Weekend Reading for Financial Planners (Apr 15-16)

Author: Michael Kitces

Team Kitces

Michael Kitces is Head of Planning Strategy at Buckingham Strategic Wealth, which provides an evidence-based approach to private wealth management for near- and current retirees, and Buckingham Strategic Partners, a turnkey wealth management services provider supporting thousands of independent financial advisors through the scaling phase of growth.

In addition, he is a co-founder of the XY Planning Network, AdvicePay, fpPathfinder, and New Planner Recruiting, the former Practitioner Editor of the Journal of Financial Planning, the host of the Financial Advisor Success podcast, and the publisher of the popular financial planning industry blog Nerd’s Eye View through his website Kitces.com, dedicated to advancing knowledge in financial planning. In 2010, Michael was recognized with one of the FPA’s “Heart of Financial Planning” awards for his dedication and work in advancing the profession.

Read all of Michael’s articles here.

Weekend reading for April 15th/16th:

TD Ameritrade Shocks RIAs [By Changing Its Advisor Referral Program With] A Tight Deadline To Sign (Lisa Shidler, RIABiz) - Last month on March 20th, TD Ameritrade "informed" the roughly-150 RIAs in its advisor referral program that they must acquiesce to new terms, which for many will involve substantially higher costs, with a contract and an April 5th deadline to sign or be dropped from the program. The primary changes were a shift in the revenue-sharing agreement for advisor referrals from 25% of the advisor's fee, to 25 basis points (regardless of the advisor fee) which drops to 10bps above $2M and 5bps over $10M; for those who charge more than 1% in AUM fees for million dollar accounts, the change would actually be a discount, but for most advisors who charge 1% or less - sometimes much less on large accounts thanks to graduated fee schedules - the change amounts to a substantial increase in the cost of the referral arrangement. In addition, the 25bps fee will apply on referred assets, not just closed assets, which means if TD Ameritrade refers a $2M account but the client only agrees to have $1M managed initially, the advisor still has to pay 25bps on the entire $2M that was referred. Also notable was a big change to the exit rules - in the past, advisors who left TD Ameritrade would have to pay a one-time 75bps fee if they left the platform and took TD-Ameritrade-referred assets, but now the cost will be a 75bps one-time fee plus a 25bps trail for five years. The shift comes at a time when TD Ameritrade is finalizing its Scottrade acquisition, which is expected to boost its branch network from about 100 locations up to a whopping 450 branches, and as a result, could turbocharge what is already a referral flow of about $25B to $30B per year to RIAs... but now with much higher revenue-sharing and retention terms for TD Ameritrade. Of course, the reality is that most advisors would and do gladly share revenue in exchange for high-quality referrals provided to them on a silver platter, and the buzz is that most firms have simply accepted the new terms and moved on - especially since firms already charging right around 1% AUM fees and closing most new business referred to them won't see much change, and if they plan to stick with TD Ameritrade anyway the new departure provisions are a moot point. Nonetheless, there were substantial rumblings about the way TD Ameritrade handled the rollout, providing many firms less than 2 weeks to read the notice and make a decision (once the letters physically arrived in the mail), and using the DoL fiduciary rule and its April 10th applicability date as the justification for the push (even though the rule has since been delayed 60 days) on the basis that TD Ameritrade had a conflict of interest by getting paid 25% of an advisor's revenues (which meant advisors who charged more would result in a conflict of interest by paying more in revenue-sharing to TD Ameritrade). Although ironically, in practice the new pricing structure will squeeze investment-only firms (that tend to have lower AUM fees for investment-only services, and might not be able to pay 25bps if they only charge 40bps to 50bps in the first place), in favor of more comprehensive financial planning and wealth management firms that charge a higher price point (for which 25bps is expensive but not fatal).

Why Many Financial Advisers Aren't Worried About Posting Anti-Trump Opinions (Bob Powell, Marketwatch) - It's common for parents to teach their children not to discuss politics in polite company, and the practice is especially rare amongst financial advisors who don't want to accidentally offend a client who might hold differing political views. At the most, "politics" only came up in the context of discussing potential policy changes in Washington, and the impact it might have on either investors/markets in general, or a client's financial plan in particular. But Powell notes that with the rise of President Trump, it's become increasingly common for many financial advisors to share their political views, especially via social media platforms. On the one hand, some believe the shift is simply due to the fact that social media, including sharing political views via social media, just simply become more socially acceptable. On the other hand, some advisors note that their political beliefs are so strong, they don't care if they upset and lose a client from the other side of the political aisle, and prefer to work with clients with whom they have shared beliefs anyway. In fact, while advocating for or against any highly political figure is likely to offend at least some prospects and clients (and there are pro-Trump advisors speaking out more as well), what impairs a relationship with some may also resonate especially well with others, and could attract as many clients as it repels anyway (or even more, if being publicly political actually becomes a viable differentiator for the advisor!). Notably, the nature of political posts also varies by social media platform - as advisors seem to be more likely to post politically on Facebook (which is more often used personally) than other platforms like Twitter (which is more often a professional platform for learning and sharing expertise). At a minimum, though, marketing experts urge that if advisors are going to speak up on political issues, they should have a plan for whether/how they'll deal with any pushback that may arise, as making civil political posts is one thing, but an emotional outburst on social media is another.

June 9th: Strict Fiduciary Obligations To Arise? (Ron Rhoades, Scholarly Financial Planner) - The big buzz last week was that the Department of Labor had imposed a 60-day delay on the applicability date of its new fiduciary rule, shifting the key date from April 10th until June 9th. In addition, the fine print of the new regulation further delayed the rollout of the full Best Interests Contract Exemption requirements on Financial Institutions until the end of the year, alleviating most of the policies and procedures and disclosure requirements, and also the requirement for advisors to acknowledge in writing that they will be fiduciaries with their clients (which reduces their exposure to fiduciary lawsuits and/or a class action lawsuit for any fiduciary breaches that might occur between June 9th and the end of the year). Nonetheless, Rhoades points out that the new rules will still require advisors to adhere to the "Impartial Conduct Standards" on June 9th, which require that the advisor provides best interests advice, for reasonable compensation, and make no misleading statements, as part of the "transition BIC" rules. Which means advisors will still have at least an implied contract with every client going forward after June 9th (although for level-fee fiduciaries, it appears the obligation will apply only during the IRA rollover process, but not thereafter). And, in turn, this suggests that even if firms don't have an obligation to engage in the full scope of policies and procedures and fiduciary disclosures required under the Best Interests Contract Exemption, it may still be in their interests to voluntarily adhere to them anyway, if only to better protect themselves from what could still end up being a legal fiduciary breach under the Impartial Conduct Standards. Of course, there's still a possibility that the rule could be delayed further, but Rhoades notes that another delay from here would almost certainly violate the Administrative Procedures Act, at least unless there is first a thorough economic cost/benefit analysis before a new delay or rule change (which isn't realistically feasible by the June 9th deadline). As a result, Rhoades suggests that with the rising likelihood that the delayed June 9th date will hold, and the substantive fiduciary obligations that still apply under the Impartial Conduct Standards (even if the full Best Interests Contract Exemption is delayed), that for most firms it's actually still "game on" for adopting DoL fiduciary compliance procedures by June 9th after all!

3(38) vs 3(21) Investment Fiduciary Services: Pros And Cons For 401(k) Advisers (Greg Iacurci, Investment News) - For advisors serving 401(k) plans by providing fiduciary investment services, there are two primary camps: 3(21) investment advisers, who provide advice to the employer on the 401(k) investment menu by leaving the employer the discretion to accept or reject the advice; and 3(38) advisers that take on the full discretion to make fund decisions. The key distinction is that a 3(21) advisor is a "co-fiduciary" with the plan, while as a 3(38) the advisor is the primary fiduciary, which means from the plan's perspective, the plan administrators offload more of their own fiduciary exposure by working with 3(38) advisors instead of 3(21) advisors (though the plan still has the fiduciary obligation to monitor the 3(38) advisor). Yet because of the increased fiduciary exposure for those advisors, along with the fact that not all plans want to give up so much control and discretion, only 47% of retirement plan specialists today are serving as 3(38) advisors, while 82% are offering 3(21) services. On the other hand, with plans becoming more wary of their own fiduciary liability exposure - especially after the recent spate of class action lawsuits against 401(k) plans - the demand for 3(38) services is on the rise (especially amongst 'mid-sized' plans with $2M to $10M in assets), and a number of major advisor platforms - from LPL to Morgan Stanley - have been offering packaged outsourced 3(38) solutions for advisors to offer. And notably, while the advisor does strictly speaking have greater fiduciary exposure as a 3(38) advisor, many also note that being a 3(38) can actually be easier from an execution perspective, because investment decisions can be followed through on immediately (since the advisor has discretion), rather than needing to pitch recommendations to the employer and its investment committee first; in addition, 3(38) fiduciaries can more easily implement consistent investment models across multiple clients (which means far fewer funds to monitor for due diligence purposes). And at the same time, because they take on additional fiduciary exposure, financial advisors sometimes charge a premium fee that is as much as 20%-25% higher when serving as a 3(38) fiduciary (though others simply include 3(38) services as a no-cost-increase differentiator)... which means as long as the advisor doesn't actually get in trouble and get sued, offering 3(38) services allows for higher fees with more efficient execution and the potential for better margins.

5 Regulatory Issues Every Financial Adviser Should Be Watching (Mark Schoeff, Investment News) - While most recent regulatory attention for financial advisors has been focused on the Department of Labor's fiduciary rule, a recent "Regulatory Roundtable" from Investment News notes that there are a number of other important regulatory issues on the horizon for advisors. Other regulatory issues to be aware of include: a provision in last year's Dodd-Frank overhaul bill that directs the SEC to consider alternatives to a uniform fiduciary standard, including "simplifying the titles used by brokers, dealers, and investment advisers" that could amount to a "fiduciary lite" rule by limiting who actually holds out as a financial advisor or not; new leadership at both the SEC (Jay Clayton) and FINRA (Robert Cook) could bring new regulatory initiatives (and while it remains unclear whether Clayton intends to give investment advisers any more or less focus, Cook has been on a "listening tour" of FINRA firms and may soon propose some new FINRA initiatives or reforms); a potential change to the accredited investor rules, which incoming SEC Chair Jay Clayton has signaled his support for, though questions remain about whether or how financial advisors might be involved in the accreditation process (with at least one proposal suggesting that accredited investor status might be waived if the recommendation is made by a fiduciary advisor?); and pressure to reduce the overlaps and redundancy in regulation, particularly in areas where multiple regulators are becoming increasingly active, such as cybersecurity, and battling elder financial abuse. And of course, there's also the looming potential for tax reform, which isn't directly about the regulation of financial advisors, but proposed changes like curbing tax preferences for retirement accounts and limited tax deductions, could impact the nature (and the potential value) of tax planning advice that advisors commonly provide!

Why Evidence-Based Investing Can Improve Your Practice (Michael Finke, Research Magazine) - For much of the history of investment markets, our capabilities and tools to evaluate investments were very limited. Over the past 50 years, though, the rise of computers, and the research they've powered, have given us new perspectives on explaining the behavior of markets and the opportunities for investors. First was the development of the Sharpe/Lintner capital asset pricing model (CAPM). Then the Ph.D. thesis of Eugene Fama, which showed that stock prices tended to follow a random walk. And then Michael Jensen's work showing that most mutual fund returns could simply be explained by their systematic risk as defined by the CAPM equation (and that most "outperforming" funds of the day weren't providing better risk-adjusted returns, they were simply taking more risk and benefiting from the upside that entails in a bull market, and not really producing much alpha). Of course, research has since found that CAPM doesn't explain 'everything' about the behavior of stocks, leading to the rise of research around how factors like small-cap and value stocks can help explain why certain stocks/funds tend to outperform, which in turn became known as factor-based investing. More recent research has added additional factors, including momentum effects (recent outperformers do tend to persist, at least in the short run), a liquidity effect (companies that trade less frequently tend to outperform), and a profitability effect (as the most profitable firms also tend to do better). Cumulatively, this growing base of research about the factors that drive stock returns is becoming a phenomenon known as "evidence-based investing", where investment strategies and opportunities are developed based on the growing volume of evidence-based investment research about how stocks and markets really behave. The challenge of this approach, however, is that as more and more evidence of the driving factors of stock returns and investment opportunities become known, their benefits shrink - a phenomenon that Swedroe and Berkin have dubbed the "Incredible Shrinking Alpha" (in a book by the same name). At the same time, the rise of evidence-based investing is leading to new challenges in how to evaluate and benchmark portfolios in the first place, as one of the key insights of evidence-based investing is that the traditional Morningstar Style Box is not necessarily a good way to segment (and benchmark) the underlying components of market returns. Though on the plus side, better insights into the true underlying investment factors are leading to the creation of investment vehicles that make it easier and easier to capture and participate in them, at lower costs than ever.

Diversification, Adaptation, and Stock Market Valuation (Jesse Livermore, Philosophical Economics) - There is a classic hierarchy of "excess" returns available to those who are willing to take more risk, with small caps outperforming large caps, which outperform corporate bonds, which in turn outperforms Treasury Bonds, all of which outperforms cash. Yet with nearly 100 years of data showing this, the question arises: if markets are efficient, and such investment opportunities are known already, then why do they persist, and why haven't markets adapted to the point of closing the gap? The presumption is that investors are being rewarded for the additional risks they're taking; yet, again, if 100 years of history persistently shows that certain assets outperform, are the investors who buy them for the long run really even taking "risk" at that point, and why don't they just pay more for those assets (until eventually the prices rise to the point that the excess returns come down)? Livermore explores the phenomenon with a thought experiment - imagine that a stock is like a "Lotto Share", where there's a 50% chance it ends up being valuable, and a 50% chance it ends up being worthless, and then asks "what would you pay for the Lotto Share"? The answer quickly becomes apparent that your willingness to invest, and at what price, is a function of whether or how much you can diversify, and whether the Lotto Shares will pay more than just buying an equivalent government bond with a comparable expected return. In fact, given the sheer uncertainty - the possibility that the Lotto Share could underperform - means that it makes no sense to buy a Lotto Share if it provides a comparable return to a bond; it must be cheaper, such that it offers a higher expected return. This, then, becomes the essence of why stocks can persistently generate higher returns, even when the expectation of higher returns is known; as long as there's still some possibility and uncertainty regarding that outcome, the stocks must price cheaper (and thus for higher returns) than an equivalent bond that eliminates such uncertainty. Especially since a deeper analysis of markets reveals that in reality, why "stocks" in the aggregate outperform, they only do so thanks to a small number of "superstocks" that drive the majority of returns, while the remainder really do languish far behind.

Do Stocks Outperform Treasury Bills? (Hendrik Bessembinder, SSRN) - It is an almost universally accepted truism in the investment world that stocks outperform bonds in the long run, yet this recent research study reveals that in reality that is usually not the case. In fact, when analyzing data from the Center for Research in Security Prices (CSRP), Bessembinder finds that monthly stock returns only outperform one-month Treasuries 48% of the time, and a whopping 58% of all individual common stocks have holding period returns less than one-month Treasuries over their entire lifetimes! In fact, in dollar terms, the entire gain of the U.S. stock market since 1926 is attributable to a mere 4% of listed stocks, and half of that is driven by the wealth creation of just 0.3% of the 26,000 stocks in the CRSP database since 1926. In other words, the overwhelming majority of market returns are actually driven by a very small subset of stocks. Which is notable, because it means the greatest "risk" of concentrated portfolios isn't just the danger of a negative "black swan" even, but the risk of missing out on a golden swan event - failing to invest in one of the small subset of stocks that ends up with extraordinarily positive returns that drives the cumulative returns of the entire stock market. In fact, Bessembinder concludes that one of the primary reasons that active managers (and concentrated portfolios in general) struggle to outperform is that an investment manager doesn't just need to select "above-average" (or avoid below-average) stocks to outperform; instead, beating cash (and especially, beating a passive index) means being able to proactively overweight amongst the very narrow number of stocks that are actually driving almost all of the long-term cumulative return of markets.

20 Years In, Have TIPS Delivered? (Maciej Kowara, Morningstar) - On January 29th of 1997, the U.S. Treasury held its first auction for a 10-year inflation-indexed bond - what is now known as a Treasury Inflation-Protected Security (TIPS) bond -  and was followed by a five-year version later that year, and a 30-year version in 1998. Early on, investor interest was tepid, in part because TIPS "only" had a sub-4% real yield in a world where conventional Treasuries were yielding close to 7% at the time. In fact, when combined with the fact that the government didn't need to do much borrowing at the time - thanks to a budget surplus between 1998 and 2001 - the five-year note was actually discontinued not long after its debut, and only reappeared in 2004 (and similarly 20-year TIPS bonds were introduced in 2004 but eliminated in 2009). Nonetheless, the TIPS market has now grown to $1.2 trillion, which is about 9% of the overall Treasury market, and the U.S. inflation-protected bond Morningstar category now includes 55 funds that hold $80B. And, looking back, the good news is that TIPS bonds have in fact managed to substantially beat inflation over the past 20 years since they debuted, although their success in part is due to the ongoing decline in real interest rates over the past 20 years, which lifted their returns above just what their real-yields-plus-inflation-adjustments alone would have promised. In fact, most of the success of TIPS bonds for the past 20 years appears to have simply been the secular bull market that has occurred for all fixed income investors as inflation has remained subdued and interest rates have trended down. On the other hand, the pricing mechanics of TIPS have themselves been turned into a gauge to evaluate future inflation expectations. Yet while - with the exception of extreme market volatility during the financial crisis - TIPS have at least done at least an 'OK' job at predicting inflation, their return volatility is so dominated by shorter term movements in interest rates that the correlation of TIPS monthly returns to monthly changes in inflation is a mere 0.09, which means at best TIPS are holding up as a 'decent' prospective hedge against long-term inflation, but are still operating first and foremost like an (occasionally volatile) fixed income investment, albeit a unique version of a fixed-income (sub-)asset class.

What The United Airlines Incident Says About Fiduciary Excellence (Don Trone, 401(k) Specialist) - While rules are usually important to direct behavior in the "right" direction, too many rules can act as a disincentive against the best behavior; after all, most of us do our best work when we're allowed to use our own creativity to get the job done, and not just do what someone else tells us to do. Trone suggests that the recent United Airlines incident is a case-in-point example, where airline procedures are so scripted and rote, that employees become afraid of the adverse consequences of deviating and making a potentially bad decision, that they don't make a decision or intervene at all, with potentially catastrophic consequences. Which means, in essence, there's a "fiduciary paradox": to best act in the best interests of others, we need to decrease the number and complexity of rules that requires us to do so. To some extent, this has long been recognized in the fiduciary context - it's the reason that ERISA is primarily a "principles-based" standard, designed to balance Moral Obligations (what fiduciaries are told they have to do) with Moral Aspirations (what fiduciaries will want to do, when you give them guidance and a standard and get out of the way to let them execute it as best they can). When regulators become too heavy-handed with rules, we are desensitized to the Moral Aspirations part, and simply view execution of the rules as an obligation - which often results in mediocrity, or worse in the case of United Airlines. Which raises challenging questions about whether the DoL fiduciary regulations may be too rules-based, and more generally suggests that if we really want to improve fiduciary outcomes for consumers, we need to spend less time creating rules, and more time training fiduciaries in the leadership and stewardship behaviors that allow them to creativity (and positively) execute their fiduciary aspirations themselves.

Why Your Financial Adviser Can't Be Conflict Free (Jason Zweig, Wall Street Journal) - With the rise of the DoL fiduciary rule, and more generally the rising interest in and awareness of conflicts of interest and the standards that apply to financial advisors, it's become increasingly popular for advisors to market themselves as fiduciaries who put their clients' interests ahead of their own. Yet Zweig suggests that the marketing fervor may now be going overboard, with a number of advisors beginning to market themselves as being entirely "conflict free" - a description that is substantively impossible in practice. In some cases, advisors' websites stated that they were "100% conflict free", emphasizing that because they worked at an independent broker-dealer with no proprietary products, they "can provide truly objective, conflict-free advice and investment recommendations." Yet even the broker-dealer in question, LPL, acknowledges "Of course, in offering financial services, the potential for conflicts of interest often arises as the industry continues to evolve." And while independent broker-dealers don't sell proprietary products, there are still conflicts of interest in the differences in compensation and incentives from one product to another (leading LPL to issue a pronouncement to its own advisors shortly after the article was released, directing them to eliminate such "conflict-free" language from their websites). Notably, the problem isn't just one of (independent) broker-dealers, either; Zweig notes that fee-only RIAs also often market themselves as being conflict-free, despite a number of common conflicts of interest, from firms that charge more to manage stock than bond portfolios (and thus have a conflict of interest and incentive towards recommend more stock-heavy allocations), to the mere fact that recommending someone roll over an 'old' 401(k) to the advisor to manage has a conflict of interest (as the incentive won't get paid if the client doesn't change providers!). Other conflicts for fee-only advisors include an incentive to encourage clients to use mortgages to buy real estate (to keep investment assets in the managed portfolio), to use bonds in lieu of CDs (for the same reason), and even to spend less in retirement (to keep more assets on the books). All of which isn't meant to bash any particular type of financial advisor for the existence of those conflicts of interest, but simply to recognize that virtually any/all financial advisor business model will have some conflicts of interest, and can't be fully conflict free - which means it's time to spend less time talking about having "no conflicts", and more time admitting what conflicts of interest we do have, followed by a fruitful conversation about how we manage those conflicts of interest to provide the right advice anyway.

The Reason Why We Need [Regulators]... Hint: It's Marketers (Seth Godin) - Regulation is often lamented for the ways that it inhibits innovation and slows the growth of business. Yet Godin notes that without regulation, in a competitive environment, too many marketers are rewarded for generating a short-term hit, which inevitably produces a race-to-the-bottom for who can create the most inappropriate advertising. For instance, Godin provides as an example one of the original advertisements for Coca-Cola, from before the Food & Drug Administration (FDA) existed to regulate how food and beverage products were regulated... where the ad suggests various that the product was "endorsed by over 20,000 of the most learned and scientific medical men in the world", and that consuming it would be "infallible in curing all who are afflicted with any nerve trouble, dyspepsia, mental and physical exhaustion, all chronic wasting diseases, gastric irritability, constipation, sick headache, neuralgia" and more, along with Coca being "a most wonderful invigorator of the sexual organs and will cure seminal weakness, impotency, etc., when all other remedies fail." The irony was that the original Coca-Cola was laced with cocaine - thus the actual origin of the name - such that the marketer who wrote the ad himself ultimately died from stomach cancer while addicted to the cocaine in the product... and six years later, his son died from the same Coca-Cola cocaine addiction. Simply put, self-regulation doesn't work in large markets that have easy entry, when there are too many short-term competitive battles going on. Thus, Godin suggests that smart, ethical marketers should recognize that regulation actually helps them do their work, by not only benefitting a potentially unsuspecting public that might be mislead, but also providing clear guardrails to marketers about what lines shouldn't be crossed even when locked in a competitive battle. Arguably, the same case could be said for why smart, ethical financial advisors should support fiduciary regulation, too.

I hope you enjoyed the reading! Please leave a comment below to share your thoughts, or make a suggestion of any articles you think I should highlight in a future column!

In the meantime, if you're interested in more news and information regarding advisor technology, I'd highly recommend checking out Bill Winterberg's "FPPad" blog on technology for advisors as well.