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Regulation and Compliance > Federal Regulation > DOL

ETFs Will Be in DOL’s Crosshairs

By Melanie Waddell

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Exchange-traded funds will be among the products the Department of Labor zeroes in on to make sure they can pass fiduciary muster.

While ETFs aren’t likely “the primary [or] the most obvious place for the Department of Labor and regulators to scrutinize” under the new DOL fiduciary rule, “ETFs are an evolving financial innovation,” as the recent Morningstar ETF Conference in Chicago highlighted, Michael Wong, a senior equity analyst at Morningstar, told ThinkAdvisor.

“Actively managed ETFs, strategic beta ETFs and a proliferation of thematic ETFs mean that there’s potential for bad apples worth investigating,” Wong said.

Indeed, in a Thursday panel discussion Wong moderated about the DOL rule, Joe Craven, managing director at BlackRock, told attendees that compliance with DOL’s rule is akin to the second-most famous line from the blockbuster hit, “Jerry Maguire”—“You had me at hello.”

“As soon as you say hello, you’re a fiduciary,” Craven said.

Craven, who spoke on the panel with Gib Watson, vice chairman of Envestnet, said he’s spent “60% to 70%” of his time over the past 10 months pouring over the DOL fiduciary rule.

He warned registered investment advisors that just because they are already fiduciaries doesn’t mean there are “no worries” for them. IRA rollovers, he said, are now a fiduciary recommendation. “That’s the biggest difference for an RIA, and the litigation risk is going to be higher” regarding these recommendations.

Also, he said, RIAs need to be assessing the mutual fund share classes they offer to clients, as well as reassessing “their business model.”

Wong noted that DOL’s rule will also “ripple out” to other segments of the advisory community—to mutual fund providers, distributors like wealth management firms, insurance companies as well as individual investors. “Very large companies have made some pretty dramatic moves already” because of what DOL’s rule is going to do to their sector, he said.

In separate comments to ThinkAdvisor, Wong stressed while the rule’s Best Interest Contract Exemption “and related potential for litigation is the primary enforcement mechanism” of the fiduciary rule, “people shouldn’t forget about the Department of Labor and the IRS—they still have enforcement power, especially in regards to employer benefit plans, which should tie into advisors justifying IRA rollovers.”

DOL, Wong told ThinkAdvisor, “is likely to be looking more closely at illiquid, complex, hard-to-value and risky products that financial advisors use. This is why we believe that there’s going to be a shift in the products that financial advisors use, creating opportunities and threats to the financial product manufacturers.”

Wong, who was the lead author of the report, “Final Department of Labor Fiduciary Rule’s Effects Are Substantial,” released in June, noted that DOL would be releasing another DOL fiduciary study soon.

Watson stated the compliance issues that he sees cropping up under DOL’s fiduciary rule. For independent broker-dealers, “they tend to have a fairly large number of non-specialist advisors who don’t specialize in 401(k) plans [that are] generalists advising wealth management clients who also have retirement plan assets. Along the way they may have picked up a few 401(k) plans where they’ve been asked for advice on a company’s 401(k) plan.”

Now, under DOL’s rule, “those arrangements are going to need to be protected under the BICE. In the short term, you’ll see usage of the BICE with those smaller plans on those more commission-based types of product sales by advisors,” Watson said. “Longer term [there will be] a move to convert that business to fee-based advisory business, or there will be a requirement from the indie BD that those accounts need to be outsourced to an independent 321 fiduciary advisor.”

Craven pointed to the rule’s little noticed “BIC light” provision, a less stringent version of the BICE that says as long as the advisor isn’t receiving any outside revenue for sources such as sub-transfer agency fees, “there’s no contract needed and the litigation risk isn’t as high.”

With DOL now regulating broker-dealers, BDs’ “shelf space arrangements are going to come under much more scrutiny,” Craven added. “I would closely examine those payment relationships in paying for the shelf space.”

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