Advisor vs. Advisor: Two RIAs and two brokers advocate [a total of] four different ways of earning fees and caring for clients

For the first time in decades, a healthy debate seems to be breaking out on the topic of fees. Comments by the hundreds are flowing into the SEC as it proposes and studies new rules that would change the way investors pay advisors and registered reps. Similar questions are playing out in the market, with a debate over the fees and costs of ETFs vs. mutual funds. The Department of Labor’s proposal to regulate the way retirement plan advisors (registered reps and RIAs) are compensated is another example of the fee wars cropping up in a federal agency.
Obviously, the main driver of the debate has been the financial crisis and the recession, which turned long-simmering issues up to a boil. What does all this turmoil signal? First and foremost, that change is likely coming, and fairly quickly. But the fact that the debate over fees is cropping up on so many fronts also begs the question of what will happen if companies, the SEC and the Department of Labor all drive in different directions?

Here are the three main arenas where RIABiz has recorded some of the fee debate of late:

The fiduciary issue

The question of whether brokers ought to be fiduciaries, held accountable for operating in their clients’ best interests, is one of law. But the passion on the issue is driven by money: The fundamental questions are whether imposing a fiduciary standard on brokers will destroy the entire business model; and whether investors will pay more or less under a fiduciary model. Neither question is settled – which is why, to date, there are hundreds of comments on the issue. Insurance agents are well-represented among those are commenting, as are people with CFPs (the CFP Board of Standard just launched a grassroots letter-writing campaign to urge CFP holders to write in — to some effect, it seems).

Here’s a sample from either side.

Andrew Cosgrove, the director of investments for Bethesda, Md.-based Bluestone Financial Advisors, wrote the following. (It’s fairly representative of the comments in favor of extending the fiduciary duty, in that it paints the debate as a matter of principle.)

I’d like to make two simple points:

1. The authentic fiduciary standard, as currently defined in the 1940 Advisors Act, is the standard that is in the best interest of investors and should be preserved. This is the “bright line” standard that should be heavily communicated to the investor community so that it is clear that anyone who provides advice as to the selection of any investment must put the client’s interest ahead of their own and disclose all conflicts in advance.

2. It is hard to comprehend how lawmakers and regulators persist in advocating the notion that a financial professional can be both an advisor and a broker to the same client. This abhorrent conflict was observed in the “Merrill Lynch” rule and was also observed in certain versions of the House bill leading up to Dodd-Frank. This concept only serves to further confuse the investor community.

Surely we can require that financial professionals serve either as advisors (with the greater responsibility associated with the authentic fiduciary standard) or as brokers, but not both. There is a place in the investor community to provide both services – but the SEC must ensure that the distinction between the two is made abundantly clear.

Put investor interests first by finally make the line between advisor and broker absolutely clear.

Principles-based regulation has its problems

Meanwhile, Nathan M. Perlmutter, CLU, ChFC, the CEO of Forest Hills Financial Group, a leading agency for The Guardian, sent in three page letter that included this section. Again, it’s fairly typical of comments opposing the extension of the fiduciary standard in that it focuses on what he argues could be the dire consequences of such a change.

In comparing the investment adviser and broker-dealer regulatory regimes, the broker-dealer regulatory regime provides better guidance to registered representatives and their supervisors, and therefore better protection to their customers, because the rules are clear and specific, and the conduct of registered representatives is capable of being monitored and audited. By contrast, the principles-based nature of the investment adviser regulatory regime is more difficult to follow and enforce.

One of the most significant gaps in regulation is the lack of FINRA inspections and examinations of investment advisers. The fiduciary duty of investment advisers gives scant protection to investors in light of the infrequency of Commission examinations. Moreover, most small advisers (those with less than $100 million under management) will have no federal regulation and oversight whatsoever, whereas insurance producers who sell variable insurance products must respond to examinations and audits at both the federal and state level, and are subject to regulation by both insurance and securities regulators. These gaps and shortcomings in oversight of advisers is an area of investor protection that the Commission should address first, before changing any standards of care for brokers. In other words, the need (if any) to adopt a “uniform” standard of care for broker-dealers and investment advisers pales in comparison to the need to adopt uniform standards for examination and inspections of securities professionals.

If the issue of investor confusion over the legal obligations of the investor’s particular financial service provider is a point of concern—as has previously been suggested in published research reports—there are remedies currently available to address the confusion. Existing FINRA and Commission rules are extensive, but those rules, if necessary, could be supplemented with additional disclosures of the role in which a financial services professional is operating, including additional disclosures of the existence of any conflicts. I believe investors, if presented with appropriate information, can make a choice that is right for them. Disclosure is a far better alternative than eliminating investor choices by attempting to make all financial professionals the same.

I have serious concerns about the possible adoption of a new “best interest” standard for broker-dealers, and by extension, life insurance producers who sell variable insurance products. I believe such a general standard it will create liability and uncertainty, but will provide no measurable benefit to investors. ...

If you want to add your voice on the fiduciary issue, go here.

12b(1) fees

Meanwhile, the SEC’s proposal to cap 12b(1) fees is also inspiring a healthy stream of comments. Many are from smaller advisors and registered reps (or advisors or reps who serve smaller investors) in defense of C shares, which the proposal could, in effect, do away with. So far, there are about 100 comments, with the majority criticizing the sweeping nature of the SEC’s proposal.

Wade Meeks, a financial advisor with Morgan Stanley Smith Barney, wrote this comment to point out that doing away with fees in one place will likely push them up in another. He also makes the point that C shares allow changes to a portfolio that don’t force clients to pay an up-front fee (this point was echoed in other comments).

The current trend in asset management is to use the “a” shares bought at “NAV” and wrap a management fee over this asset allocated portfolio. This proposed change will encourage more of this type of business. It will be extremely good for the Broker/Dealers and the Financial Advisors but will be more expensive for the individual investors.

First, the asset management fees and the combined fees inside of the mutual fund add up to more than the fees paid by the individual investor using the “C” share. The asset fees can go as high as 2% or more and then you add in the mutual fund management fee. This part of the business has exploded over the last 10 years. Before this proposed change is enacted it would be worth studying to see which one is really better for the investor.
Second, the average mutual fund holding period for individual investors is under three years. The “C” share fund has given advisors the ability to recommend appropriate changes to portfolio’s without the client having to pay up front sales charges.

Third, by encouraging through regulation advisors to us the “a” share fund I believe you will encourage more “churning” of accounts. I do not believe industry wide investors will hold the “a” share funds long enough to realize the lower fees. These savings are only realized after a heavy upfront commission and a seven plus year ownership.

This proposed change will be more costly not less for investors but will give the political types something to cheer.

Why should fund shareholders subsidize advisory services?

But Eric E. Haas, the chief investing officer of Altruist Financial Advisors LLC, wrote this long letter to support SEC action on 12b(1) fees. He even compares stockbrokers to Bonnie and Clyde!

1. Virtually all mutual funds (with the notable exception of Vanguard funds) exist not for the benefit of fund shareholders, but for the benefit of the fund sponsor, who is also typically the fund advisor.

2. As the fund sponsor/fund advisor are the entities to benefit from increased fund assets, they should certainly be the ones to bear distribution costs. It doesn’t make sense for existing shareholders to bear the costs of distribution which are designed to further enrich the fund sponsor/fund advisor. That paradigm amounts to a “Heads I win, Tails you lose” proposition in which the fund shareholder is the loser.

3. The argument that “ongoing services” provided by intermediaries need to be paid from fund assets is specious. – To quote William Bernstein, “The stockbroker services his clients in the same way that Bonnie and Clyde serviced banks.” – While there may be a very small minority of commissioned salespeople behaving as objective fiduciaries on an ongoing basis to their clients, the overwhelming majority of them appear to be commission-crazed salespeople who wouldn’t mind “selling a refrigerator to an Eskimo.” Thus, the “services” which ongoing 12b-1 fees subsidize are, at best, nothing, and at worst, continuing sales pitches intended to generate more commissions for the salesperson. Not only is this sort of “service” not valuable, but it doesn’t make sense for a consumer to pay for it in any way, shape, or form. – The need to, for example, pay a mutual fund supermarket to distribute one’s funds is a cost that need not be borne by fund shareholders. For example, Vanguard funds don’t pay such fees and still are available (albeit with a usually modest transaction fee) in mutual fund supermarkets. Thus, the funds would be forced to stand on their own in competing for assets. If a consumer doesn’t want to pay a modest fee to utilize the value-added of a mutual fund supermarket, they can typically avoid such fees entirely by buying directly from the fund company. – Even if salespersons were providing ongoing advisory services, why should current fund shareholders be forced to subsidize those services? It would make much more sense to completely “externalize” said expenses (i.e., deduct them directly from shareholder accounts rather than from fund assets). This would allow the fees to be dramatically more visible to the average investor. It would allow providers of said “services” to set their own fees for those “services”. This might better inspire competition, both by the price of the fees and the nature and extent of services provided in exchange therefor.

In summary, I propose completely eliminating 12b-1 fees and completely externalizing all such distribution and service fees.

If you’d like to add your voice on the 12b(1) fees issue, go here.

Mutual funds vs. ETFs

With the rising recognition of the costs of mutual funds, ETFs have been promoted as the low-cost alternative. Many advisors are beginning to build business models around ETFs – just in the past week, RIABiz has written about two of them. See: Advisor spotlight: Vern Sumnicht was determined to diversify — but it cost him and One-Man Think Tank: A method for analyzing and comparing the costs and fees for mutual funds and ETFs.

But that debate is by no means settled. Today, RIABiz’s One-Man Think Tank Columnist runs through a detailed analysis of how RIAs can measure the fees and costs of mutual funds and ETFs for investors – and comes to the conclusion that there is not a sweeping answer. Adam Bold, meanwhile, offered this critique of ETFs in How ETFs have been oversold when it comes to flexibility, lower costs and tax efficiency.

He was taken to task by Paul Weisbruch. See: Criticism of ETFs is based on fear more than factual basis.