Advisors to President-elect Donald Trump have been vocal about rescinding the Department of Labor’s new fiduciary rule, introduced earlier this year to protect retirement savers from advice that isn’t fully in their best interests. The rule has already been under fire from the securities industry, and lack of presidential support could spell its ultimate demise.
As someone who has worked on both the fiduciary and non-fiduciary sides of the industry, I think revoking the rule is a bad, even dangerous, move. My rationale for such a position starts with my experience, early in my career, at one of the nation’s largest insurance companies.
“Look, you can set up your business any way you see fit after you’re successful. But right now? With a young family? You need to put yourself and your family first, and that means selling A-share mutual funds,” said my sales manager.
In other words, you must put your interests ahead of your clients’.
As a brand new financial advisor, I was having a heart-to-heart with my supervisor after laying out my plan for creating a fee-based business within the agency, which would have meant recurring revenue for the firm but apparently in much smaller increments than were preferable.
“A-share mutual funds” are a variety with some of the largest up-front commissions—for both the salesperson and the company they represent. Variable annuities were even better, often generating more of a “front-end load.” Whole life insurance was the pinnacle of up-front commissions.
In the newbie bullpen, we were encouraged to sell in various and sundry ways. The general agent in charge of the Baltimore metro area—the self-proclaimed “big dog”—was, indeed, a large man. A former starting lineman for a recognizable college football team, I’m quite sure that he routinely watched the classic Alec Baldwin “motivational speech” from Glengarry Glen Ross (turn the speakers down if you’re at work or children are nearby).
My favorite anecdote from that time, though, was my general agent’s big fish story: “When you get a big fish on the hook, I want you to set a noon lunch meeting at the Oregon Grille.” (The Oregon Grille is an excellent restaurant north of Baltimore in pastoral horse country, where most of us had never dined.) “Go to the restaurant 30 minutes early and introduce yourself to the maître d’. Let him know that you’ll be returning shortly to the restaurant with a guest, and that you’d like to be referred to by name.”
“Then, ask who your server will be at lunch,” he would continue. “Introduce yourself to that person to ensure they know your name as well—and tell them what your drink will be so you can simply order ‘the regular.’”
New recruits to the agency were encouraged to buy a new car with a payment high enough to help maintain our motivation to produce when the going got rough, to get a membership at a local country club and to offer our inexperienced counsel to any local non-profit boards who would have us.
I ended up at this insurance company after getting turned down to join the ranks as an advisor at the biggest brokerage firm in town. I thought I had paid my dues, working in their back office and then as a listed equity trader. By 2002, I had four years of industry experience and all of my requisite securities licenses—but I didn’t have any sales experience (or a natural affinity for it by birth). “You’d be better off with experience as a copier salesman,” I was told on my way out the door, shaking my head in confusion.
It was all about the sale.
Years later, at the end of my time with the insurance company, I called my wife, holding back tears of frustration. I’d been sent to a conference—not a financial conference, but a sales conference.
“I don’t think the job that I’ve been searching for actually exists,” I said. “I’m not sure I can do this anymore.”
I spent the first eight years of my now 18-year career in the financial services industry with proprietary (and independent) brokerage firms, insurance companies and banks. In each case, I experienced significant pressure to sell products that were not necessarily in the best interest of my clients. While I gained invaluable life and occupational experience in each of those roles—and met many genuinely great people I still count as friends—I failed as a salesman before finding the true financial advisory profession.
The first signs of light came when I began taking classes to earn my CFP®—Certified Financial Planner™—designation. Here I was exposed to professional advisors (not professional salesmen) and an academic approach to comprehensive financial planning. I learned of the FPA (Financial Planning Association) and eventually NAPFA (National Association of Personal Financial Advisors), both of which expanded my horizons. What’s more, the latter was filled with advisors who’d pledged to take no commissions for the sale of products and to always act in the best interest of their clients, as fiduciaries.
This word—fiduciary—began to take on new meaning for me. In it, I found an ideal much closer to the professional daydream that so far had driven my career pursuits. Like the medical, legal and accounting professions, these fiduciaries begin practicing their craft at a simple starting point—with a pledge to put their clients’ interests ahead of their own.
Eureka! There were actually real financial advisors out there.
But the majority of the financial services industry—brokerage firms, banks and insurance companies—have resisted increasing the duty of care they owe to their clients, clinging to a lesser “suitability” standard or, in some cases, caveat emptor (buyer beware).
Even following the financial crisis of 2008, largely seen as linked to proprietary conflicts of interest, the majority of the industry held fast. So finally, the Department of Labor stepped in, announcing in April 2016 that it would require anyone advising retirement accounts—like 401(k)s and IRAs—to be held to a new fiduciary requirement.
It’s not a perfect rule, and right now it will only cover retirement-specific accounts, but it represents a major leap forward. However, post-election, it is being mentioned as a candidate for revocation. What could anyone have against a rule that requires financial advisors to act in the best interest of their clients? Only two arguments even deserve mention:
1) That it is a governmental overreach and unnecessary regulation that will only slow economic growth. My default response is skepticism when it comes to new regulation, but the financial services industry has failed to self-regulate in this regard—as the medical, legal and accounting professions have—requiring an outside force to step in.
2) The second reason is barely defensible enough to mention, except that it keeps getting play. The majority industry claims that it is “the little guy,” the proverbial “small investor,” who will lose access to financial advice because the rule will presumably increase costs for financial firms, no longer allowing them to serve smaller clients. The we-have-to-laugh-to-keep-from-crying irony is that most of these firms have already turned their backs on small investors, having discontinued paying their advisors commissions on accounts less than $250,000, a sum well above the average baby boomer’s retirement savings!
Any argument suggesting that smaller investors are better served by advisors who don’t have to act in their best interest is simply logic twisted to serve self-interest. And there is no shortage of fiduciary financial firms able to serve the small investor market that supposedly will be forced to exit big brokerage firms.
What is the real motivation behind the anti-fiduciary movement? I suspect that all you have to do is follow the dollars. It’s estimated that wire houses and independent broker-dealers will lose $11 billion in revenue to the new rule by 2020.
Before you discount me as a blinded romantic painting a black-and-while picture of angelic fiduciaries and Faustian salespeople, let me assure you that there are, without question, “fiduciaries” who are not—and salespeople who are.
There are indeed a lot of good people in the securities industry, but its institutionalized system of incentives to “sell” is still in need of fixing. I implore President-elect Donald Trump, whose rise to popularity was fueled in part by anti-establishment sentiment, and Speaker Paul Ryan to allow the Department of Labor’s new fiduciary rule to be the first step in that repair.
Let’s begin with a simple, sensible premise, one that I believe will actually free many financial advisors from conflicted compensation regimes and help many more of their clients: Advisors must act in the best interests of their clients.
This commentary originally appeared December 3 on Forbes.com
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© 2016, The BAM ALLIANCE
One of the risks investors should consider is how their human (or labor) capital correlates with equity risks. Given the risk of correlation, it is logical to conclude that human capital could have explanatory power when it comes to stock returns.
Sean Campbell, Stefanos Delikouras, Danling Jiang and George Korniotis contribute to the literature on this subject through their study, “The Human Capital That Matters: Expected Returns and High-Income Households,” which appears in the September 2016 issue of The Review of Financial Studies.
The authors proposed a new human capital asset pricing model (HCAPM) that separates the income risk of households at the top and bottom of the income distribution. They decided to decompose aggregate income into high and low income for two reasons.
First, human capital is not tradable and financial markets are incomplete. Second, aggregate wealth is primarily held by households concentrated at the top of the income distribution—households in the top 10% of the income distribution hold about 72% of risky assets.
Results
The authors’ data set covered the period 1933 through 2011. Following is a summary of their findings:
Hedging High-Income Risk
Using firm-level wage and profitability data from Compustat, the authors found that their high-income factor co-varies more with the per-employee wage growth of value firms than with the wage growth of growth firms, rendering value stocks a poor hedge for high-income risk.
The authors determined their findings “suggest that high-income investors may be disproportionately employed by value firms. Given that the average U.S. household cares about income hedging, it is possible that high-income investors may avoid investing in value firms.”
Thus, the authors concluded that their “findings suggest that the income risk of high-income investors is a unique source of macroeconomic risk that is not captured by the alternative factors.” Their conclusion is consistent with the conjecture made by Eugene Fama and Kenneth French in their paper “Multifactor Explanations of Asset Pricing Anomalies,” which appeared in the March 1996 issue of The Journal of Finance.
Fama and French attributed the value premium to investors whose human capital was correlated with value returns. Those investors shun value stocks, generating a premium for the lucky investors whose outside income is not so exposed, and who then buy value stocks.
It’s interesting to note that Campbell, Delikouras, Jiang and Korniotis’ findings are consistent with the findings of the study “Do Dividend Clienteles Exist? Evidence on Dividend Preferences of Retail Investors,” which appears in the June 2006 issue of The Journal of Finance. The authors, John Graham and Alok Kumar, found that the portfolio exposure of retail investors to the HML (high minus low) factor varies with income level.
For example, the exposure of low-income investors to the HML factor is twice that of the exposure of high-income investors (0.25 versus 0.12). Thus, the tilt of high-income investors away from value stocks may contribute to the value premium.
While the authors suggested high-income investors may be disproportionately employed by value firms, another explanation might be that these high-income investors own companies whose earnings co-vary with the earnings of value firms.
Conclusion
In summary, Campbell, Delikouras, Jiang and Korniotis demonstrate that high-income risk is priced in the cross section of expected returns, both at the portfolio and at the individual stock levels. In contrast, they found that the low-income factor is irrelevant for asset pricing.
It’s worth noting that the high-income risk they employed in the study also been used to try to explain what is called the “equity risk premium puzzle.” The equity risk premium has been so great that it implies an implausibly high level of investor risk aversion that is fundamentally incompatible with other branches of economics, particularly macroeconomics and financial economics.
One explanation for the puzzle is that a large percentage, if not the vast majority, of equities are owned by high net worth individuals. As net worth increases, the marginal utility of wealth decreases. While more wealth is always better than less, when individuals attain a level of wealth at which there is no longer a need to assume risk, only a very large risk premium might induce them to take it.
This commentary originally appeared December 2 on ETF.com
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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE
In a recent article, I discussed the findings from a study by Brad Barber, Xing Huang and Terrance Odean, “Which Factors Matter to Investors? Evidence from Mutual Fund Flows,” which appeared in the October 2016 issue of The Review of Financial Studies.
In their paper, the authors investigated whether investors tend to consider common equity factors when assessing mutual fund managers. In other words, do investors attempting to identify a skilled active manager strip out the returns that can be traced to a mutual fund’s exposure to the investment factors known to explain cross-sectional equity returns?
In a perfectly rational world, fund flows should only respond to alpha, and not what is simply beta (loading on, or exposure to, a factor). They found, however, that the single-factor capital asset pricing model (CAPM), with market beta as its sole explanatory factor, did the best job of predicting fund-flow relations.
Market Risk Correlation To Fund Flows
This result implies that investors primarily tend to consider mutual funds’ market risk when evaluating performance, and that it is positively correlated with fund flows. The authors found that while investors do not completely ignore other factors that affect fund performance, they place less emphasis on the size and value factors than they do on market risk. In addition, they found no evidence that investors pay attention to the momentum factor.
Interestingly, Barber, Huang and Odean also found that investors who buy mutual funds from the broker-sold channel respond more to factor-related returns than investors buying in the direct-sold channel. This means that investors in the former channel are likely attributing returns to fund managers’ skill rather than to the factors that are responsible for the returns. The results are consistent with the notion that investors in the broker-sold channel are less sophisticated in their assessment of fund performance than investors in the direct-sold channel.
Furthermore, the authors found that investors buying in the direct-sold channel, as well as wealthier investors (more sophisticated investors), use more sophisticated models to assess fund managers’ skill, taking into account a fund’s exposure to factors (such as size and value) rather than attributing the excess returns to manager skill.
‘Unaware Of Other Factors That Drive Returns’
Barber, Huang and Odean concluded: “Our empirical analysis has revealed that investors behave as if they are concerned about market risk, but are largely unaware of other factors that drive equity returns. We have found some evidence that investors attend to the value, size, and industry tilts of a fund when assessing managerial skill, but these effects are much weaker than those we observed for a fund’s beta. Moreover, we have found that investors strongly respond to the factor-related return associated with a fund’s Morningstar-style category. Since the category-level return is not under the control of the manager, this result suggests some mutual fund investors confuse a fund’s category-level performance and manager skill.”
The authors also observed that, when evaluating a fund, investors must first know the factor-related return in order to adjust for it. They write: “Sophisticated investors will seek out this information. But less sophisticated investors may not be aware of size, value, momentum, or industry returns. The market’s performance, however, is ubiquitously reported. This may be one reason why investors do pay attention to market risk when evaluating mutual fund managers.”
How Hedge Fund Investors Judge Performance
Thanks to Jesse Blocher and Marat Molyboga, authors of the October 2016 study “The Revealed Preference of Sophisticated Investors,” we now have an insight into how hedge fund investors evaluate performance. Supposedly, these are more sophisticated investors. What they are for certain is wealthier—which does not necessarily imply greater sophistication. Perhaps surprisingly, they found that “hedge fund investors’ revealed preferences are also best modeled by the CAPM.”
Blocher and Molyboga add: “This finding is surprising, given the diversity of risk faced by hedge fund investors and the well-documented failure of the CAPM to price the cross-section of assets.”
The authors cautioned their results didn’t show that the CAPM fits the data very well. Rather, they demonstrated the CAPM fits the data better than all of the other candidate multifactor models proposed thus far in the literature. Thus, much of investor behavior remains unexplained.
Summary
The bottom line is that the evidence from both studies shows that, in general, both mutual fund and hedge fund investors are ignoring the large body of evidence that factors beyond market beta have explanatory power in the cross section of returns.
Thus, they end up attributing to skill what is really nothing more than exposure to common factors, exposure that can be obtained far more cheaply through low-cost index mutual funds and ETFs.
Fortunately, today investors can determine the risk-adjusted alpha of any mutual fund, whether active or passive, simply by using the multifactor regression tool available for free at Portfolio Visualizer.
This commentary originally appeared November 30 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE