Rules and Observations

Vladimir Putin dominated headlines once again Monday, distracting investors from two items with potentially more significant long-term implications for the investment industry. Photo by Mark Ralston – Pool/Getty Images.

Between slowing Japanese growth, tanking Chinese exports and Russia’s continued efforts to annex Crimea, investors had plenty to chew over Monday. But lost in the noise were two seemingly unrelated items that flew under the radar. In the UK, regulators announced they’re investigating potential conflicts of interest in brokers’ and mutual fund shops’ top fund recommendations. Meanwhile, at an industry conference in Virginia, SEC Division of Investment Management head Norman Champ said the regulator is “intensifying its consideration” of applying a universal fiduciary standard to all brokers and advisers in the US. Neither is anywhere near as exciting as Japan’s foibles, China’s trade wobbles (which really aren’t so wobbly) and Vladimir Putin’s putsch, but over time, they could carry far more significant implications for the functioning of the investment industry.

Currently, brokers and registered investment advisers in the US are held to separate standards. Registered investment advisers (RIA) like Fisher Investments, the company behind MarketMinder, are held to the fiduciary standard, which requires advisers to put investors’ interests before their own—to make the recommendations they reasonably believe position clients to reach their financial goals and to disclose potential known conflicts of interest. There are currently over 10,500 SEC-registered RIAs and more registered at the state level. While there are some hybrids held to both, many of the 630,000 registered representatives in the industry are held to the suitability standard, which states investments sold to a client must be suitable for them. However, it contains no requirement to put clients’ interests first, nor does it require advisers or brokers to disclose the conflicts of interest potentially arising from compensation arrangements—like, say, if brokers recommend products carrying a bigger commission.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 mandated regulators review this breakdown and consider dropping the dual standard in favor of an industry-wide fiduciary standard. Four years later, not much has happened. The SEC completed and published its study in early 2011, and last November the Investment Advisory Committee recommended the uniform standard with small exemptions for brokers who strictly sell products, without offering ongoing advice. SEC Chair Mary Jo White has called settling the issue her “top priority,” but whether it actually moves forward is anyone’s guess.

If the uniform fiduciary standard becomes reality, Wall Street will be a different place than we know today—but not because it will automatically become more transparent and accountable. Rather, because the rule changes will force firms to adjust their business models so they can comply with the rule without hollowing out their core businesses.

Exhibit A: The UK, which enacted a similar regulatory overhaul when 2013 began. Known as the Retail Distribution Review (RDR), the new regime aimed to remove conflicts of interest in adviser compensation. Before the rule change, some advisers would advertise “free” advice, recommend funds with high fees, and then receive a trail commission from the fund—a system, said regulators, that incentivized advisers to recommend something that was better for them than the client. RDR aimed to prevent this and other similar conflicts by banning “free” advice and requiring advisers to disclose the cost of every service they provide and products they sell—in theory creating a much more transparent, investor-friendly system.

In reality, however, it has carried unintended consequences. RDR also introduced stricter educational requirements for advisers, which partly contributed to 3,700 advisers (10% of the UK total) leaving the industry before the law took effect. Compounding matters, several banks cut their financial advisory services, believing it would no longer be profitable. The new fee structure also prompted several investors to shun paid advice in favor of “execution only” services, which simply execute trades of securities and funds for clients without advising on whether the product is right for the client—similar, it seems, to the services brokers exempted from a uniform fiduciary standard in the US might provide.

Now the execution-only providers are in the UK regulators’ crosshairs. The Financial Conduct Authority (FCA) launched a general review to determine whether customers were getting the “right outcomes” from these firms. Then, over the weekend, came word the FCA is investigating how certain mutual funds come to be on execution-only firms’ (including mutual fund shops) lists of recommended funds. While these firms, in theory, can’t give investment advice, regulators believe the recommended fund lists constitute implicit advice, and they suspect some of these lists aren’t compiled on the up and up—once again causing investors to receive potentially inferior advice that happens to benefit the broker’s bottom line. Their findings are scheduled to be published this summer.

Our goal here isn’t to point fingers—rather, to point out that no rule change can make the financial services industry perfect. RDR was extremely well intentioned, as is the potential application of the uniform fiduciary standard, but rules only accomplish so much.

Rules matter, but values trump rules. For example, FINRA requires every broker licensed in the US to disclose any and all criminal charges, bankruptcy filings and similar “red flags.” A recent Wall Street Journal study found over 1,600 brokers have failed to do so. Laws don’t guarantee perfect behavior—Bernie Madoff in Finance. Vladimir Putin in international law.

Nor is a rule change necessary for the industry to change—transformation can come from within. For example, starting January 1, Barclays introduced a new adviser pay model that backs away from the traditional revenue-based system—now, their conduct impacts their take-home pay. Some advisers reportedly quit in response—their values didn’t match their firm’s. But many stayed, illustrating it’s entirely possible for advisers to continue making money while upholding ethical standards as long as their incentives are aligned accordingly.

If a meaningful uniform fiduciary standard becomes reality, the industry will change—that’s a given. Perhaps more firms move toward Barclays compensation standards, or perhaps they do something different. How the industry adapts will depend on the rules. But adaptation is the key word here. Don’t expect a sea change, where a simple rule change eliminates all would-be wrongdoers. (Even if they aren’t wrongdoers, one must question the resources and expertise of these advisers.) Some will, but others will likely adapt in other ways, exploiting loopholes and exemptions. No rule can ever exterminate all the rats in this industry, and regardless of how rules evolve, investors should employ a rigorous due-diligence process when selecting an adviser—discovering the adviser’s values and how they employ said values for the benefit of clients will remain essential.