Category Archives: Getting financial advice

brokers, IRAs and the fiduciary standard

August 19, 2016 By in fiduciary standard, How your broker gets paid, Uncategorized Tags: , , , , 2 Comments

a fiduciary

Being a fiduciary basically means putting your client’s financial interest ahead of your own.

A practical example:  

…given the choice between two products, one with a checkered performance record and high costs, but which makes payments (cash or trips or dinners…) to a financial adviser for selling the product, and a second with stellar performance and lower costs, and which makes no such payments, a fiduciary is required to recommend the second over the first.  At the very least, the fiduciary is required to disclose the facts of the situation, including the payoff from product #1, and allow the client to choose.

A brokerage firm registered representative, on the other hand, is not a fiduciary.  So he’s not required to alert the customer in advance if he’s recommending an inferior product, which is ok, but not great for the client and which–oh, by the way–pays him more.

For a long time consumer advocates have been trying to get Congress to change the laws so that brokers are redefined as fiduciaries.  Their push has intensified since the financial crisis.  But, although the change seems to me to be just common sense, and is in line with the standard of service customers already assume they are receiving, the financial industry lobby is still strong enough to have stymied these efforts.

retirement funds

The Labor Department, however, has recently used its administrative authority to issue guidelines for retirement investments which require advisers to act as fiduciaries, that is, to give investment advice that is in the client’s best interest.

Today, I heard the first reaction to these guidelines–other than general disapproval–from the brokerage industry.  According to the Wall Street Journal, the Edward Jones brokerage firm is withdrawing its mutual funds from retirement products affected by the Labor Department rules.  I looked on the Edward Jones website for clarification, but there’s no press release I can find.

To me, this means one of two things:

–EJ thinks its business practices run afoul of DOL guidelines and it is choosing to withdraw from this market rather than change them, and/or

–it thinks that 401k/IRA providers that sell Edward Jones products have potential compliance issues and prefers not to be involved.

Either way, this all seems to me evidence of how reliant the traditional brokerage profit model must be to offering investment “advice” that can’t pass the fiduciary test.

 

 

mutual fund and ETF fund flows

July 21, 2016 By in ETFs Vs. Mutual Funds, mutual fund holders and financial advisors, Portfolio management, Uncategorized Tags: , , , , , , 2 Comments

away from active management…

There’s a long-term movement by investors of all stripes away from actively managed mutual funds into index funds and ETFs.  As Morningstar has recently reported, such switching has reached 2008-era levels in recent months.  Surges like this have been the norm during periods of uncertainty.

The mantra of index proponents has long been that investors can’t control performance, but they can control costs.  Therefore, all other things being more or less equal, investors should look for, and buy, the lowest-cost alternative in each category they’re interested in.  That’s virtually always an index fund or an ETF.

Active managers haven’t helped themselves by generally underperforming index products before their (higher) fees.

…but net stock inflows

What I find interesting and encouraging is that stock products overall are receiving net inflows–meaning that the inflows to passive products are higher than the outflows from active ones.

why today is different

Having been an active manager and having generally outperformed, neither of these negative factors for active managers bothered me particularly during my investing career.  One thing has changed in the current environment, though, to the detriment of all active management.

It’s something no one is talking about that I’m aware of.  But it’s a crucial part of the argument in favor of passive investing, in my opinion.

what is an acceptable net return?

It’s the change in investor expectations about what constitutes an acceptable net return.

If we go back to early 2000, the 10-year Treasury bond yield was about 6.5%, and a one-year CD yielded 5.5%.  US stocks had just concluded a second decade of double-digit average annual returns.  So whether your annual net return from bonds was 5.5% or 5.0%, or whether your net return from stocks was 12% or 11%, may not have made that much difference to you.  So you wouldn’t look at costs so critically.

Today, however, the epic decline in interest rates/inflation that fueled a good portion of that strong investment performance is over.  The 10-year Treasury now yields 1.6%.  Expectations for annual stock market returns probably exceed 5%, but are certainly below 10%.  The actual returns on stocks over the past two years have totalled around 12%, or 6% each year.

rising focus on cost control

In the current environment, cost control is a much bigger deal.  If I could have gotten a net return of 6% on an S&P 500 ETF in 2014 and 2015, for example, but have a 4% net from an actively managed mutual fund (half the shortfall due to fees, half to underperformance) that’s a third of my potential return gone.

It seems to me that so long as inflation remains contained–and I can see no reason to think otherwise–we’ll be in the current situation.  Unless/until active managers reduce fees substantially, switching to passive products will likely continue unabated.  And in an environment of falling fees and shrinking assets under management making needed improvements in investment performance will be that much more difficult.

 

12b-1 fees: what they are

April 25, 2016 By in 12b-1 fees, Getting financial advice, How your broker gets paid, securities markets Tags: , , , , Leave a comment

fiduciary

The recent Labor Department determination that all financial advisors making recommendations for individuals’ retirement savings must act as fiduciaries is reviving interest in the topic of mutual fund/ETF fees and expenses.

Being a fiduciary means that the advisor has to place the client’s interest ahead of his own.  It isn’t permissible, for example, for a fiduciary to recommend an investment that is likely to return 5% per year, for selling which he gets a large commission, over a virtually identical one that will return 8%, but which pays a small commission.  For a non-fiduciary, which is what brokers/financial planners are when dealing with non-retirement assets, pushing the low return/high commission alternative is still ok legally.

Personally, I don’t like it that the fiduciary standard doesn’t apply to non-retirement investments.  I also don’t understand why individual investors don’t appear to be worked up about this.  I do understand why the big banks are opposed to fiduciariness, since applying the fiduciary standard to all advice to individuals strikes at the heart of the profits of the traditional “full service” brokerage industry.

12b-1 fees

The 12b-1 part refers to the section of the Investment Company Act of 1940 that governs how an open end mutual fund is allowed to pay for fund distribution and servicing.  It covers things like advertising, sending materials to prospective shareholders or having a call center to answer questions about the fund.

The general idea is that a fund benefits from retaining existing shareholders and adding new ones, so it’s a legitimate use of shareholder money to promote both objectives.

But the most common use of funds under the 12b-1 rule–and the least well understood, in my view–is periodic payments to financial advisors by a fund while clients continue to hold shares.   In the industry, these payments are called “trailing commissions,” or “trailers.”

The SEC doesn’t limit the amount of this fee, although FINRA (the Financial Industry Regulatory Authority, the investment industry trade group) rules set an effective  cap of 1.0% of fund assets yearly.  My sense is that the most common fee percentage for an equity fund is 0.25% – 0.50%.  The best hard data I can find come from the ICI (Investment Company Institute, a mutual fund trade group), and are from 2003.  At that time, aggregate 12b-1 fees amounted to just under half the total administrative expenses, at 0.43% of assets annually.  The rest were old-fashioned (more clearly understood by customers) sales charges.

why is 12b-1 a current issue?

Historically, disclosure of these fees has been exactly crystal clear.  Try finding information about them on the ICI website, if you don’t believe me.  In fact, I can’t recall having met anyone not involved in selling mutual funds who was aware these fees exist.

So, does a broker/financial planner who advises a client on retirement investments in mutual funds have to make sure the customer understands that 12b-1 fees are being subtracted from NAV on a regular basis?  Once he gets that, does the customer put two and two together and realize he’s subject to these fees on non-retirement investments, too–and has been from day one?

How does he react?

The difficulty I’ve experienced in gathering factual data for this post tells me that fund companies think the reaction will be strongly negative.

 

investment advisers as fiduciaries: a new Labor Department proposal

April 6, 2016 By in Getting financial advice, How your broker gets paid, Uncategorized Tags: , , , , 1 Comment

The Labor Department proposed new rules today that would require that brokers or financial planners or other professionals giving advice to individuals on their retirement savings act as fiduciaries.

what a fiduciary is

Being a fiduciary means being legally bound to give advice that’s best for the client, without regard for any benefits the adviser might get for recommending one investment over another.

Strangely, in my view, the fiduciary standard is not the rule advisers work under now.  Rather, advisers are only required to recommend products that are “suitable” for customers, meaning they fit the client’s goals, financial circumstances and risk tolerances.

The difference?

Another way of saying the same thing, the fiduciary is required to do what’s best for the client; under the old standard the adviser has simply got to avoid products that damage the customer.

For example:

A broker/planner has two general equity fund offerings:

–Fund A has a long history of strong investment management, consistently beating the S&P 500, and charges low fees

–Fund B has weak managers and an equally long record of sub-par investment performance, consistently losing to the S&P.  It also charges fees that are double the size of Fund A’s.  However, Fund B offers higher commissions to brokers who sell its product, plus trips to weekend informational seminars at resort locations to those who sell the most of it.

Under current rules, a broker/planner is permitted to recommend B over A, even though B is only better for the broker, and will presumably be considerably worse for the client.

costs are the smoking gun

Other than in hindsight, it may be hard to say whether manager X is better than manager Y.  And managers who consistently underperform are eventually culled, even in retail brokerage houses, where the emphasis is typically on strengthening the sales force, not the portfolio management team.

But I think it would be hard for a fiduciary to defend recommending one so-so product over another that costs half as much, and for selling which the fiduciary gets gifts, trips or a corner office and a secretary.

traditional brokers will be hurt the worst by these rules

That’s because they charge the most–partly to compensate highly-paid salesmen, partly to fund an expensive network of retail sales offices.

The traditional retail brokerage business has been dying a slow death since the advent of discount brokerage services in the 1970s.  Imposing a requirement that brokers do the best for their clients is another nail in the coffin.

for now, the rules only affect retirement savings accounts,

…not general savings/investments.  I presume this limitation is the result of fierce lobbying by financial advice providers opposed to the fiduciary standard.  But we may just be seeing the thin edge of the wedge.

Stockpile.com and stocks

January 13, 2016 By in How your broker gets paid, Uncategorized Tags: , , , , 1 Comment

A couple of days ago my California son sent me a picture of a Stockpile kiosk in an office supply store.  I’d known about the company, a subsidiary of stock market clearing house Apex, for a while but hadn’t looked into it before this.

The idea is that you can buy or gift small fixed dollar amounts of high profile stocks, like Amazon, Nexflix or Tesla, or index ETFs for that matter, either using a gift card you buy in office supply stores, supermarkets etc. or find online (gift card or e-card) at stockpile.com.  The recipient can either redeem the card for cash or use it to purchase fractional shares of the stock whose name is on the card.

My son’s first reaction is that this is a symptom of the kind of craziness that marks the top of a stock market cycle, like when strangers on the subway start to trade stock tips or when a cab driver does the same thing, explaining he’s a day trader who now drives as a hobby.  (I was a cab driver in Manhattan once and I can’t imagine anyone doing this who doesn’t have to.)

My hunch is that this isn’t a sign of the market topping, however (I’d be more worried if the kiosk offered bonds).  Of course, I think I’m pretty good at recognizing bottoms, but I know I’m bad at seeing tops.

Rather, I think this is another step in the evolution of stock investing away from the traditional brokerage model.  That model has three main defects:  the prices are outrageously high; the brokerage salesperson (around 90% are men) has no legal responsibility to do what’s best for the client; and in my experience the service and advice are poor.

Stockpile.com, in contrast, is bare bones.  No advice.  All trades are done at the day’s closing price.  Commissions are $.99 a trade.  And, of course, you can buy and sell fractional shares.

Target customers appear to be either impulse buyers, desperate gift givers or younger investors without much money to spare.  It’s hard to know how long the service will stay this way or how it will evolve.

I remember speaking with traditional brokers when marketing my mutual funds who believed (correctly, I think) that many clients kept most of their investment assets with Fidelity or Charles Schwab.  That way they would get advice from their brokers but only do, say a third of their trading at several hundred dollars  pop and the rest for $7 or $8 with a discount broker.

Maybe Millennials will end up keeping a third of their money with Fidelity or Schwab to get access to the statistical information they have available but do most of their trading for $.99 with Stockpile.  Maybe retiring Boomers, now more money-conscious, will do the same thing.

My overall reaction:  another evolutionary step, another nail in the coffin of traditional brokers.