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Two Small Improvements to the Order of Things

I keep hoping that someday I will live in the ideal world, where everything makes sense and the circumstances are orderly and fair.  As a writer with the best audience in the profession, occasionally I have a chance to close the gap between what is and what I wish would be.  I have two wishes to share.

First, I wish that we could finally clarify what we mean by fiduciary advice under the DOL rule.  Some have taken the rule to mean (I think falsely) that only ETFs and index funds would be considered as fiduciary recommendations, since, after all, they cost the least on an annual basis.  But I would argue that if the merit of all investments is going to be determined purely by looking at a cost ranking, only a handful of funds would survive, and there would be no room for active investment management in the profession.

And if you follow that slippery slope, than any fees that advisors charge for simply selecting the funds at the bottom of the cost rankings should be reduced to an absolute minimum as well.  Eventually, advisory firms would only be “fiduciary” if they were charging a basis point or two for doing nothing more than reading the Morningstar cost rankings.

If we leave room for actively-managed funds under a fiduciary standard, then the question of fiduciary advice becomes complicated—and I think we should be prepared to embrace that complexity.  Fiduciary advice requires judgment: to determine what recommendations the advisor, with his or her professional judgment, believes would be best for the client based on an analysis of the client’s circumstances and the full range of the investment opportunity set.  An entire session at our Insider’s Forum conference will be devoted to exploring the times and circumstances under which active managers can be expected to outperform passively-managed funds, and while those circumstances are not unlimited, it appears that they do exist, and more so as more money is managed by rote rather than by analysis and research.

Moreover, a number of studies are providing hints that finding superior active managers may not be as difficult as the academics would have us believe.  Yes, if you throw darts at the mutual fund tables, you are unlikely to find a superior-performing fund.  But if you refine your dartboard to funds in asset classes where there is a high dispersion ratio between the performance of some stocks vs. others, or if you look for managers who put their own assets alongside those of their investors, and if you further winnow down the list based on annual costs and what might be called a passion for investing, the dartboard suddenly becomes more selective, and the darts have a better chance of hitting a winner.  The research has suggested that the odds can be made better-than-even—but this, too, falls in the realm of professional judgment.

The exclusion of actively-managed funds from the definition of fiduciary advice seems to me to be a straw-man argument made by broker-dealers who are angry about their (low) chances of getting high-commission products like business development companies and non-traded REITs through any reasonable fiduciary filter, and insurance agents who are racking their brains for a way to build a fiduciary argument for selling equity-indexed annuities with a 20-year surrender charge.

I would argue that so long as a reasonable person would follow the logic of a professional’s judgment, and as long as there is a visible effort to determine what investments would have the best chance to serve the customer, then the recommendation should pass the fiduciary test.  Comparing the American funds to non-traded REITs is either silly or deceitful, depending on your level of cynicism.

While I’m improving the world, I would also like to change FINRA arbitration rules and force arbitrators to take into account the fiduciary promises made or implied by brokers and reps—particularly due to the fact that they hold the CFP designation.  Advisors who serve as expert witnesses have told me stories of how injured investors told the arbitration panel that they believed the broker or rep was required to act in their best interests, because the broker or rep was a CFP, and the CFP Code requires all CFP certificants to act as fiduciaries when giving advice.

Open and shut, right?  Not at all.  FINRA is not required to accept the CFP standards, and so this argument is summarily tossed, without further deliberation, because under FINRA rules the broker or rep was only required to make “suitable” recommendations—CFP or no.

Of course, brokerage firm advertisements also promise that they will give advice in the best interests of the customer—and then the firm’s attorneys will argue in arbitration that the broker, in fact, was only acting in a sales capacity, no matter what the paid actor told millions of people on behalf of the firm.  The advertisements are not admissible as evidence in individual cases, so a consumer who relied on the extravagant promises made in the TV ads loses the case because the recommendations are only held to those weak suitability standards.

If FINRA declines to change its arbitration procedures—and I am not going to hold my breath here—then perhaps the CFP Board could impose a requirement that brokers or reps who hold the certification immediately disclose all circumstances where they or their attorneys, in arbitration proceedings, argued that they should not be held to a fiduciary standard when addressing customer complaints.  If they deny that they should have to be held to the standards imposed by the Code of Conduct, then even if they don’t lose their arbitration case, they should immediately lose their designation.

I’d also like all nations to dismantle their nuclear arsenals, but maybe that’s a longer-term project.