a more expensive option is appropriate and worth the additional cost is likely to push many advisors into plain-vanilla indexing (and probably already has). Nevertheless, we continue to see an influx into factor-based (or Smart Beta) funds that are designed in many cases to do the same thing traditional active management does at significantly lower cost. Factor investing offers the potential for outperformance and/or risk reduction at generic prices, which we believe advisors will value in a fiduciary world, which we further believe will go beyond retirement accounts.
Sweeny’s view and the view of Symmetry makes a lot of sense, and it is in the best long-term interest for investors. The problem is that it’s unclear if the bulk of advisors are willing to take the legal risk of doing what’s right for their client in the long run at the risk of the short run. All investment strategies have ups and downs, and advisors putting clients into a more-expensive strategy that ends up suffering in the short run may face client wrath in the form of lawsuits.
Such suits are ultimately unlikely to be successful, since any court looking dispassionately at the issue would find that more expensive products in some cases do carry higher returns. There is no guarantee of higher returns, of course. Higher returns come with higher risk; just as stocks are sometimes outperformed by bonds, vanilla indexing will sometimes outperform factor investing. Vanilla indexing will always lose in the long run, but neither the investor nor an overeager attorney might admit that fact in the heat of a bad investment outcome. Advisors need to help them understand it.
The reality is that the average individual investor earns a return of roughly 4% in their portfolio over time, according to the best studies on the topic. That abysmal return is despite a market that has an average return of 10.8% since 1949. The reason individual investors do so badly is that they get emotional and trade too often, buying into the market when it is highest, and selling when it is lowest.
In that sense, attorneys and advisors play a similar role – one of risk management and counseling clients to help avoid significant errors in judgment. Sage attorneys should take a little of this guidance themselves as the Fiduciary Rule comes out, and avoid jumping to conclusions about the suitability of investments or investment strategies based on short-term results.
Michael McDonald is an assistant professor of finance at Fairfield University in Connecticut. He holds a PhD in finance. Michael consults extensively with organizations ranging from Fortune 500 companies to start-up businesses on financial matters through Morning Investments Consulting. Michael has served as an expert witness in legal disputes, and is an arbitrator with the Financial Industry National Regulatory Authority (FINRA). Michael can be reached at [email protected].