The Fiduciary Rule

The implementation of the Fiduciary Rule has been delayed as the Trump administration studies it.  The part of the Fiduciary Rule that requires advisors to act in their client’s best interest would be great for investors.  It’s suitability for financial professionals is much less salutary.

Currently a financial professional is held to a rather mediocre standard.  Their advice about investments is considered appropriate as long as the investment meets their client’s “defined need and objective.”  Such investments are considered “suitable.”   http://www.investopedia.com/updates/dol-fiduciary-rule/   The standard sounds pretty good until you consider that it allows financial professionals to consider their own interests when providing advice.

There are hundreds of diversified mutual funds and exchange traded funds that invest in the US stock market.  Most of them are “suitable” for you if your objective is to invest in the US stock market.  Given the vastly different cost structures among the funds, some are more suited to your financial health than others.  That is where the current allowed disconnect between your goals and your advisor’s goals can hurt you.

Most funds are no-load, meaning that they do not charge an up-front sales fee, but many funds charge fees, often from 3-5%, but as high as 8.5%.  Assume that two people invest $10,000 in funds that buy substantially similar stocks.  At the end of the transaction, the no-load investor would have $10,000 invested in the stock market and the other investor would have $9,150 invested.  I know which person I would rather be.  http://www.fool.com/school/mutualfunds/costs/loads.htm   For an argument suggesting that load funds can be better than no-load funds in the abstract, see https://www.thebalance.com/no-load-vs-load-funds-2466715.

Moreover, ongoing management fees effect costs at least as much as load charges.  A quick screen on schwab.com reveals that there are 125 mutual funds that invest in large capitalization value stocks that are rated four or five stars by Morningstar.[1]  The annual management fees average 1.07%, but range from .26% to 1.96%.   Remember that these funds all invest in approximately the same value-oriented stocks of large cap US companies.  The funds are, of course, not exactly the same, but they are similar in profile.  For simplicity’s sake, I will assume that the funds stay flat except for fees.  At the end of five years the fund with the cheaper fee would have declined to $9,871, not great (obviously) but not bad given that stocks didn’t move.  The other fund would have declined to $9,058.  Ouch.  Fees matter.

The dollars that pay the fees don’t simply disappear from your account, they go somewhere.  That somewhere is to your financial advisor or the company he or she works for.  They hate the Fiduciary Rule because it would prevent them from purchasing funds that charge a high load (which goes to them) when a substantially similar fund with a lower load or fee structure is available.  Paying more fees is rarely in your best interest, though it is often in your advisor’s.[2]

There are various aspects of the Fiduciary Rule that are arguably good or bad.  It depends in large part on your perspective.  I am not aware of any investor advocacy groups that are against the Fiduciary Rule, whereas virtually the entire financial services industry is against the rule.  There are likely sound reasons not to adopt the Fiduciary Rule, to delay it, or to modify it.  But forcing advisors to consider the fees their clients pay when making investment decisions is an overwhelmingly good reason to implement the rule.  Advisors should not be required to be perfect, but they should act in their clients’ best interest, not their own.[3]

[1] A four or five-star rating means that after assessing risk, return, consistency, and other factors, Morningstar considers the fund to be in the top third of its peers.  http://www.investopedia.com/terms/m/morningstarriskrating.asp

[2] I suspect that a significant majority of advisors act ethically and would not recommend funds that have higher loads or fees solely because they have a higher load or fee.  But some advisors are almost certainly tempted beyond their ability to resist.  The rule would have little impact on ethical advisors even as it severely curtailed the excesses of unethical advisors.  That strikes me as a good thing.

[3] Teaser alert (if you read endnotes), I’m working on a post about another group of people that should be held to a higher standard.  This post was supposed to be a one-paragraph prelude, instead it is a one-post prelude.