SEC’s New ‘Best Interest’ Rule Is Far From Best for Investors

There is much to be said for the fiduciary standard of care for investors, meaning that those in the business of selling investment advice and services put the interests of their customers first. It makes perfect sense that the people who buy financial services want a level of care closer to what a lawyer provides than a used-car salesman.

There now are two different standards of care for investors. Registered investment advisors (RIAs), or buy-side asset managers, must meet the fiduciary standard mentioned above.

The other standard applies to brokers, or the sell side, and is known as suitability. It was created by the industry’s self-regulating organization, the Financial Industry Regulatory Authority, or Finra. We can go into a lot of detail about what the suitability standard actually is, but the real problem with it is that it doesn’t address broker conflicts.

The Securities and Exchange Commission (SEC) recently tackled this issue, and perhaps predictably came up with a set of rules that can only be described as a win for brokers. The new Regulation Best Interest proscribes some of the most offensive sales tactics of an industry replete with them. No more free trips to the Bahamas for brokers who sell lots of their firms’ garbage to investors. But the bad news is this new industry-dictated rule does too little to improve the quality of advice so many investors receive. It also doesn’t resolve who is an advisor and who is a salesperson.

But maybe we don’t give investors enough credit; they seem to be figuring out on their own that much of the investment industry in no way has their best interests in mind. This may be one reason so many people have been moving billions of dollars from expensive actively managed funds to low-cost passive funds. In other words, money is shifting from the sell side to the buy side.

Why is this happening now? Passive index investing has been around for almost five decades, but has become wildly popular in the past decade or so. Could it be that investors started making a connection between the accounting scandals of the late 1990s, the analyst scandals of the early 2000s, then the initial public offering spinning scandal, the mutual-fund timing scandals, the Bernie Madoff Ponzi scheme and, of course, the subprime scandal and the financial crisis?

It might be a stretch to say that any of these were caused by active stock picking. But then is the shift in money to passive strictly coincidental? My thesis is that the investors who dealt with fiduciaries suffered much less from these events and some of the investing public began to notice that.

If this theory is true, it might explain why the brokerage industry was so intent on pushing through these rule changes. I suspect this is all about marketing and image management for the brokerage side, and not about what level of care those who sell financial services owe to investors.