Investment managers could be forgiven for thinking they have fallen into Charles Dicken’s A Tale of Two Cities.
It is the best of times and the worst of times for the profession. Even as the market sits near all-time highs, the threat of the DOL’s new Fiduciary Rule looms over the industry, threatening at its extreme to destroy many advisors’ businesses. The Fiduciary Rule is the burning platform issue of many investment firms right now, and it is time advisors came up with a plan to put out that fire.
The fundamental issue with the new DOL rule is that it forces advisors to act as fiduciaries which in turn will lead many advisors to try and play it safe by only recommending the lowest cost investment products such as basic plain vanilla index funds. There is nothing wrong with being cheap and trying to save a buck, but the problem is that choosing only the lowest cost investment vehicles forces investors to give up slightly more expensive investment options that are still very much worthwhile.
For instance, international stock ETFs are almost always more expensive than domestic equity ETFs. That’s understandable because international stocks are more expensive to trade. Yet advisors concerned about mitigating lawsuit risk and meeting a fiduciary obligation might give up the value of diversification and higher returns associated with international stocks in exchange for the safety of a defensible holding in pure US equities. That would be costly long-run error for the investor though – at the end of the day while international stocks can be volatile, they still serve a valuable diversification purpose in one’s portfolio.
Factor investing or Smart Beta investing is another area that investors are likely to overlook if they hew to a simple lowest cost approach. There is unambiguous scientific evidence that factor investing leads to significantly higher returns than simple market indexing. That evidence was the basis for a Nobel Prize in economics a few years ago. Giving up that extra return for a few basis points of upfront savings would be the epitome of penny-wise pound-foolish.
Investment management firms in the factor investing space are saying this to clients as loudly as they can. According to Patrick Sweeny, Principal and Co-Found of Symmetry Partners, one of the largest factor investing firms out there:
“The DOL Rule does not require advisors to choose the lowest cost investment option for their clients. However, being required to prove as a fiduciary that a more expensive option is appropriate and worth the additional cost is likely to push many advisors into plain-vanilla indexing (and probably already has). Nevertheless, we continue to see an influx into factor-based (or Smart Beta) funds that are designed in many cases to do the same thing traditional active management does at significantly lower cost. Factor investing offers the potential for outperformance and/or risk reduction at generic prices, which we believe advisors will value in a fiduciary world, which we further believe will go beyond retirement accounts.”
Sweeny’s view and the view of Symmetry makes a lot of sense, and it is in the best long-term interest for investors. The problem is that it’s unclear if the bulk of advisors are willing to take the risk of doing what’s right for their client in the long-run at the risk of the short-run. All investment strategies have ups and downs, and advisors putting clients into a more-expensive strategy that ends up suffering in the short-run may face client wrath.
For advisors, the way to put out this fire (and protect their own business), is through investor education. Investors need to understand that higher returns come with higher risk – just as stocks are sometime outperformed by bonds, vanilla indexing will sometimes outperform factor investing. Vanilla indexing will always lose in the long run, but the investor does not know that. Advisors need to help them understand it.
The reality is that the average individual investor earns a return of roughly 4% in their portfolio over time according to the best studies on the topic. That abysmal return is despite a market that has an average return of 10.8% since 1949. The reason individual investors do so badly is that they get emotional and trade too often buying into the market when it is highest, and selling when it is lowest.
One role of advisors in the future should be to keep clients from making that mistake. Helping investors stay the course and avoid panicking when markets turn down is a valuable service. To help investors make the right long-term choices though, advisors are going to have to withstand the pressure to move to all vanilla indexing. Standing on the burning platform is not easy, but it is the right call in the long-run.
Mike McDonald is a PhD in finance and a university professor in the subject at Fairfield University in Connecticut. He also runs a consulting company doing work on quantitative investing, big data, and machine learning for a variety of financial firms, asset managers, institutional investors, and government regulators. Prior to getting his PhD, Mike worked for a major Wall Street bank and one of the top hedge funds. Comments, questions, and concerns are always welcome – email Mike at M.McDonald@MorningInvestmentsCT.com or visit his firm’s website at www.MorningInvestmentsCT.com