Fighting Finance: The Fiduciary Rule

DOL Fiduciary Rule Picture

Simplified portfolio construction process. A “manager” mixes stocks and bonds into a fund, and an “advisor” combines funds together to create a portfolio. Each step results in fees charged to the investor.

By Sasha Ramani, MPP 2018

In early February, President Trump announced that he would instruct the Department of Labor (DOL) to review its Fiduciary Rule. Initially marketed as protecting consumers from predatory financial advice, the Rule (generally) required financial advisors to avoid conflicts of interest, clearly disclose fees and compensation, and to act in the best interest of the client. But despite its noble intent, the Fiduciary Rule—and its repeal—would ultimately not have a significant effect on consumers.

To better understand the Fiduciary Rule and the implications of its repeal, some background is required. Simplifying greatly, financial instruments consist primarily of stocks and bonds. Picking the precise mix of each to achieve a financial goal is part art and part science, so investment management firms do this for investors by packaging stocks and bonds into a “fund”. They then charge a management fee for the convenience. An advisor then combines different funds into an investment portfolio, taking another fee in the process.

These fees have come under strict scrutiny lately. An active manager is one who claims to “pick the best stocks,” as defined by their ability to construct a fund that achieves greater returns than a pre-defined index, such as the S&P 500. The active manager traditionally charges high fees on their funds for this privilege. Conversely, passive managers make no claim to “beat the market,” but offer simply to “match the index.” For example, they would claim to match the performance of the S&P 500 index, and ordinarily charge only rock-bottom fees.

Multiple papers have concluded that few active managers can consistently “beat the market” to a degree that justifies their high fees. Realizing this, American investors have increasingly moved funds over to passive managers: passive consists of about 80% of “net new flows” into the American fund market.

However, few individual “retail” investors buy funds directly. Instead, they go through financial advisors who select funds for them. Traditionally, advisors have been compensated through multiple streams, including by the active managers themselves—thus creating a conflict of interest. Therefore, the unsuspecting client may be invested into high-fee, actively managed funds. Their advisor did not represent the interests of the client, but of the fund manager—unless the advisor held a fiduciary responsibility to serve the client.

This is what the Department of Labor’s Fiduciary Rule attempted to change. The Rule intended for advisors to clearly disclose their fees and compensation, to avoid conflicts of interest, and to act in the interest of the investor. Although there is a secular trend towards passive management, the DOL Fiduciary Rule may have been the final nail in the coffin for high-fee active managers. Advisors that held a fiduciary responsibility to their clients would have balked at the high fees and dubious performance of active managers, and would have steered their clients nearly exclusively towards low-fee passive investments.

This is why active managers lobbied heavily against the Fiduciary Rule, claiming that it would prevent advisors from serving clients with smaller portfolios. This argument has merit: financial advisors ordinarily receive a fee from their clients that is proportional to the size of their portfolio. Clients with smaller portfolios would therefore become unprofitable to serve without kickbacks from active managers.

There is some precedent for active managers’ concerns. When the United Kingdom passed its Retail Distribution Review (RDR) in 2012 promoting “higher standards of financial advice,” advisors largely stopped serving unprofitable clients with smaller portfolios. The concern is that this would lock out smaller investors from financial markets, ultimately depriving them of retirement savings and cutting off the economy from a valuable source of capital.

However, these concerns are widely overblown. The RDR did shut out some smaller investors from formal financial advice, but low-cost online services have largely filled the void of traditional advisors. Retail investors without “advanced” financial needs can get their portfolio allocation advice through online robo-advisors. In the United States, these generally include Betterment and Wealthfront, among many others. These startups invest primarily in the products offered by the passive manager Vanguard, who has generally lead the passive trend. They charge ultra-low fees (0.15% to 0.25%) that traditional advisors would be unable to match. Seeing an opportunity, Vanguard and Schwab have expanded their own robo-advice capabilities. Neither charges a fee, but direct investors towards their own passive fund offerings.

The firms most affected by the Fiduciary Rule are big banks and insurance companies. President Trump is likely trying to appease these firms by repealing the Fiduciary Rule. However, doing so will not abolish passive management or save unscrupulous advisors. Many of the trends that have caused passive management to thrive—including consumer skepticism about the merits of active management, institutional investor scrutiny of fund management fees, increasing consumer-friendly legislation, and the availability of cheap online advice—are not about to reverse. Abolishing the Fiduciary Rule will not change the fact that active managers need to re-think their offerings and how they compete in the fund market. As HKS Professor Dick Cavanagh claims, “active managers need to learn how to make their offerings cheaper. The Fiduciary Rule would only have accelerated an existing trend.”

A wise investor will always be conscious about fees, scrutinize their advisors’ compensation, and ensure that those giving them advice are fiduciaries. It should be celebrated that today’s investors have an expanded selection of low-cost financial services—with or without the Fiduciary Rule.

NOTE: This article is intended to be informational only, and should not be construed as representing financial advice. For investment advice, contact a financial advisor (who is a fiduciary). For more information, this clip from HBO’s Last Week Tonight is a good layperson’s introduction:

About the author: Sasha Ramani is a CFA Charterholder and has previously worked as a consultant for Casey Quirk by Deloitte, advising investment managers like the ones mentioned in this article. His work included advising active managers about how to adapt to pioneering industry trends and a changing regulatory landscape. He is currently the VP of Finance for the Kennedy School Student Government.