Winners and Losers of Department of Labor's Fiduciary Rule

Today, the Department of Labor is rolling out the long-anticipated “Fiduciary Rule” that will bring an ever-larger swath of individuals under the umbrella of “fiduciary.” For the most part, I think this is a good thing, but it will have significant impact on the investment landscape.

Suitability Standard

At the moment, people who interact with clients about their investments can fall under any number of umbrellas. Some are “Registered as Investment Advisors” (RIAs) with the SEC. That’s pretty much the highest standard you can ask for, and anyone who’s an RIA is already working as a “fiduciary” on behalf of his or her clients. That means that RIAs are obligated to put their clients’ interests ahead of their own . . . which is frankly what you expect when you pay for a professional service.

But there are lots and lots of folks out there who work with clients but are not themselves RIAs. The traditional “broker,” for instance, lives under the umbrella of the Financial Industry Regulatory Authority (FINRA) and is held to a “suitability” standard. Those Series 7 licensed brokers can (until this rule is phased in) get paid commissions on stock trades, just like you see in 1980s Wall Street movies, as long as that broker can stand in front of some future judge and say, “Yes, Your Honor, I believe MSFT was a suitable investment for my client,” regardless of whether a particular trade or strategy was really advancing the client’s long-term goals.

Insurance agents, meanwhile, are generally regulated by state insurance regulators and can have a whole host of professional standards to follow, which may or may not go past a simple “suitability” test.

The new DOL rule brings everyone (at least everyone who touches retirement accounts, which is the DOL’s purview), theoretically, under one standard. On the surface, this is a great thing. I’m all for clean, easy-to-understand standards that protect investors and simplify the process of getting and giving advice. Of course, there are wrinkles. Under the rule, a client can sign a contract that effectively opts him out of the fiduciary relationship with his advice-giver. Doing so allows the advisor to be paid a commission or a revenue share based on the products being sold. Why would an investor do such a thing? Well, perhaps because he really trusts and likes his advisor and is fine with that advisor getting paid by someone else. Like any piece of regulation, there are complexities in how this new standard will be implemented, and that will lead to winners and losers.

Who Wins? Who Loses?

The big winner here is likely the end investor. Why? Because she can at least have some assurance that anyone she’s hiring to help run her money is actually working in her best interest, with no funny business going on. The counter argument to this is that by effectively shutting down potential revenue streams for certain kinds of advisors, small investors will get left out in the cold.

I’m not sure I buy that argument. The major robo-advisor platforms like Wealthfront and Betterment are already RIAs, and thus obligated to act as fiduciaries for their clients. And the robo-advice model is perfect for smaller accounts, where complexity is generally at a minimum. So robos are probably winner number two.

Winner number three? Exchange traded funds. There’s a reason why every major robo-advisor platform is leveraging ETFs: they are often the cheapest, most tax efficient, most flexible way to get exposure to an asset class. As more and more advisors are forced to act — legally, and defensibly in court — in their clients’ best interests, they’ll naturally gravitate towards ETFs.

Imagine this scenario: a client with a $1 million portfolio goes to an advisor and asks for a basic asset allocation plan. The advisor is sitting at his desk, looking at options for large cap equity exposure. On one hand he sees an S&P 500 ETF with a 5 basis point expense ratio that’s never made a capital gains distribution. On the other, he sees an S&P 500 mutual fund with a 10 basis point expense ratio that pays out capital gains year after year. Which one does the advisor want to defend —either to the client or to a judge?

And winner number four? Indexing writ-large. Based on the latest S&P Index vs. Active Scorecard , 66% of all large-cap managers, 57% of all mid-cap managers, and 72% of all small-cap managers failed to beat their simple benchmarks in 2015 — benchmarks that all available in dirt-cheap ETFs and mutual funds. Over the past five and 10 years, the numbers are worse.

Does that mean active management never works? Of course not. Last year, 33% of large-cap managers did, in fact, beat their benchmarks. Their investors are happy. But any advisor acting as a fiduciary will have to convince both her clients and a judge that she is so good at selecting active managers that she can confidently beat the odds and select the active managers who will beat the benchmark in the next year. Because if advisors can’t convincingly make that argument, how can they claim they are acting in their clients’ best interests?

Oh, Brave New World

Whether you love it or hate it, this new rule will head to Congress for a vote in 60 days. If passed, the DOL fiduciary standard starts going into effect, with full phased-in compliance by 2018. That’s a good long time for the industry to adjust. In the coming weeks and months, you’ll be reading more about how different firms are preparing to comply. Many folks will complain that the new rules have been watered down (which, indeed, they have been, compared to the initial proposals) and contain too many loopholes under the “exemption” contract discussed above. Others will argue that the rule goes too far and presents an undue compliance burden. Like most regulations, when both sides are grumbling, it’s probably a decent compromise.

In any case, it’s here, and, honestly, it’s going to shake up the industry for years to come. Whole business models based on revenue sharing in retirement plans are going to go by the wayside. Investors will have a much clearer understanding of what they’re getting for their advice-dollars, and as always, the industry will adapt.