What do Fiduciaries, ETFs and 12b-1 Fees Have in Common?

A few days ago, we wrote a posting on the repeal of the so called Merrill Rule that allowed brokers to offer fee-based accounts without the full fiduciary responsibilities of traditional fee-based financial advisers.  We argued that repealing this rule was good for those who want their adviser to present them with pure alpha or pure beta products without regard to the compensation they would receive from each.  In short, we argued it was good for alpha-centric investing.

Three separate stories published today by Investment News illustrate the complex inter-relationship between the regulatory landscape and alpha-centric portfolio construction.  Seemingly disparate stories about fiduciaries, ETFs, and 12b-1 fees have roots in the same underlying phenomena.

Merrill rule meant choice.  Or was it just bullying?

In their effort to capture both sides of this complex and often rancorous debate over the Merrill Rule, Investment News ran two related editorials today: Should Advisers be Fiduciaries – No and Should Advisers be Fiduciaries – Yes.

Arguing the No side (for the brokers) was Ira Hammerman, senior managing director and general counsel of the Securities Industry and Financial Markets Association (SIFMA).  Said Hammerman:

Investors are best served by choice…Sadly, there is no doubt that choice is limited by the court’s decision to eliminate fee-based brokerage accounts.

He goes on to say that traditional brokerage accounts have left billions in investors pockets since in aggregate, they charge a lower effective fee on assets than do fee-based accounts from financial advisers.  He further argues that investors receive equal protection against disclosure as do their peers in fee-based advisory accounts (as a result of NASD and SEC rules).

But Charles Austin a lawyer and former president of the Public Investors Arbitration Bar Association is not persuaded by Hammerman’s pitch and accuses the brokerage industry of being disingenuous about its motives.  Said Austin:

(The brokerage industry’s) argument against repeal of the rule was based largely on the notion that broker-dealer customers already enjoy the benefits and protections of existing laws and regulations, and therefore don’t need the protections that fiduciary status would confer. So why, then, the fear among member firms of being branded with the Scarlet F? (ed: for Fiduciary).

One can only hope that policymakers will respond to (the brokerage industry’s threats the way all bullies should be dealt with: call its empty bluffs. The investing public will be safer as a result, and perhaps SIFMA will cease threatening investors every time its members’ practices are questioned. The SEC’s recent decision to not appeal the court’s abolition of the Merrill Lynch rule is a good first step.

…In any case, repeal said to be good for ETFs…

Thankfully, the transition of a million fee-based brokerage accounts to bona fide advisory accounts seems like it may pave the way for more low cost, pure-beta ETFs.  Investment News also offers up a story on this topic (ETFs are finding favor among brokers).

The story suggests that ETFs will likely benefit from this transition since they are so inexpensive.  With revenues fixed at, say 1%, advisers for these new accounts will likely seek the lowest cost option in order to create the largest possible profit margin.

Investment News quotes Charles Roame, of Strategic Advisors LLC:

ETFs are a perfect fit for advisory accounts, he said. If a brokerage firm is going to run an advisory program and charge a 1% fee for advice, it behooves it to use the lowest-cost investment vehicles it can find, and in most cases, those vehicles will be ETFs, Mr. Roame said.

This trend is apparently not lost on the ETF industry.  In fact, the same article quotes a State Street executive as saying brokerages are the single-largest focus for our business today.

But sticky issue of 12b-1 fees remains

But as we suggested last week, the repeal of the Merrill Rule is only a step in the right direction – toward the transparency required for alpha-centric portfolio management.  While it’s important for an investor to know that their adviser is not making undisclosed commissions on execution, fee-based accounts that include mutual funds still face the sticky issue of 12b-1 fees.  And according to Investment News, the time is right to recast 12(b)-1 fees.

It can be argued that these fees are the financial adviser’s allegory to the broker’s sales commission that started this imbroglio in the first place.  And thus, by the same token, the advisory businesses may not be totally rid potential conflicts until it removes such compensation and becomes entirely fee-based.  While Investment News argues that disclosure may be sufficient to justify the continuance of such fee arrangements, we’re not so sure.  Simply revealing a bias to an accepting client does not mitigate that bias.

At the core of all three of these trends is the unbundling of retail financial services.  And this lays the groundwork for alpha-centric investing.  The repeal of the Merrill Rule is about unbundling trade execution from asset management services, the move toward ETFs is about unbundling beta from alpha and the potential demise of 12b-1 fees is about unbundling asset management and financial planning services.  Taken together, they provide a glimpse into the disintermediation and structural re-organization that will likely face the financial services industry in the coming years.

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