The law of unintended consequences may well trump the rule of Buffett.
This article originally appeared in the June/July 2012 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
Perhaps no two groups are more passionate
about Warren Buffett than active fund managers and fee-based advisors. Active managers see Buffett
as a shining example of how brainpower can beat the market.
He would seem to embody their mission and to justify their purpose, even if Buffett has
publicly stated that most investors would be better served by owning index funds. Fee- based
advisors, many of whom got into their profession out of a love for investing, often have a similar
admiration for Buffett. Dozens
of advisors whom I know travel regularly to the Berkshire Hathaway annual meeting just to hear his
insights. The Alpha Group, a coalition of some of the country’s most respected advisors, even held
one of its meetings in Omaha last year to coincide with the Berkshire meeting. Given the support
from both of these bases, it’s a strange twist then that active managers and fee-based advisors
stand to be among the bigger losers in the unlikely
event that Congress enacts the “Buffett rule,” which would create new tax penalties for taxpayers
with incomes above $1 million.
The Buffett rule is a clear loser for active managers. Small and tax-deferred accounts wouldn’t be affected, but the very lucrative high-net-worth market could be sharply penalized. If you earn a salary in the high six figures, the last thing that you’ll want are unpredictable capital gains being disgorged by your mutual funds that put you in the Buffett-rule penalty box. Index funds and non-dividend-paying stocks (coincidentally like Berkshire?), where you have more control of the timing of capital gains, become vastly preferable to actively managed funds in such a scenario. Ironically, it would be the Buffett-inspired buy-and-hold managers who would be the least attractive choices for investors potentially subject to this new tax. These managers unlock gains in lumpier, more concentrated fashion than do managers with persistently high turnover. They would pose an annual threat of a big, late-in-the-year distribution that could subject holders to the Buffett rule. For wealthy investors, the Buffett rule may relegate active managers exclusively to tax-deferred accounts.
For fee-based advisors, the Buffett rule invokes the notion that no good deed goes unpunished. These advisors forged a clean business model. They moved away from commissions and shunned the 12b-1 fees of B and C share class funds. They built portfolios around low-cost, institutional-type funds and bill their clients separately for their services. It’s a better mousetrap, but it would be penalized by the Buffett rule, particularly for the high-net-worth clients. Here’s the problem: Clients pay for these advisors’ services with aftertax dollars. Given that the tax rate on much of their investment income would rise, possibly doubling this year’s rate, the cost of engaging a fee-based advisor would escalate dramatically. It gets worse. If these advisors were paid through 12b-1 fees, not only would their compensation be paid in pretax dollars, but it would also lower the amount of investment income that could push an investor over the $1 million income threshold. The same remuneration paid outside the fund would lose this benefit. In essence, the Buffett rule could tilt the playing field away from the open, independent model of the fee-based RIA back toward the murkier, more-conflicted model of brokers selling C shares. Clients would lose sight of the fees that they are paying, and their ability to judge the value/cost ratio of the services they receive will be lessened. That’s not a step forward for the planning profession.
If these tax changes tilt the investment world back toward structures that embed distribution costs in a fund’s expenses, there could be further damage. When you push a fund’s expenses up, you lessen the fund’s yield, as expenses are taken directly from a fund’s income stream. A manager who’s saddled with a higher-cost fund must take proportionally higher risks to generate the same yield as a lower-cost fund. Thus, shifting distribution costs back into the expense ratio would tempt some managers to take risks they otherwise wouldn’t take to stretch for yield. The cleaner model forged by independent RIAs safeguarded clients from these pressures. The Buffett rule could undermine that protection.
One could argue that the Buffet rule would only affect a small number of investors, but these investors are the high-net-worth accounts that the asset-management industry depends upon for its profitability. These lucrative accounts push the costs of a mutual fund down for all investors. These are the big clients that give advisors the margins to take on smaller clients or do pro bono work. Leaving aside the arguments of whether the Buffett rule is good or bad economics or good or bad politics, it clearly isn’t good for financial-planning models or for active managers. Simplistic notions, even those with the best intentions, seldom lead to good policy. The law of unintended consequences may well trump the rule of Buffett.