Should There Be a Single Fiduciary Standard for Financial Advisors?

Keeping It Simple
Last weekend, The Wall Street Journal's Jason Zweig discussed Washington's ongoing debate about fiduciary responsibility. Those who give financial advice follow a dual regulatory standard. If they are Registered Investment Advisors, they are overseen by the SEC and are treated as fiduciaries who must act solely for the benefit of their clients. In contrast, if they work with a broker-dealer and report into FINRA, they face the lower hurdle of suitability--meaning that they are permitted to make self-serving recommendations, as long as the recommendations also suit the client's need. Many onlookers argue that all advisors should meet the stricter standards.

Knut Rostad, a registered investment advisor who runs an organization called The Institute for the Fiduciary Standard, puts the matter this way: "That an industry's central argument against modernizing regulations is that it can no longer do what's right for the client should be considered, at the very least, an odd admission of a gigantic failure. A gigantic failure when, at the very same time, registered investment advisors (RIAs) ARE apparently doing what's right for the client, or at least not waging a campaign based on their inability to do so." 

My initial thought was to defend the dual standard. An advisor serving the complex needs of an older, wealthy investor--involving multiple accounts, estate planning, tax strategies, and so on--has a very different set of tasks than does an advisor who places a young buyer into his or her first mutual fund. The former mostly delivers a service; the latter is a sales person. Why should they not be regulated differently?

Then again, who needs the market confusion? Another RIA making the case for the single fiduciary standard, Samuel R. Scott, points out that 85% of investors do not understand the difference between the fiduciary and suitability rules. Even if they do, that doesn't mean that they understand the conditions under which each standard is applied (I had to double-check myself when writing this article) or the status of a particular advisor. That's not good. The confusion harms the investor experience, and it's a disincentive for advisors to strive for the higher fiduciary approach, since their additional effort may not be recognized by the marketplace.

Also, in thinking more about the issue, I fail to understand what actual problems the fiduciary standard will bring to advisors who currently operate under the suitability rules. Sales contests will need to cease. So too will selling securities because the brokerage firm has those issues in inventory. Both of those changes would be for the better. Varying levels of commissions among funds might be an issue--but presumably fund companies would quickly adjust to their customers' difficulties by having their commission payments converge.

I could be wrong. There could be large practical difficulties that I haven't imagined. However, I suspect that the resistance to upgrading the standard owes mostly to the general tendency to resist change, especially change that seems to require more work and more legal liability, rather than to the specifics.

On Second Thought
A reminder of the industry's tendency to overstate the difficulty of changes comes from India. In 2009, the Securities and Exchange Board of India banned all front-end sales loads on funds. As Indian funds were already banned from paying distribution costs out of ongoing expenses--the equivalent of U.S. 12b-1 fees--the action pretty much ended commission-based sales in India. This move was met by widespread predictions of sales doom, both within India and from outside observers.

Sales did indeed decline. However, according to four researchers at the Indira Gandhi Institute of Development Research, fund sales did not fall because of the change in distribution rules. The slide occurred instead because of market conditions. Conclude the authors, "Contrary to industry claims that banning distribution fees would dramatically reduce investment in mutual funds, we find no evidence that post-reform asset growth was lower for funds charging higher distribution fees prior to the reform … our results suggest that Indian mutual fund growth in the post-policy period was lower for reasons independent of this policy change, such as a general move away from mutual funds toward real assets such as gold and real estate following the 2008 financial crisis."

These authors, too, might be wrong (I haven't combed through the paper in detail). But it's a worthy reminder of how the fear of making change is usually greater than the change itself.

Round Trip
Two weeks back, The Wall Street Journal wrote about research finding that MBA admissions departments rewarded students from colleges that had grade inflation. That is, the admissions departments looked more at an applicant's absolute grade-point average than at the relative performance. Per the article, a student with a GPA of 3.6 from a college that had an average GPA of 3.7 (Gasp! Such a thing exists?) would fare better than a student who had a GPA of 3.4 from a college with an average of 3.2.

Twenty years ago, I would have said that MBA admissions departments aren't very astute. Then I attended business school and learned that markets are efficient and rational, so that they deliver optimal solutions. By that logic, MBA admissions departments must be very insightful, only it appears otherwise from the outside. More recently, however, I learned that markets are efficient and rational, but its solutions may not be optimal. Per game theory, market participants adjust their behavior based on what other participants do. That can lead to odd results. 

However, I can think of no plausible explanation via game theory as to why MBA departments would prefer students from colleges with grade inflation. (No, I don't believe for a moment that anybody cares about the average GPA of students entering an MBA program. The average GMAT score, yes, but not the average GPA.) This returns me to my original line of thinking: MBA admissions departments aren't that astute. 

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.