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The investment advisory regulatory systems are in a state of flux on both sides of the Atlantic. In the US, the new fiduciary rule introduced in 2016 was expected to trigger the biggest shake-up in the advisory system for more than a generation, but its ultimate fate is now uncertain under the new administration.

The Markets in Financial Instruments Directive (MiFID) II in Europe is making fund managers, advisers and other distributors scratch their heads as to how the distribution system will operate. Notwithstanding any Trump era developments, on current evidence it looks as if the US system has the better chance of evolving to become a role model globally compared with MiFID II facing ongoing structural problems and the relatively rigid Retail Distribution Review (RDR) in the UK.

US fiduciary rule survives trump but with uncertain future

The Trump administration was expected to abolish the new fiduciary rule requiring independent advisers to put clients’ interests ahead of theirs as legislated under President Obama. However, outright withdrawal has proved to be too hard a nut to crack. The Department of Labor has announced that it will delay the final compliance deadline to 1 July 2019, pending reevaluation of the regulation. It is widely expected that the rule will be subject to significant revisions. This rule, announced in April 2016, was described at the time as set to cause the most radical transformation seen in the US financial advisory sector for decades.

The aim of the rule is to end conflicts of interest by imposing the fiduciary standard already applicable to registered investment advisers and fee-only planners on all who advise on retirement savings. Brokers can continue to rely on commission structures, but subject to various provisions.
It is expected that the rule will encourage and accelerate the shift to charging fees already well underway

When advising on retirement plans, they can only charge reasonable compensation, and in selecting investments they must serve their clients’ best interests. These stricter criteria contrast with the current standard which has encouraged some to advise investing in vehicles that offer high commission rates regardless of clients’ interests.

The Department of Labor is considering a flexible system for compliance. It will consider a more streamlined exemption system for firms, encouraging investor-friendly products posing low conflicts of interest. It is suggested that on the whole the rule might survive the review but without some of its most important enforcement clauses.

Though commissions can still be charged, because of conditions such as the need to show reasonableness, it is expected that the rule will encourage and accelerate the shift to charging fees already well underway.

The review is not all. The Securities and Exchange Commission has also intervened in an endeavour to encourage the Department of Labor to work with it, drawing upon its decades of experience. Legislators are putting forward bills to amend the rule. But perhaps the most important development is that the Fifth Circuit of Appeals at the federal level is hearing arguments to abolish the fiduciary rule altogether on the grounds that the Labor Department exceeded its statutory authority in putting forward the rule, which introduces another layer of uncertainty.

Fiduciary rule benefits top wall street firms

Some of the largest and most influential brokerages belonging to top Wall Street firms, even prior to the new fiduciary rule, had been shifting towards fee-based systems, as the latter are more lucrative than the commission-based approach.

The benefit to the top players from the new regulation is already visible. Bank of America’s global wealth units, including Merrill Lynch fee-based assets, increased by 19% to just under $1tn in the second quarter of 2017 compared with one year earlier, amounting to 38% of client assets.

Morgan Stanley has adopted a different approach. It has reduced commission charges to comply with the rule’s ‘reasonable compensation’ standard. It is also establishing a new computer-based robo-advisory tool. Its fee-based assets went up by 17% to more than $950bn from a year earlier in the second quarter. Pruzan ascribes some of the move to the fee-based system to the new fiduciary requirement.

Successful fund managers hit by the fiduciary rule

Extra compliance burdens imposed by the fiduciary rule are causing quite a bit of dislocation in the distribution system for US mutual funds, having adverse effects even on some of the successful ones. The large brokerages have been making available thousands of mutual funds to their clients. The sheer number of such funds is now posing difficulties, considering the due diligence and documentation required on investments recommended by advisers. Litigation risks have become a strong consideration.

Unsurprisingly, the brokerage firms are aiming to remove some funds, including those with higher charges or those seen as too risky, both of which might require justification if offered to clients.

Matt McGrew, chief operations officer of USA Financial, a financial services firm in Michigan, expects that his firm will eliminate more than 350 sales arrangements covering mutual funds, variable annuities, alternative investments and fund managers, leaving fewer than 150.

There is now the worry that fund costs may be the key measure in the choice of funds, ignoring the issue of overall return, including costs. Some advisers are also worried that funds they have recommended to clients for years may no longer be available for reasons given below.

Commission-based versus fee-based

The move away from commission-based systems is not always to the benefit of even affluent clients who have no problem in paying fees. Though advisers can be biased by high commissions, fee-based systems are not free of conflict either, and in some cases clients would be better off paying commission.

To avoid the typical 1% fee plus another 1% or more for an actively managed fund, they automatically put clients into index funds. Ben Johnson, director of global exchange-traded fund (ETF) research at Morningstar, feels that this approach is having an impact because of the pressure to keep down the total cost of the adviser relationship.

The following is an example of how the commission-based model can be cheaper for some. Consider paying 5.75% for A-share class of the American Funds Fundamental Investors fund with a relatively small 0.6% expense ratio. If this charge of 5.75% is spread out at 1% per annum over 5.75 years, then the overall charge becomes 1.61% per annum for 5.75 years dropping to 0.61% per annum thereafter. On the other hand, if a fee-based adviser uses  an exchange-traded fund (ETF) such as iShares Core S&P 500 ETF with a 0.04% expense ratio, when added to the 1% fee will be 1.04% per annum – 0.57% per annum cheaper than for the active fund for the first six years but 0.43% more expensive after that.

Barron’s points out that not using the American fund above would have been bad as its performance over 15 years of 10.3% exceeded the S&P 500’s 9% and also beat 96% of other funds in its category. But investors have fled for the above reason, with the fund suffering nearly $2bn in outflows over the year. Similar top performing load funds from Franklin Templeton and BlackRock are also suffering, even great no-load active funds such as Fidelity Contrafund, a perennial success, have lost out. Thus, paying commission rather than fees can be to the benefit of long-term buy and hold investors regardless of wealth levels.
In some cases clients would be better off paying commission

Of course, fee-based advice means ongoing payments and continuing service whereas commission-based advisers have no incentive to advise further for buy and hold customers. Also, remember that very few funds outperform consistently.

Other conflicts arise when fees are charged. For an adviser, the more assets the client has for investment, the better. Thus, the adviser could argue against paying off a mortgage or investing in areas such as business, which will leave less in his/her advice spot.

Furthermore, many advisers are not passive but actively trade ETFs in a dubious attempt to beat the market. Research from the Financial Planning Association finds that percentage of advisers exclusively passive fell from 25% to 15% from 2014 to 2017, during which time ETF use increased from 80% to 88%.

According to Michael Kitces, director of wealth management at Pinnacle Advisory Group, most advisers don’t publish returns. His feeling is that not wanting to publish performance indicates lack of good results. Also, these advisers are not as experienced and skilled with support as portfolio managers at fund companies. So, they are unlikely to outperform active funds.

Banks’ fund managers and distribution platforms are faced with uncertainty concerning the new rules covering fund distribution and advice in Europe, and in many cases are still needing clarification. The problem is much more acute on the continent of Europe, where, unlike in the UK, banks and distribution platforms dominate the advisory and distribution scene.

Research by Platforum, a consultancy, shows that at least 80% of distribution comes from banks in many countries. MiFID II is demanding that distributors have to perform product reviews, should supply more information on sales and charges as well as need to understand and collect data on their target markets for funds. The idea here is that they need to establish that funds are reaching the target markets they are designed for.

It is expected that this will cause banks offering fewer third-party funds to limit the burden. According to Diana Mackay, CEO of Mackay Williams, a highly regarded expert on retail distribution, it makes sense for banks to reduce the number of fund management partners they deal with. Benjamin Quinlan, CEO of the consulting firm Quinlan and Associates, agrees that the banks could offer fewer funds from external managers. A paper by Deloitte in 2016 forecasts that MiFID II could lead to fewer third-party funds on offer by banks to the retail public to keep cost down, thus reducing choice.

But Mackay feels that it could be difficult for those banks that boasted of choosing the best external funds for their customers, to now focus on in-house products only. She feels that some may continue to make available third-party funds through their own label, including fund of funds, reducing the level of due diligence required.

Allfunds, the largest fund platform in Europe, does not expect platforms to reduce the number of offerings as they need to add value to clients. Marta Oñoro, global head of legal at Allfunds, believes that MiFID II will actually boost open architecture.

The situation is different yet again in the independent advisory sector. Mackay predicts consolidation in Europe as independent financial advisers (IFAs) are forced to become larger to reduce the new compliance burdens and pressure on fees. Even in the UK, knock-on effects will occur for IFAs as MiFID II changes the definition of independent advice. But Rodolfo Crespo, senior analyst at Platforum, predicts that independent advice will still grow especially in France, Germany and Spain.

Overall, there is no clear agreement on how MiFID II will shake up European distribution. Mackay points out that many areas are subject to uncertainty. Different distribution structures in the various countries will lead to local interpretation of MiFID II by the national regulators and result in patchwork of rules without any consistency. She says that the ideal of unifying Europe in a single set of regulatory requirements has moved further away.
Editor's comment

MiFID II is introducing measures across the board, some controversial and some applauded. But in the area of investment advisers and distribution, its stipulations leave much to be desired in terms of clarity and clear direction, leaving its potential impact very much suspect. A patchwork of rules across Europe is not an enticing prospect.

Dr Wolfgang Mansfeld, former president of the European Fund and Asset Management Association (EFAMA) writing in the Autumn 2017 edition of Investment Management Review, expressed scepticism whether MiFID II could deliver a satisfactory outcome for European distribution and suggested the possibility of the EU moving to the US approach of a fiduciary rule or a UK-style commission ban in a couple of years.

Compared with the US and the UK, distribution in Europe and much of the world remains backward, dominated as it is by the big banks. Over time this is bound to change. The evolving US system received a fillip from the fiduciary rule, but its total abolition is not likely to halt the gradual evolution towards a very flexible approach, minimising conflicts of interest. The fact that this rule is actually benefiting these big players points to their lobbying power and influence, ensuring that some professional version of the rule will come into being.

It looks as if, despite initial expectations, the authorities are adopting a constructive approach to revision, which appears to be not politically motivated on a blanket basis, as widely felt at the outset of the Trump administration.

Some of the arguments on commission versus fees highlighted in the US are valid universally and may be relevant in the long term in the UK as well, when charges come down under pressure of passive fund management and digital disruption.

Much of the world needs to get away from archaic and potentially biased retail bank dominated fund distribution. Despite Trump regime uncertainties, on current form, the US system looks most likely to evolve towards a globally copied model rather than the nationally fragmented system in the EU or the more rigid RDR in the UK.