Congress is wrestling with the idea of creating a uniform fiduciary standard for all investment advisers. This would either force stockbrokers (registered reps of brokerage firms) to adhere to the same fiduciary standard that fee-only advisers must follow, or lower the standard for fee-only advisers and raise it somewhat for brokers so there is a meeting in the middle. Will any change fix the problems in the adviser industry? I have doubts.
Even if brokers were required to be fiduciaries at the current standard, there is a difference between following a legal fiduciary standard and upholding a personal stewardship standard. Good stewardship doesn’t come from laws; it comes from strong moral character. It is a self-imposed higher level of care that embodies a passion and discipline to protect and promote the long-term well-being of others. Figure 1 illustrates.
Figure 1: Stewardship is a higher order of fiduciary care
Source: Rick Ferri, from materials by Don Trone, CEO of 3thos: The Leadership Center for Investment Stewards
Stockbrokers are regulated by FINRA and currently follow the suitability rule. This rule states that brokerage firms and those who work there “must have a reasonable basis to believe” that a transaction or investment strategy involving securities is suitable for the customer to whom it is being recommended. This belief must be supported by a reasonable effort to “know your customer.”
In short, suitability means every recommendation should fit a customer’s investment profile. For example, it’s probably suitable to recommend intermediate-term Treasury bonds to an 80-year-old customer who has limited investment experience. It’s probably not suitable to recommend that this person speculate in naked out-of-the-money stock options.
Once suitability is established, there isn’t much under the suitability rule that restricts a stockbroker from recommending investments with high fees. An intermediate-term Treasury bond mutual fund that has a 5% up-front sales charge and 1.2% annual expense ratio is fair game for trading even though a newly issued 5-year Treasury bond bought at a Treasury auction would be far less costly to the customer.
Registered investment advisers (RIAs) fall under a stricter fiduciary standard. They are regulated by the state they do business in or by the Securities and Exchange Commission (SEC). Some RIAs are dually registered as stockbrokers, in which case they follow either the suitability rule or a fiduciary standard, depending on the product or service being recommended to a client.
According to Don Trone, Scott Simon and other industry experts, a fiduciary puts their client’s best interests first. They act with the prudence, skill, care, diligence and good judgment of a professional; provide conspicuous, full and fair disclosure of all important facts; avoid conflicts of interest; and fully disclose and fairly manage, in the client’s favor, unavoidable conflicts.
Do RIAs adhere to this fiduciary standard? That’s debatable. From what I’ve seen in my 25 years in the business, I’ve come to the conclusion that most RIAs operate at a legal fiduciary standard, but not much higher. RIAs are required to avoid conflicts of interest but not eliminate them.
It’s up to each adviser to determine what a conflict of interest is and what facts need to be disclosed to clients, and that’s when things get complicated. The number of times I have seen fiduciaries barely scrape the legal limit is profound. Here are a few examples:
An RIA charges 1.0% to manage a client’s $1 million portfolio in passive low-cost index funds. This fee is for basic asset allocation advice and ongoing portfolio management services. The adviser knows of several competing RIA firms that provide the same quality service for a substantially lower fee. Does the adviser have a fiduciary obligation to disclose this fact to his or her clients?
Another adviser follows an actively managed mutual fund strategy that they believe will beat a comparable portfolio of low-cost index funds. Unfortunately, their track record reflects performance well below index fund returns. Does the adviser have a fiduciary obligation to disclose the failure of their strategy to clients?
Financial fiduciaries other than RIAs have issues also:
- Bank trust officers put their clients in underperforming co-mingled funds managed by the bank’s investment subsidiary.
- Trustees of public pension funds routinely change performance benchmarks to muddle the subpar returns in the funds they oversee.
- In the 401k industry, plan sponsors may demonstrate full compliance with ERISA and DOL requirements and still not produce appropriate outcomes for participants.
A fiduciary is required to act with prudence, skill, care, diligence and good judgment, and they are required to provide full and fair disclosure of all important facts. Ask any RIA or trustee if he or she adheres to a fiduciary standard and they will answer, “Of course. It goes without question.” Yet, when asked about the apparent conflicts of interest stated above, some become annoyed and close-lipped. Click the following link to read a pointed conversation I had with an adviser in 2010, Look at Me, I Beat the S&P!
Here’s the rub. There are two levels of fiduciary care. One is a legal standard and the other is a stewardship standard.
A legal standard exists in the RIA industry and may soon exist in the brokerage industry. A legal fiduciary will act in the client’s best interest provided these actions are also in the interest of the adviser.
The stewardship standard is a higher personal order. This level requires individuality and leadership. It originates from within rather than legislated by law.
Table 1: Governance of adviser standards
Source: Don Trone, How a Uniform Standard Might Institutionalize Mediocrity
According to Mr. Trone, stewardship is a fiduciary of higher order driven by principles, not profit. He calls it the passion and discipline to protect and promote the long-term well-being of others. I think of it as a family fiduciary standard – it’s the caring advice you would give to a close relative.
Congress may require all advisers to follow a legal fiduciary standard, but laws only go so far. It takes a leader and free-thinker to become a good investment steward. I applaud Don Trone’s work and hope the passion and discipline to protect and promote the long-term well-being of others spreads within the investment industry.