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The Third Rail

Don Phillips: If most investors use advisors and most investors continue to do the wrong thing, then there must be a tremendous amount of bad advice being given.

Don Phillips, 10/07/2010

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I recently attended a panel discussion on fund distribution at a major fund industry conference. These panels are always well attended. Fund company executives are eternally eager for hints on how to build stronger relationships with firms that could sell their wares. I've watched dozens of these panels over the years, and they all play out the same way.

The distribution executives on the panel start by asserting their importance to the overall fund industry. The panel at this conference threw out the statistic that 83% of assets going into funds today are directed by financial advisors. No one in the industry disputes the figure, as witnessed by the packed room. Then, panelists inevitably launch into a critique of how foolish fund investors are, presumably as evidence of why individuals need advisors so much. This panel followed suit, citing the futility of investors chasing technology stocks in the late 1990s and piling into bond funds today. Investors, we are told, always do the wrong thing, fight the last war, and chase past performance. Again, no one in the industry disagrees.

What no one did at this panel--indeed, what no one does at any of these discussions-- was put these two widely accepted facts together to voice an unsettling implication. If most investors use advisors and most investors continue to do the wrong thing, then there must be a tremendous amount of bad advice being given. Or, said more charitably, the current state of financial advice cannot counteract the self-defeating inclinations most investors have. Somehow, our collective ability to push investors toward sound decisions is not yet up to the task, even though huge sums are being charged for the service.

Criticizing fund distribution, of course, is the third rail of personal finance. No one, especially a fund company executive who depends on such distribution for his livelihood, will raise these concerns publicly. The industry has stood largely silent as distribution costs for everything from payments to brokerage houses to fees charged by fund supermarkets have skyrocketed over the past two decades. Fund managers take the public lashings for high fees while distributors go unscathed, even though the reality is that fund management has significantly lowered its percentage take while distributors have steadily increased their toll. No one bites the hand that feeds.

Silence, however, looks noble compared with active support of bad distribution practices, which was on display at this same conference. The debate about the proposal to enforce a fiduciary standard upon advisors echoed through the halls of this event, as it has at many fund events this year. Everyone agrees that the current uneven playing field confuses investors. Registered investment advisors hold themselves to a fiduciary standard, while many brokers and insurance reps who sell funds are held to a simpler suitability standard. There are only two ways to level the field: raise the standards of one side or lower those of the other. Privately, nearly every fund executive I've spoken to concedes that raising standards is the right long-term path. Indeed, fund leaders boast of their embrace of a fiduciary standard as one of the keys to the U.S. mutual fund industry's long-term success. Why not move to the same standard for those who represent the industry's services to the public?

Saying that publicly, however, is a dangerous proposition for those fund executives whose firms depend on suitability-based advisors for distribution. That's why we hear eloquent, if convoluted, explanations from these fund executives as to why a lower standard really is preferable. One can't help but think that the executives making these statements won't shudder to have them read back to them 20 years from now, just as Jack Bogle must when reminded of his fervent advocation of front-end loads in his youth.

In any case, it's time to stop defending weak practices or remaining silent on the true state of advice. We can debate if the issue is that investors get bad counsel or if they fail to implement well-intended advice. Probably both are true in some cases and to some extent. But the one thing we can all agree on is that somehow the collective state of advice isn't where it should be. More needs to be done to improve the fate of investors. The time for silence has passed. It's time to study and advance the best advice practices and to stop defending the weakest. It's time to embrace rather than shun higher standards. Only by conceding that there's a problem can we move toward a solution. Not only does the reputation of the fund industry rest on this issue, but the fate of most fund investors does as well.

Don Phillips is a managing director of Morningstar, Inc.

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