Why Using Passives to Fulfill Best Interest Mightn't Work
Guided in part by an abundance of caution against potential litigation, many advisors are shifting to lower-cost investment products to help prove they have the best interest of their clients in mind. But some advisors say that instead of giving in to the “cheaper is better” mentality, they should be educating investors about the merits of an investment product and why one may be more expensive than another.
Index equity mutual funds, which are relatively cheaper than actively managed equity funds, are expected to gain the most in terms of inflows in the aftermath of the implementation of the Department of Labor’s fiduciary rule. Around 26% of 281 of the Financial Times’ Top 401 Retirement Advisors surveyed from June to August last year by FA-IQ sister publication Ignites Research say they will increase their usage of these products because of the fiduciary rule. ETFs also stand to benefit, with 17% of the advisors planning to increase allocations to these products.
The fiduciary rule, which was partially implemented on June 9, requires that retirement financial advisors put their clients’ best interests before their own. The rule is scheduled for full implementation on Jan. 1, 2018, but is currently under review. Whether the DOL rule remains in its current form or not, advisors generally accept that investors have come to expect their advisors to act as fiduciaries.
“Costs are important to investors. They should be among the things considered when evaluating portfolios. However, cheapest is not always best,” says Gregory Miller, a Hartford, Conn.-based portfolio manager at RIA firm Bradley, Foster & Sargent, with $3.2 billion in client assets.
He acknowledges the proliferation of low-cost investment vehicles designed to meet various client needs challenges advisors to explain why a higher-cost option is being used.
“Advisors with a clear justification for using higher cost funds should have no difficulty explaining their rationale to clients,” he says.
He says most consumers make decisions about value and cost every day. “The general principle is easy to understand but when applied to investing, the calculation often gets complicated. Advisors should have a cogent explanation of their strategies and the components they use to implement them,” he says.
On the other hand, “advisors who do not have a clear justification that can be easily measured for the higher-cost product might do better by their clients if they opt for the low-cost alternatives,” he adds.
He suggests a set of “critical” questions when assessing the value achieved by using a higher-cost product: Does it have a superior information ratio or returns above the benchmark? Does it generate a higher level of income the client needs? Is it more tax-efficient? Does its pattern of returns offer diversification benefits?
David Geibel, King of Prussia, Pa.-based managing director at Girard Partners, an RIA with around $900 million in client assets and part of Univest Wealth Management, adds more questions to assessing the value of a product: Does the intended goal of the product match that of the client? Has the product delivered consistent results? How much risk does the product carry, and how does this fit in combination with other investments?
“If you are a fee-only fiduciary advisor recommending a managed portfolio that correlates to the client’s risk tolerance and time horizon, you have nothing to fear,” he says. “If you are an advisor who wants to broker a transaction, such as the sale of an annuity which pays you a hefty commission, and have not changed your practice under the new guidelines, a regulatory sanction and/or litigation will most likely be part of your future.”
Paul Miller, Burlington, Mass.-based portfolio management director at broker-dealer Axial Financial with around $1.4 billion in client assets, says higher-cost products “make a lot of sense” when a specific investment characteristic is needed to meet an investor’s goals. These include products with rising dividends, products that produce regular income or products with a more flexible asset allocation that can potentially outperform a benchmark better than a static cap-weighted index product.
“Price should not be an issue when you are looking for a different kind of investment experience,” he says.
He says around half of Axial Financial’s client assets are invested in active funds and around half in passive funds. He adds that around 90% of the firm’s client assets are in fee-based accounts. Most of the mutual funds it uses are in institutional shares and it typically uses a “pretty hefty blend of low-cost ETFs” mixed with actively managed strategies.
Net-after-fees performance is of major concern for Axial Financial’s clients, so product selection is key, he says. “We have to know what product to use that will not have an internal expense that will put a drag on the net-after-fees performance.”
He says the firm has stopped using certain types of products – such as non-traded real estate investment trusts – for retirement accounts such as IRAs, “simply because the pricing is not uniform between providers.” He notes that this kind of pricing discrepancy across the same asset class is among the things the DOL wants to address via the fiduciary rule.
But Axial Financial still uses REITs for its non-retirement clients because it believes they are a “good diversifier” due to their “low correlation” to stocks and bonds, he adds.
“We disclose to our non-retirement clients that real estate investment trusts are less liquid than other products, and are more expensive. But they are comfortable with that,” he says. “Until providers come up with a uniform fee-based model, we’re not using them in IRAs.”
Bradley, Foster & Sargent’s Miller says for both the purposes of fulfilling fiduciary responsibility and for optimal portfolio management, both advisors and investors must be mindful of balancing the value they expect to get from any investment with the cost of that investment.
One solution is a properly crafted investment policy statement. The statement should address the question of product costs, whether higher-cost products may be used, and criteria to be used by advisors when making product selections, he says.
John Frownfelter IV, the Oaks, Pa.-based managing director for investment solutions at SEI Investments, also believes in the power of documentation.
“It all comes down to documenting their process. How did they conclude that the recommendations they gave their clients were appropriate? They can fall back on that research if litigation were to ensue,” he says.
Girard Partners’ Geibel says advisors should share with their clients their own research on a particular product – for example, an emerging market mutual fund versus an emerging market index fund. Using that example, he notes that there can be "inherent flaws" with an emerging markets index because often these indexes own a high percentage of state-owned companies. Thus, he says, investing in an emerging markets index fund carries a risk that may not be worth the cheaper expense ratio.
“If your research is sound and you are recommending an investment vehicle that outperforms the cheaper option historically, and does so with better risk statistics, then the higher cost is justified,” he says. “Sharing those findings with the client will go a long way in supporting not only the choice but the relationship."