fi360 Blog

Fiduciary Links: David Swensen on mutual fund conflicts

>>>>In a New York Times op-ed, chief investment officer for the Yale Endowment, David Swensen, chronicles the inherent conflict mutual fund companies have between their obligations to produce profits and to produce returns for investors and how, during times of exceptional market volatility, the problem is exacerbated to produce below-market results for investors and market-beating profits for fund companies.

In short, the industry encourages the type of buy high, sell low behavior that results in investor returns underperforming investment returns and profits from the churning this results in.

Swensen offers three ways to improve the situation:

1. Investors should be well diversified in low-cost index funds
2. SEC should use regulation to encourage low-cost index funds
3. SEC should extend an authentic fiduciary standard to the mutual fund industry

Knut Rostad of the Institute for the Fiduciary Standard further expands on Swensen’s fiduciary standard argument by pointing out in a letter to the editor two examples of how the suitability standard does little to discourage this type of behavior.

>>>>We’d also like to direct our audience’s attention to a new website. SROIIA, the Self-Regulatory Organization for Independent Investment Advisers, went live with their new site last week. SROIIA is attempting to lay the groundwork as an alternative to FINRA as the regulator for investment advisers should the SEC authorize self-regulation.

Their new site includes a newsroom and blog for the latest updates on adviser oversight. Along with the launch of the site came the official press release that fi360 has agreed to partner with SROIIA on the development of a fiduciary exam.

Now on to the rest of the best links from the past week:

Fiduciary Links: Proxy decision could have effect on fiduciary rule; analysis of SRO situation

>>>>InvestmentNews took a look this weekend at a Court of Appeals decision from July that could have ramifications on the SEC as it works on a fiduciary rule for later this year. In the decision, the U.S. Court of Appeals for the District of Columbia Circuit ruled on a petition against a new SEC rule that would have created an easier way for investors to make nominations to a board of directors. It was mostly a procedural rule that has nothing to do with fiduciary duties. However, the court based its decision on the SEC failing to provide adequate cost-benefit analysis to justify the rule, which is the same refrain being heard from opponents of expanding the fiduciary standard, including SEC commissioners Casey and Paredes.

Barbara Roper of Consumer Federation of America even acknowledges in the article that when Casey and Paredes objected to the release of the SEC’s fiduciary study in January due to not enough cost-benefit analysis having been conducted to justify the conclusions, they were basically laying out the basis for a legal challenge similar to this one.

Knut Rostad, now of the Institute for the Fiduciary Standard, commented that he doesn’t read much into the decision, as there is more concrete evidence of the benefits of non-conflicted advice than there is of benefits related to proxy access.

>>>> In a conversation with Bob Clark, fi360’s Duane Thompson shed some light on the oversight debate for advisers. His conclusion is that he doesn’t see the SRO issue being tied to the expansion of fiduciary duty. While both the SEC and DOL are already working on their new fiduciary rules, there is no major momentum for an SRO, which would require Congressional action. Couple that with elections next year, and he doesn’t see much interest in changes to the status quo for a while. And, even if an SRO for RIAs happens, his prediction is that Congress will shy away from designated a single SRO, such as FINRA, and instead opt for multiple SROs. That could presumably open the door for a new regulator to emerge, such as Mercer Bullard’s SROIIA.

Now on to the rest of the best links from the past week:

Court decision a reminder that plan document procedures are to be followed

As most fiduciaries know, investments should be managed in accordance with governing documents, including the investment policy statement, and, in the case of a retirement plan, plan documents.  In addition, fi360 often promotes the concept of ensuring a fiduciary engages in procedural prudence when managing investments in order to reduce their exposure to fiduciary liability.  "Procedure," in this case typically applies to how investments and services providers are chosen and monitored.  However, a recent case serves as an important reminder to plan sponsors and other investment stewards serving as fiduciaries that they need to ensure the procedures set forth in governing documents for all issues affecting plan and investment management are properly followed.   

In the case of Tatum v. R.J. Reynolds Tobacco Co., the plaintiff representing a class of RJR employees and retirees brought a claim in 2002 of a breach of the duty of prudence related to the removal of Nabisco Stock Funds from RJR Tobacco’s retirement plan.  The breach of duty of prudence is still being decided by the trial court, but the court recently issued an order ruling on an amended complaint by the plaintiff that is equally important to fiduciaries. 

Fiduciary Links: Using ETFs

>>>>Last week, InvestmentNews published a special report on exchange-traded funds (ETFs). As ETFs have steadily grown in popularity, adoption by fiduciary accounts has been considerably slower. As one article in the IN special report summarizes, administrative difficulties of implementing ETFs and the nullification of both tax efficiency and intraday trading advantages in 401(k) plans combine to make ETFs a tough sell for that market.  On the other hand, the advantages that ETFs provide for creating managed model portfolios are starting to overcome those shortcomings. ETF portfolios can create a lower-cost managed option, allow for the introduction of more asset classes and pass fiduciary responsibilities on to professional money managers. Obviously there is a lot to consider before introducing any new strategies into a fiduciary account and this special report section provides a good summary of the latest thinking related to ETFs.

Coincidentally, MorningstarAdvisor also published a fairly lengthy analysis of the ETF market as a whole, taking the stance that ETFs are the investment vehicle for the digital age defined by fee-based advising and the technology revolution.

>>>>While on the subject of looking at the future of the retirement market, Nevin Adams, in his weekly PLANSPONSOR Perspectives blog post, presents five predictions for the next five years that look pretty prescient to us: participant disclosure won’t be as effective as we’d like it to be, while plan-level disclosure will make a difference, all ERISA plan advisers will be required to be fiduciaries, we will come to regret not tackling TDF design issues and retirement income will continue to haunt Americans.

Now on to the rest of the best links from the past week:

Practice 3.3: Investment vehicles are appropriate for the portfolio size

The primary focus of Practice 3.3 is the implementation of an investment strategy with appropriate investment vehicles, specifically the proper use of separately managed and commingled accounts, such as mutual or exchange-traded funds and unit trusts.

It is important for the fiduciary to be familiar with the universe of investment options (mutual funds, ETFs, and seperate account managers to illustrate the more common investment vehicles), as no one implementation structure is right for all occasions.

Let's take a look at the actual Practice and Criteria. You can click on the image to view a larger version:

 
There are four primary considerations related to this Practice, presented below along with our general commentary:

Fiduciary Links: A guide to undermining fiduciary duties

>>>In his most recent Fiduciary Corner column for InvestmentNews, Blaine takes a look at the Congressional model of outwardly embracing accountability and ethical behavior, while simultaneously building a system of easily circumvented rules.

The model consists of four parts:

1. Profess to be wholly supportive of having a fiduciary standard apply to your line of work.
2. Secure self-regulation.
3. Rather than avoid conflicts of interest, make rules that rely on disclosure to provide a theoretical means of controlling self-dealing.
4. Provide rule interpretations that prevent real accountability in case anyone discovers that disclosures don’t work.

In the article, Blaine uses an academic study of the trading activities of Senators and Representatives and Congress’ meek attempts to control its members from trading on privileged information as a case study for the model.

What we find is that disclosure is woefully ineffective in monitoring conflicts and virtually worthless in deterring them. It took intensive academic studies to do the monitoring because citizens do not spend the time to delve into disclosures.  The studies demonstrate that members of Congress are undeterred from essentially front-running their stock trades based upon what they learn from their public duties.

Even before the last study of insider trading by House Members came out, there was some recognition of the problem. Various incarnations of the Stop Trading on Congressional Knowledge Act have been introduced since 2006 to address the problem by prohibiting Members and employees of Congress from trading on nonpublic information. However, the bill has never gone very far, with the latest version having been referred to five different House committees where it languishes to this day.

It is hard not to notice the parallels between what Congress has done and what financial industry lobbyists appear to be working hard to copy. And who can blame them? The strategy works. Today we see momentum building towards self-regulation, the long history of an effective principles-based fiduciary standard being threatened by a rules-based standard rife with exceptions and disclosures, and progress torwards real reform generally being bogged down by lobbying and politics.

With that said, it’s not too late to affect effective reform. As regulators consider the extension of the fiduciary standard to all who provide investment advice, we would remind them what that reform would look like:

1. Preserve the undiluted fiduciary standard by adhering to the Dodd-Frank provision to assure a standard “no less stringent than that established under the Investment Advisers Act of 1940.”
2. Provide SEC with full-funding for independent regulatory oversight.
3. Require conflicts of interest to be avoided when possible and mitigated in the client’s best interest when unavoidable.
4. Protect against “disintegrating erosion” inflicted upon the fiduciary standard through exceptions rules that condone conflicts of interests.

>>>While on the subject circumventing fiduciary accountability, we recommend you read Scott Simon’s most recent column for Morningstar Advisor, in which he looks at how the “promise” of ERISA that all retirement plan participants “should be able to trust their advisors and rely on the impartiality of their investment advice” has similarly been left unfulfilled by exemptions and ineffective disclosure requirements.

Now on to the rest of the best links from the past week:

Congress, regulators strike out on fiduciary titles

After the financial crisis of 2008, in addition to their primary focus on fixing gaps in systemic risk, Congress also saw the opportunity to address other hotly debated issues that had been festering for years. The fiduciary standard for brokers is an obvious one. The closely related issue of titles associated with fiduciary standards is another that unfortunately remains almost hidden to the public.

When we look at the history of regulation of financial advice, the 111th Congress that passed Dodd-Frank is only the most recent failure in this regard.

Back in 1940, the 76th Congress was perhaps the first to address advisor titles. At the time, the Investment Advisers Act was under consideration, largely in response to a study of stock "tipsters" who charged fees while ripping off the public. Because they fell below the radar and couldn't be studied, the only organized group of advisors called to testify were investment counselors. While they weren't thrilled about regulation, they testified to fully supporting a fiduciary standard and complained that numerous stockbrokers or "customer’s men," as they were called then, often misrepresented themselves by using the same title.

In response, Congress wrote into the new law a provision under Section 208 restricting the use of the title “investment counsel” to those registered under the new Advisers Act. Unless his principal business was acting as an investment adviser and rendering investment supervisory services, a person could not use the title.

Unfortunately, as we know, Congress does not have a long-term memory. Indeed, even with the housecleaning undertaken by the 111th in Dodd-Frank, it did little except study the matter.  Had it moved aggressively to mandate registration as investment advisers or a fiduciary standard of conduct, there would have been a chorus of howls and protests the like of which would probably have killed the bill.

Fiduciary Links: In support of DOL's fiduciary rule

>>>>The DOL has been getting hammered from all sides this week, as the feedback has been almost universal that they should be going back to the drawing board on their definition of fiduciary rule proposal.  To recap, the DOL is trying to replace their five part test for what constitutes fiduciary advice to a broader definition under which more financial services practitioners would fall. Our Director of Legal and Regulatory Affairs, Kristina Fausti, recently wrote a comprehensive recap for the American Bar Association of the DOL activities.

Just in the past week, we’ve seen a deeply divided Congress come together in a bipartisan call for a re-do, SIFMA and the Financial Services Institute speak out against the rule and even the Consumer Federation of America and ASPPA have expressed reservations. You can check out our Twitter feed for even more links to DOL-bashing articles from the past week.

We’d refer you back to Blaine’s most recent Fiduciary Corner column for InvestmentNews though, for why we support the new rule proposal. It is aimed at trying to restore the fiduciary definition to how it was originally intended, to cover all service providers who are dispensing advice.

DOL assistant secretary Phyllis Borzi is also standing up for the proposed rule by noting that 40 years on the enforcement beat make them pretty adept at spotting the problems.

>>>>We’d also like to direct you to an article by AIF designee Andy Rice, who is a former winner of fi360’s Article Competition. In his most recent column, Andy describes how and why Congress should be held accountable to the same fiduciary principles advocated by the Committee for the Fiduciary Standard. If only, Andy, if only.

Stay tuned for our next InvestmentNews column, in which we’ll also be taking a look at the fiduciary conduct of our elected officials.

Now on to the rest of the best links from the past week: