Eyes Wide Shut: Why the SEC Will Not and Cannot Adopt a Fiduciary Standard

Living is easy with eyes closed, misunderstanding all you see. – “Strawberry Fields Forever”

In recent appearances on Capitol Hill, SEC Chairman Jay Clayton and DOL Secretary Alexander Acosta pledged to work together on a fiduciary rule applying to stockbrokers and other financial advisers providing investment advice to the public. Both men are on record as saying any fiduciary rule must not curb the public’s access to advice or products. That’s all you need to know. Mr. Clayton and Mr. Acosta are clearly drinking the Kool-Aid supplied by the investment industry.

The investment industry has failed to provide any credible and court-admissible evidence that establishes their claims that the public would suffer access to advice. To date, the investment industry has produced nothing more than speculative and self-serving statements. And to be honest, they cannot produce any credible evidence until a meaningful fiduciary is implemented and experience either supports or disproves their theories. As far as access to products, the public’s best interests would be better served if many of the investment products currently available were completely removed, as they clearly are not in any investor’s best interests.

And yet, it appears that Chairman Clayton and the SEC have already made up their mind to oppose adopting any type of meaningful fiduciary standard, a standard that would simply require that stockbrokers and other financial advisers always put a customer’s best interests ahead of their own financial self-interests.  Adoption of a meaningful fiduciary standard by the SEC would simply be furthering the Commission’s vision and mission statements:

Vision Statement:  The SEC strives to promote a market environment that is worthy of the public’s trust and characterized by transparency and integrity.

Mission Statement: The mission of the SEC is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.

However, it can be argued that the failure of the Commission to adopt a meaningful fiduciary standard would be consistent with the SEC’s pattern of ignoring the needs and protection of the public. In 2o07 the Financial Planning Association won a lawsuit that it filed against the SEC to force them to enforce the registration provisions of the 1940 Investment Advisors Act against Merrill Lynch. In an attempt to resolve the dispute, the SEC had proposed the following disclosure in lieu of registration:

Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits and our salespersons’ compensation may vary by product and over time.

Once the court ruled against the SEC. the SEC withdrew the disclosure requirement. Despite subsequent calls for bringing back the disclosure to address current conflict of interest issues plaguing the investment industry, the SEC has not done so. One would think the SEC would re-institute the disclosure requirement to at least educate and warn the public, which would clearly be in furtherance of its mission statement.

Given the SEC’s dismal record in proposing protective measures for the public, one could argue that the SEC’s recent announcement is nothing more than posturing, nothing more than providing Congress with rhetoric to support its effort to stop the DOL rule. Some might consider that allegation harsh. However, a fair and realistic appraisal of the situation clearly leads to only one conclusion:

The SEC will not, and cannot, afford to create and adopt a meaningful universal fiduciary standard.

Before everyone grabs their torches and pitchforks, allow me to present the evidence supporting my position. As intimated earlier, my primary theory is that many of the investment products currently on the market would not pass a meaningful fiduciary standard. By “meaningful” fiduciary standard, I mean a fiduciary standard that is consistent with the standards set out in the Restatement (Third) Trusts (Restatement), especially Section 90, more commonly known as the Prudent Investor Rule.

I have recently written a couple of articles addressing the fiduciary duty of cost-consciousness, as set out in the Restatement. The current pricing platforms used by actively managed mutual funds and variable annuities raise legitimate questions as to whether such products would pass the Restatement’s prudence requirements. Quite simply, is the Commission willing to risk the wrath of Wall Street and the investment industry by honoring  its stated vision and mission statements and enact a meaningful fiduciary standard to protect the public and ensure fair and equitable treatment for all investors?

Actively Managed Mutual Funds
LPL, one of the nation’s largest independent broker-dealers announced twenty funds that will make up their new “fiduciary friendly” platform of mutual funds. LPL announced that the funds on the list may have “onloading” fees of up to 3.5 percent. Most have interpreted the referenced “onloading” fees as simply an attempt to avoid using the term “front-end” load.

Whatever you choose to call such front-end charges, the fact is that front-end fees are never “fiduciary friendly” since they automatically reduce an investor’s initial investment in a fund, placing them at a disadvantage and guaranteeing a reduced return on an equivalent return in a comparable fund that does not charge such front-end fees. When you also factor in the higher expense ratios and trading costs normally associated with actively managed funds, the result is usually a situation where the investor forever suffers significantly lower returns than a comparable passive, or index, fund.

Evidence of that fact can be seen by comparing the performance of American Funds’ Growth Fund of America (AGTHX)(American Funds was one of the fund families on LPL’s list) with a comparable index fund, in this case Vanguard’s Growth Index Fund (VIGRX). Both funds are classified as large cap growth funds by Morningstar.

According to the Morningstar Investment Research Center (MIR Center), as of July 14, 2017, AGTHX charged a front-end load of 5.75 percent, with an annual expense ratio of 66 basis points (1 basis point equals 1/100th of 1 percent) and an annual turnover rate of 31 percent. Since mutual funds are not required to disclose their actual trading costs, this paper will estimate a fund’s trading costs by using a metric created by John Bogle. The Bogle metric estimates a fund’s trading costs by doubling a fund’s stated turnover ratio, and then multiplying that number by 0.60. For example, the estimated trading costs of a fund with a turnover rate of 50 percent would be 60 basis points.

According to the MIR Center, VIGRX does not impose a front-end load, and has an annual expense ratio of 18 basis points and an annual turnover rate of 13 percent, or 13 basis points using the Bogle metric.

Assuming an initial investment of $10,000 and an annual return of 10 percent, and applying the annual expense ratio and trading costs for each fund, AGTHX would never break even with VIGRX. In fact, the additional return that AGTHX would have to achieve each of the first five years in order to just break even each year would be

Year 1 – 6.88%
Year 2 – 7.65%
Year 3 – 8.42%
Year 4 – 9.21%
Year 5 – 10.01%

The numbers produce two noticeable trends. First, even with less principal each year, AGTHX’s higher costs result in a lower comparable return each year. Second, the size of the deviation in returns, and thus the additional return needed to break even each year with the applicable benchmark, increases annually.

In deciding to recommend or select an actively managed mutual fund, the Restatement states that a fiduciary has a duty to be cost conscious. In establishing criteria for use in meeting this fiduciary duty, the Restatement sets out two important criteria, namely

[Fiduciaries], like other prudent investors, prefer (and, as fiduciaries, ordinarily have a duty to seek) the lowest level of risk and cost for a particular level of expected return – or, inversely, the highest level of return for a given level or risk and cost.(1)

[A] decision to [recommend or select actively managed mutual funds] involves judgments by [a fiduciary] that: a) gains from the course of action in question can reasonably be expected to compensate for its additional costs and risks;…(2)

The numbers shown above clearly indicate that the actively managed mutual fund has consistently underperformed a comparable index fund, raising clear questions of prudence. This under-performance should not be surprising, as the S&P Indices Versus Active (SPIVA) semi-annual reports have consistently reported that a large percentage of actively managed mutual funds fail to outperform their comparable benchmarks.

Other questions regarding AGTHX’s fiduciary prudence can revealed by evaluating the fund using the Active Management Value Ratio™ 3.0 (AMVR) metric. The AMVR evaluates the cost-efficiency of an actively managed mutual fund by comparing the fund’s incremental cost relative to the fund’s incremental return. The AMVR analyzes an actively managed mutual fund using four types of returns: nominal, load-adjusted, risk-adjusted and a return adjusted using Ross Miller’s Active Expense Ratio (AER) metric. The AER metric is becoming more significant in the forensic analysis of mutual funds, as it addresses the issue of “closet indexing.”

An AMVR analysis based on nominal returns was not done for AGTHX since nominal returns are of no significance with funds that levy a front-end load. In such cases , the fund’s load-adjusted return is the important return. That said, using data as of June 30, 2017 and VIGRX as the applicable benchmark, AGTHX failed to outperform VIGRX based on AGTHX’s load-adjusted, risk-adjusted and AER adjusted returns, resulting in a “cost-inefficient” designation for AGTHX.

Most AMVR analyses of various actively managed mutual funds that I have conducted have resulted in a “cost-inefficient” designation for a fund due to the fact that the fund either failed to outperform the relative benchmark, or the fund did outperform the relative benchmark, did produce a positive incremental return, but the incremental costs incurred in doing so were in excess of the incremental return, thereby resulting in a loss for an investor.

The fact that an increasing number of actively managed mutual funds are “hugging” their relative index or a comparable index fund is a fiduciary prudence issue that is gaining more attentions. Such “index huggers,” more commonly known as “closet index” funds, are generally cost-inefficient since their returns will generally track the returns of their relative, but their costs, in terms of both annual expense ratio and turnover trading costs, are usually significantly higher than those of comparable index funds. The issue of “closet indexing” is especially prevalent among large cap funds.

The failure of so many actively managed mutual funds to outperform their relative benchmarks and/or their failure to satisfy the cost-conscious fiduciary prudence standards established by the Restatement will create obvious legal issues under any meaningful fiduciary standard adopted by the SEC, or any other regulator.

Variable Annuities 
Another investment product that has created, and will continue to create, legal issues under the fiduciary duty of prudence is variable annuities (VAs). My articles on variable annuities are by far my most frequently read articles on both my blogs, “The Prudent Investment Fiduciary Rules,” and “CommonSense InvestSense.”

Should the SEC adopt a universal fiduciary standard, the primary issue that the they would have to face involving VAs is the clearly inequitable pricing platforms used by most (VA) issuers in assessing a VA’s annual fees. Even industry insiders have openly admitted that the pricing used by VA issuers is inequitable and needs to be changed.(3)

The pricing method drawing the most criticism is the VA’s use of inverse pricing in connection with the VA’s annual mortality and expense fee (M&E fee). A VA’s M&E fee is the cost assessed for the VA’s death benefit protection.

The problem with the M&E is that most VA issuers use a method known as “inverse pricing” to calculate the fee. “Inverse pricing” refers to the fact that the M&E fee is based on the accumulated value of the VA. Studies have shown that very few VA owners ever need to rely on the death benefit given the historical performance of the stock market.

So the fact that a VA owner will be paying a higher M&E fee exactly when the value of the VA is such that they cannot use the death benefit is what raises a primary fiduciary  issue with the product. Industry expert Moshe Milevsky conducted a landmark study of the VA industry’s pricing in connection with the death benefit.

Moshe Milevsky estimated that the inherent value of the annual M&E fee charged by variable annuities was only between 5-10 basis points (a basis point is 1/100 of 1 percent), depending on factors such as age and gender.(4)The fact that insurance companies were charging a median annual M&E fee of 115 basis led Milevsky to conclude that the M&E fee being charged was not actually related to the actual costs of providing such a benefit to variable annuity owners, and therefore,

if the M&E fee was only meant to cover true risk — the typical VA policyholder was being grossly overcharged for this so-called protection and peace of mind.(5)

Indeed, I still stand behind those results. Our basic position was that for many investors, a similar financial economic outcome could be achieved at a lower cost.(6)

The fiduciary issues created by such inequities in such a pricing differential involving the cost and inherent value of the VA’s death benefit are obvious. Even now, with the debate over the DOL’s new fiduciary standard, the M&E pricing issue has been recognized and sales have declined dramatically.

The VA M&E pricing issue involves more than just the cost-inherent value issue. Each additional 1 percent of investment fees and costs reduces an investor’s end return by approximately 17 percent over a twenty year period. Given the fact that a VA’s M&E fees are the largest part of a VA’s overall cost, usually in the range of 2.5-3 percent, investors can easily find themselves in a situation where the M&E fee alone will result in them losing 50 percent or more of their end returns. Toss in an additional 1 percent for the VA’s investment account fees and another 1 percent for a “living benefit” rider, five times 17 percent….That is why a popular saying in the VA industry is that “variable annuities are sold, not bought.” It would be extremely difficult for the SEC or any regulator to justify those conditions and results as being in the “best interest” of any investor under any meaningful fiduciary standard.

Conclusion
To revise a statement that I made earlier in this paper:

The SEC will not, and cannot, afford to create and adopt a meaningful universal fiduciary standard because far too many products currently on the market are not “fiduciary friendly.”

The evidence overwhelmingly shows that some of the investment industry’s most successful products will never pass scrutiny under a meaningful fiduciary standard, at least not without major revisions. Therefore, it is highly unlikely that the SEC will stand up and risk the ire of Wall Street and the investment industry by enacting a meaningful fiduciary standard that is consistent with the fiduciary standards set forth in the Restatement (Third) of Trusts. As the saying goes, “ wise owl does not poop in his own nest.”

The chances of the SEC adopting a meaningful fiduciary standard are even less when one considers the SEC’s recent track record in being proactive in protecting the investing public. Far too often the SEC’s attitude has been to protect the investment industry, while treating the investing public as the proverbial “red-headed stepchild.”

For all the stories I have read about the industry’s speculative and meritless allegations of  impending doom-and-gloom that any fiduciary standard will create, as well as the empty rhetoric from Secretary Acosta and Chairman Clayton that the fiduciary standard is a priority, I think about a quote that I have always used in my closing argument at trial. The quote, from the late General Norman Schwarzkopf, sums up my whole opinion about the debate over the fiduciary standard, and accurately states the challenge facing both Secretary Acosta and Chairman Clayton.

The truth of the matter is that you always know the right thing to do. The hard part is doing it.

Notes
1. Restatement (Third) Trusts, Section 90 cmt f
2. Restatement (Third) Trusts, Section 90 cmt h(2)
3. John D. Johns, “The Case for Change,” Financial Planning (September 2004), 158
4. Moshe Milevsky, “Confessions of a VA Critic,” Research Magazine, January 2007, 42-48
5. Milevsky
6. Milevsky

© 2017 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

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