At year’s end, the media (including AdvisorOne.com, admittedly) is full of predictions about the future. For many advisors, the future begins in January, when under the mandates of the Dodd-Frank reform bill the SEC will be releasing the results of several studies—and instituting several rule-makings—that are likely to affect all advisors.
Holding primacy among those studies is one on whether the SEC should impose a single fiduciary standard on all advice givers. That’s why I was intrigued by the e-mail I received on Wednesday from Harold Evensky, of Evensky & Katz, and the Committee for the Fiduciary Standard, referencing an SEC comment letter from fellow Committee member Ron Rhoades.
Allow me to present below Harold’s note to me (and others) and his redaction of Ron’s letter to the SEC, sent Dec. 20. You can read the complete comment letter here. —Jamie Green
From Harold Evensky:
Along with many others, I await (fingers and toes crossed) for the SEC fiduciary study to be completed and to incorporate a recommendation that anyone providing investment advice be held to the standard incorporated in the Investment Advisers Act of 1940.
Unfortunately, gossip on the street suggests that result is unlikely. Ron Rhoades of Joseph Capital, a friend, respected commentator on regulatory issues and a member of our Committee for the Fiduciary Standard, recently forwarded to the SEC an extensive personal commentary.
While I believe a careful reading of his full submission is more than worthwhile, I recognize that your time is limited, so I’ve extracted a small, yet comprehensive section that I believe is worth your carving out a few minutes to read today. Ron calls this section the The Consequences of the SEC’s Actions: 2012-2025 and Great Depression II. It describes the market environment in 2025 if the SEC fails to seriously address the fiduciary issue today.—Harold Evensky
From Ron Rhoades:.
Imagine that it is now 2025, and over two decades have passed since the U.S. Securities and Exchange Commission (SEC) adopted a “new federal fiduciary standard” for the delivery of investment advice to retail consumers. Today hundreds of millions of individual Americans, and America itself, suffer from the consequences of the Commission’s action.
Over the decades, a string of failures by Congress, the SEC, and the NASD/FINRA failed to raise the provision of investment advice to the level of a true profession, bound together by the requirement of an appropriate strong fiduciary standard of conduct. Instead, investors remained in largely arms-length relationships with their “financial advisors.”
All the while massive marketing campaigns by Wall Street firms touted “objective advice” from “financial consultants” who attended their client’s soccer games and made so many believe that the “advice” received would result in the ability to afford that second home on the beach. All this occurred as the Commission, FINRA and other securities regulators ignored the fundamental truth that “to provide biased advice, with the aura of advice in the customer’s best interest, is fraud.”
Following is an abbreviated history of the endeavors to apply a fiduciary principle to the provision of investment advice, illustrating the many actions taken by the Commission and FINRA (formerly NASD). Before addressing such history, however, I visit the “present circumstances” (imagining that it is now 2025), in which I explore how these actions resulted in the current lack of trust in the securities markets, leading to inadequate capital formation, stagnant U.S. economic growth, and the resulting increased hardships suffered by all Americans.
The Consequences of the SEC’s Actions: 2012-2025 and Great Depression II
The Commission should have known that, rather than fulfilling its mission to “protect investors” and to “facilitate capital formation,” the results of its rule-making efforts in 2011-2012 (in which the fiduciary standard was redefined as a much lower standard of conduct) would bring about the exact opposite result. Rather than enhancing the regulation of the . . .
market participants—who had largely effected the stock market crash of 2008-9 through the formulation and sale of “sh**ty” products to individual and institutional investors—the SEC instead chose to de-regulate, by lowering the standards of conduct expected of those who provide investment advice to dual registrants.
The SEC continued to permit dual registrants to “switch hats” back and forth, preparing financial plans and investment portfolio strategies for retail investors, and thereafter switching back to a product sales role in which only casual disclosure was required of the existence of a conflict of interest. The SEC failed to require that the many hidden fees and costs of pooled investment vehicles were at least estimated and affirmatively disclosed to the client. Industry compensation practices between financial intermediaries, adverse to the interests of individual investors, such as 12b-1 fees, payment for shelf space and payment for order flow continued. While rules existed to prohibit directed brokerage, any reasonable statistical analysis would have concluded that this conflicted practice persisted between mutual fund complexes and the brokerage firms which promoted the funds of those complexes.
Customers of both broker-dealer and investment advisor firms, believing they were receiving objective advice, instead received advice which was in the best interests of the brokerage or investment advisory firm. The term “best interest” came to be utilized far too loosely. In essence, clients of “fiduciaries” who said they “operated in the best interests of our customers” were sold “sh***y products”—often products with large fees, costs and tax inefficiencies—creating a huge drag on the returns of individual investors.
A small number of fee-only investment advisors remained out there, committed to avoiding—not just disclosing—conflicts of interest. But by eschewing the multiple revenue sources enjoyed by those adhering to the lower “new federal fiduciary standard,” these fee-only advisors remained a substantial minority. It was just too lucrative, and too attractive to new entrants into the securities industry, to become an advisor subject only to the much lower casual disclosure-based “harmonized” standard of conduct.
Broker-dealer and investment advisor firms operating under the new “federal fiduciary standard” often consumed 30% or more of the gross returns investors could expect from the capital markets. The financial services industry, as a proportion of the overall U.S. economy, grew to unforeseen levels.
Time passed, and slowly clients realized the harm to which they were subjected. Media articles continued to appear noting the many conflicts of interests which were not avoided, and which infected the supposed “fiduciary relationship” between adviser and client.
Clients, already confused as to what obligations were owed to them by their “financial consultants,” slowly began to realize that they could not trust any financial advisor. Yes, there were fee-only advisors out there, but the reasonable compensation these fee-only advisors received was insufficient to counter the large marketing budgets of the broker-dealer firms; hence, while fee-only advisors somewhat thrived within their small population, the movement never grew large enough, in the face of the economic incentives offered by regulators to those able to enjoy a lower standard of conduct, and to counter the large advertising budgets of the majority of the firms working in the conflict-ridden brokerage and advisory world. The use of common titles, and the high fees received by those operating under a conflict-ridden standard of conduct, resulted in the inability by higher-quality advisors receiving lower level compensation arrangements to distinguish themselves.
As a result, clients’ trust was betrayed. The life savings they entrusted to their “fiduciary” advisor failed to earn returns even close to the market indices. Even worse, as the SEC de-emphasized the requirement of due diligence under the duty of care of a fiduciary, many new “sh**ty” investment products were developed and subsequently “blew up” – destroying the life savings of many individuals. Clients rightfully regarded the actions of their “advisors” as fraudulent. Clients of the new type of “fiduciary” advisor had their trust betrayed.
As the media continued to report on these travesties, investors largely abandoned the use of financial advisors altogether. Yet lacking the skills to navigate the intricacies of the capital markets themselves, and subject to behavioral biases which were not countered with the aid of a knowledgeable and trusted advisor, investors fled the capital markets following the inevitable price declines in the equities markets, returning only well after prices had recovered nearly fully – thereby losing out on much of the long-term returns of the capital markets. And, unable to discern all of the fees and costs of the investment products existing, or the risks to which they were exposed, many investors paid dearly.
As scandal upon new scandal was exposed by the media, many individual investors fled the capital markets altogether, for all time. Not knowing who to trust, they chose to not . . .