Why the SEC Will Never Enact a Meaningful Fiduciary Standard

I continue to enjoy reading analyses on the SEC’s BI proposal. These are analyses from industry leaders, people who I greatly admire and respect. When people ask my opinion, I just tell them it  is all just a cruel game, that the SEC has never intended to protect the public with a meaningful universal fiduciary standard, that the SEC will never do so, as it would jeopardize their own careers and risk incurring the wrath of Wall Street. Don’t believe me?

  1. In the Tibble decision, SCOTUS recognized the Restatement (Third) Trusts (Restatement) as the go-to resource for the legal system in addressing fiduciary issues, especially those involving ERISA
  2. Restatement Section 90, cmt. b, states that fiduciaries have a duty to be cost-conscious.
  3. Restatement Section 90, cmt. f, states that fiduciaries have a duty to seek the investment with the highest return for a given level of cost and risk or, conversely, the lowest level of cost and risk for a given level of return.
  4. Restatement Section 90, cmt. h(2), states that it is imprudent for fiduciaries to use or recommend actively managed mutual fund unless the reasonably expected return from such fund will cover the extra costs and risks typically associated with such funds.

The last item is the key, as most actively managed funds simply are not cost-efficient if analyzed properly. If the potential closet indexing factor is considered by analyzing a fund’s incremental costs in terms of Ross Miller’s Active Expense Metric, the number of cost-efficient actively managed funds drops to well below under 10 percent.

The incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees of a comparable index fund relative to its returns. When you do this, you’ll quickly see that the incremental fees for active management are really, really high-on average, over 100% of incremental returns.1

Increasing numbers of clients will realize that in toe-to-toe competition versus near-equal competitors, most active managers will not and cannot recover the costs and fees they charge.”2

“there is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.3

Want more evidence? Each year “Pensions & Investments” publishes a list of the top mutual funds within U.S. defined contribution plans, based on total amounts invested such plans. Each quarter I update the top ten non-index funds from said list. My scoring is based on the funds’ risk-adjusted returns (the same returns used by Morningstar in calculating their “star” system, the same “star” system funds and advisers use in their marketing programs) and each fund’s Active Expense Rating, in order to penalize funds with high closet indexing scores. The 3Q results are available at Slideshare.

Variable annuities are definitely neither cost-efficient nor prudent. Milevsky’s famous study put that argument to rest forever.

The SEC is never going pass a meaningful fiduciary standard to protect the public, no matter how badly such a measure is needed. I wish they would prove me wrong, but I am not holding my breath. They have to protect their own best interests, the revolving door to Wall Street and the big paydays. To do that, “the wise owl does not (poop) in its own nest.”

Notes
1. Ellis, Charles D., “The End of Active Investing,” Financial Times, January 20, 2017
https://www.ft.com/content/6b2d5490-d9bb-11e6-944b-e7eb37a6aa8e.
2. Ellis, Charles D., “Winning the Loser’s Game: Timeless Strategies for Successful Investing,” 6th Ed., (New York, NY, 2018, 10.
3. Meyer-Brauns, Philipp, “Mutual Fund Performance Through a Five-Factor Lens,” Dimensional Funds Advisers, L.P., August 2016.

Copyright © 2018 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice as 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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