The F Word

Perhaps it is a part of growing older, or maybe it is the effect of advances in technology. Whatever the reason, kids these days seem to speak in a language that would have gotten someone of my generation smacked by the nearest chaperone. Back then, the word most likely to elicit a reaction from peers or disciplinary action from schoolteachers was “the f word.” Funny how those adolescent behaviors then considered inappropriate seem quaint in comparison to behavior one routinely witnesses on sidewalks, in shopping malls, and on buses and trains.

The Search

One’s search for the right financial advisor involves understanding an “f word” of a different sort. The first and most important such word is “fiduciary.” Registered investment advisors and their representatives (of which I am one) are required to advise clients on their clients’ best interests. The wording of the law in question, the 1940 Investment Advisors Act (1940 Act), is sufficiently vague on this requirement, known as the “fiduciary standard,” to require extensive rulemaking at various government departments in order to implement, a struggle reinvigorated in the wake of the crisis of 2008. Moreover, the 1940 Act as originally enacted did not cover stockbrokers, considered at the time to be “order-takers” executing transactions, not investment advisors.

The S Word

Stockbroker behavior is subject instead to a “suitability standard” of conduct under the Securities and Exchange Act of 1934 (which formed the SEC or Securities and Exchange Commission). The suitability standard (think of it as the “s word,” another word considered obscene before becoming as common as the word “like”) amounts to a lower standard of care for stockbrokers. As registered representatives of brokerage firms stockbrokers do not have to advise clients on their clients’ best interests; instead, they need only believe that the recommended investment is suitable (i.e., reasonable) given the client’s situation. That these two standards sound the same is but one example of how special interests influence the lawmaking process to protect their best interests at the expense of the interests of the ordinary investor.

The Distinction

Truth told the difference between the fiduciary and suitability standards is critical to the ordinary investor’s best interests. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 mandates a new fiduciary rule to hold all professionals providing personalized retail investment advice to a standard of conduct “no less stringent” than the fiduciary standard. Additionally, Dodd-Frank mandated the amending of the wording of the 1940 Act to include stockbrokers (among other professionals) offering personalized retail investment advice under this standard of conduct, but as the saying goes, “devil is in the details,” and the intent of the law is not enforceable without changes to the related securities industry regulation. In the meantime, stockbrokers continue to work under the lower suitability standard. Unsurprisingly, the brokerage industry is fighting this rulemaking process with all its might. Opponents to the new fiduciary rules have succeeded in delaying the rulemaking process at the Department of Labor and the SEC.

The Advocates

Fortunately, there are a few investor advocates in positions of varying degrees of influence arguing for a broadened “universal” fiduciary standard. While Vanguard founder John Bogle is among the most prominent such advocates, along with shareholder activist Robert A.G. Monks, there are several leaders of this good fight in the trenches every day grappling with well-organized securities industry opposition. Phyllis Borzi, the Assistant Secretary of Labor of the Employee Benefits Security Administration is one such leader, known for her tenacity, as she seeks to strengthen protections for millions of pensioners and 401(k) plan investors under the Employee Retirement Income Security Act (ERISA) of 1974. SEC Chair Mary Jo White confronts securities industry opposition in her efforts to strengthen protections for the retail investing public while handicapped by pressure from a vocal group of congressional representatives to limit new regulation and its funding.

The Harm Done

Barbara Roper, the Director of Investor Protection at the Consumer Federation of America, is another leader in this struggle. In fact, to best illustrate why the suitability standard is insufficient to protect the ordinary investor’s best interests I cite the following excerpt from a letter to the SEC regarding the fiduciary rulemaking under Dodd-Frank signed jointly by Ms. Roper and other organizations (e.g. the AARP), posted on the Consumer Federation of America site:

“The most readily observable impact of investor harm resulting from the lack of a uniform fiduciary standard arises out of the significantly different costs imposed by otherwise similar investments.  Consumer Federation of America (CFA) … examined Morningstar data for S&P 500 index funds to determine the impact of costs on otherwise similar investments.  CFA chose this type of fund to analyze because it offers a clear example that any increase in investor fees comes directly out of investment performance without offering any added benefits to compensate for those increased costs. Based on its examination of the Morningstar data, CFA found evidence of thriving cost competition among direct-marketed funds, with investor assets heavily concentrated in a handful of very low-cost options.  In contrast, administrative costs for broker-sold S&P 500 index funds held outside of retirement plans were often significantly higher than those of direct-sold funds, even after the cost of compensating the broker was excluded.  Moreover, in several cases cited by CFA, customers of major brokerage firms paid sales loads of as much as 5.25 percent in order to purchase an S&P 500 index fund that has an expense ratio roughly ten times or even twenty times as high as the expense ratio of the lowest-cost direct-marketed fund.  Far from adding value, the recommendation of a broker, in this case at least, merely added to the already excessive cost.” (p.3)

The Burden of Proof

In other words, the suitability standard allows stockbrokers to sell customers funds with sales loads, charges the customer need not pay, as most mutual fund companies sell funds directly to retail investors. Under the fiduciary standard, the advisor making such a fund recommendation would be required to explain to his client why the recommendation is in the client’s best interests and defend that argument in court. The broker advising that same client can recommend any product he deems “suitable” and, in the event of a lawsuit, the client bears the burden of proof that the broker’s advice caused her harm.

The fact is that sales loads are a relic from an era when mutual fund sales representatives went door-to-door, and regulators approved of loads to finance the costs of fund distribution. Most fees of this nature were rendered obsolete decades ago when Vanguard and other fund companies removed the costs of the “middleman.” So there is no excuse for stockbrokers selling retail investors funds that charge sales loads as excessive as the example cited above of 5.25%. To provide context for these sales loads, note the long-term historical return on stocks has been about 10 percent per year. Such loads place a material burden on the ordinary investor in exchange for no value. Unfortunately, this practice is legal, and as the excerpt suggests, too common to dismiss as a single “rogue broker.”

As stated in the above excerpt, the suitability standard further allows stockbrokers to sell customers funds with expense ratios ten to twenty times as high as the funds tracking the same index found at low-cost fund companies like Vanguard and Fidelity. The notion that the ordinary investor is being sold funds charging annual expenses ten to twenty times as high as the lowest-cost fund alternative, knowing that fund expenses reduce, dollar for dollar, fund investor returns, to me violates even the lowest professional standard of care. A study by Morningstar noted for its candor concluded that fund expenses are the most significant indicator of long-term fund performance (i.e., the lower the fund expenses, the better the relative long-term fund performance). This conclusion was noteworthy because fund expenses had proven more accurate in forecasting relative fund performance than Morningstar’s own fund star rating.

As such, once the asset class (e.g., large-cap stocks) is chosen based on the client’s risk tolerance, time horizon, and other factors driving portfolio composition, the advisor heeding the fiduciary standard would feel compelled to recommend a fund with costs being a primary factor; indeed, with the lowest practicable costs being the first.

The Hypothetical Illustration

If all this sounds like gibberish, think of it in terms of the following hypothetical example using historical fund return and expense data per Morningstar. Let us say instead of putting the $10,000 you had saved to start your nest egg in the early nineties (on July 31, 1991, the starting date when the data for the following comparison is available), in the Admiral share-class of the Vanguard 500 Index fund, your stockbroker put your $10,000 in the “JP Morgan Equity Index A” fund. Both funds track the same index, to the same degree of statistical accuracy. Since Vanguard charges no loads, you were able to invest all of the $10,000. The JP Morgan fund charges a 5.25 percent load, so your initial investment in the fund falls to $9,475 on day one. Then, each year the JP Morgan fund takes 18.8 times the expenses (0.94%, per Morningstar) the Vanguard fund charges (0.05%).

Given the actual fund returns over this twenty-three year period, assuming you reinvested fund dividends and rebalanced annually, you would have had $79,986 in the Vanguard fund as of the end of last month (June 30, 2014), compared to only $67,690 in the JP Morgan account. That is a difference of $12,296. On average, that is over $536 per year, or $1.47 cents per day, transferred from your nest egg to JP Morgan, in exchange for no value to you. Granted, you may have sought professional guidance to help identify which fund to buy. In that case, you paid $12,296 over this period for a single fund recommendation. You could have paid a fraction of that to a fiduciary advisor for his time to provide a fund recommendation geared to your best interests. Does this example make you want to cuss like a drunken sailor?

It should. A quick search of the Morningstar universe indicates 47 mutual funds track the S&P 500 Index with an R-Squared of 100, the same degree of statistical accuracy of the Vanguard 500 index fund. Thirteen of these funds charge loads. One such fund, the “Nuveen Equity Index C” is reported has having a net expense ratio of 1.37%, more than twenty seven times the annual expense ratio of the Vanguard 500 Index Admiral or Fidelity Spartan 500 Index Advantage fund. Adding insult to injury, this fund charges its investors 1.0% per year to finance the fund’s marketing to new investors or to pay the selling representative his commission (via the “12b1” fee). Unfortunately, the imposition of these costs on the ordinary investor in exchange for no value is legal.

The Upshot

The search for the right financial advisor thus starts with an “f word.” Working with an advisor held to the fiduciary standard does not mean your investments will earn the highest absolute return. However, settling for the “s word” and working with an advisor instead held only to the suitability standard does mean that your financial advisor’s fiduciary duty is to his employer, not to you. Therefore, selecting an advisor subject to the fiduciary standard is a critical first step in protecting you from the risks of financial harm in following advice rendered without your best interests at heart.

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