As financial advisors increasingly adopt ETFs, the wholesale shift from actively managed mutual funds to passive investment vehicles is driving more inflows to ETF providers like Vanguard and Blackrock and State Street and than all other mutual fund families combined… and leading mutual fund companies into a mad scramble to figure out what they have to do to once again appeal to financial advisors.

Yet the reality is that, with the rise of the internet, the fundamental role of the financial advisor themselves is changing. In a world where consumers can purchase virtually any publicly traded investment online themselves, financial advisors are compelled to add value above and beyond “just” bringing third-party mutual fund managers to the table. In fact, an increasing number of financial advisors appear to be “coping” by eliminating third-party managers, and instead becoming the investment portfolio managers themselves.

In this context, the rise of ETFs is not so much about a shift from active to passive, but simply a recognition that when financial advisors build investment portfolios, we prefer to do it using ETFs as our “building blocks”, rather than individual stocks and bonds. Although in point of fact, a recent FPA Trends in Investing Survey revealed that advisors are increasingly building portfolios with ETFs, and stocks, and bonds, and even private equity funds – anything except third-party mutual funds. Which just helps to show how the shift from active to passive is really just a mirage; what’s really occurring is a process where financial advisors are remaining active, but disintermediating mutual fund managers and going hands-on to actively build the portfolio themselves, whether as an independent RIA, or under a Rep-As-PM arrangement in a broker-dealer.

Of course, the caveat is that just as many mutual fund managers have struggled in an increasingly competitive market for alpha to outperform their benchmarks, there’s no indication that individual financial advisors are any better at the process. Which means ultimately, the financial-advisor-as-investment-manager shift itself may be short-lived, as advisors further shift to providing financial planning value outside of the portfolio altogether. But until financial advisors get to the point that the majority of us truly view our value-add as going beyond the investment portfolio – where a bona fide shift to passive investing may gain further traction – the ongoing rise of ETFs will remain less about a shift to passive itself, and more about how financial advisors are defending their own fees by squeezing out the costs of the investment products they use for client portfolios!

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This week is the first that financial advisors must operate under the Department of Labor's fiduciary rule, subject to Impartial Conduct Standards which require that they must give best interests advice, for reasonable compensation, and make no misleading statements. While much has been said about the impact this will have for advisors and their clients, there's also a not-well-discussed secondary shift that will be triggered by the DoL fiduciary rule, which will impact actively managed mutual funds and their performance in the coming years - in a "surprisingly" positive way.

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we discuss how the DoL fiduciary rule will likely end out causing an improvement in the return performance of actively managed mutual funds, thanks to the rise of clean shares and a shift in how brokers are compensated for recommending such funds!

Most predictions about the likely impact of the Department of Labor’s fiduciary rule is that it will lead to a (continued) decline in the use of actively managed mutual funds, and support the ongoing rise of passive ETFs, thanks to the fiduciary rule’s focus on low cost. But the truth is, that there actually is no requirement in the DoL fiduciary rule that financial advisors eschew actively managed funds and switch to lower cost passive funds. The only real requirement is that if an advisor is going to use an actively managed fund, that there needs to be a clear reason and justification for paying that active manager’s fee. And if you can make the case for the active manager, there’s nothing wrong with using the actively managed fund.

There is, however, a requirement to use the lowest cost share class if multiple share classes of the same fund are available. This is why we've seen the launch of T shares and clean shares – which either pay a uniform 2.5% upfront commission and 0.25% trails, or eliminate commissions entirely with the broker-dealer then wrapping a levelized commission around the whole fund or account. And this matters, because mutual funds currently have to report their performance net of commissions and broker compensation. But as broker-dealers shift to being compensated by levelized commissions outside of the funds (even if the consumer still pays a 1% fee via the broker-dealer equivalent to the 1% trail in a C share), the mutual fund itself will no longer have to count the broker's compensation against their own performance!

And this is important because a lot of mutual fund managers have not been underperforming by the amount of the manager's fee, but instead, they've been underperforming because of the drag of the broker's commission compensation. Which means, "suddenly", we're going to start seeing the average actively managed mutual fund begin to improve on its performance... starting this week, with the rollout of the DoL fiduciary rule (and the rapidly rising adoption of clean shares in particular). Not because mutual fund managers are necessarily managing any differently or better, but simply because they’re no longer paying broker compensation out of their own performance track records! Ironically, this may even handicap RIA performance reporting relative to brokers, given that brokers typically point to mutual fund performance (which will not include the broker-dealer's level commission payout) instead of account performance, whereas advisors in an RIA that want to market GIPS-compliant performance track records will still have to follow specific rules requiring a full accounting for fees.

In the end, this shift may still result in a roughly-similar total cost to consumers - whether it's a 1% AUM fee, a 1% commission, or a 1% broker-dealer payout wrapped around clean shares - but the net result nonetheless is that with a shift to clean shares, reported performance for actively managed mutual funds is going to start looking better. Which means in a few years, we may suddenly be talking about how much better actively managed mutual funds are doing again. But it won't be because "the pendulum swinging from passive to active"... or because that's when the Fed started accelerating their rate increases... or whatever else happens economically from here. It will be because DoL fiduciary reconfigured how brokers get paid, reducing the need for 12b-1 fees, reducing the expense ratio of actively managed mutual funds, and improving the reported performance of the mutual fund itself!

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Historically, different financial advisors operated different business models depending on their industry channel - RIAs managed investment portfolios, while wirehouses sold proprietary products and securities from their inventory, and independent broker-dealers sold third-party investment products. Accordingly, asset managers and product manufacturers aligned their investment wholesalers to those channels, with one for wirehouses, another for independent broker-dealers, and a third for the independent RIA community. The challenge, though, is that as the advisor value proposition evolves, along with industry business models, and the regulatory environment, the "traditional" industry channels are breaking down as a way to segment financial advisors!

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we discuss, from the investment wholesaler perspective, the four different types of financial advisors that have emerged, how they differ based on client approach and value proposition, and how wholesalers can best add value to these different types of advisors!

The key issue is to recognize that financial advisors tend to have fundamentally different ways in which we frame our own value proposition, and approach client situations, that are no longer necessarily defined by industry channel. And this matters, because when companies with their own wholesalers are trying to reach advisors, the ways in which an advisor approaches their clients and define their own value proposition heavily impacts what that advisor will and will not see as valuable from their wholesalers!

For instance, some advisors taking a very financial planning-centric approach to clients, while others are more investment-centric. And when it comes to delivering value to clients, some are more advice-centric, and others are more product-centric. Thee various combinations result in four categories of financial advisors: (1) fee-for-service financial planners; (2) investment managers; (3) needs-based sellers; and, (4) asset gatherers.

From the perspective of the wholesaler, it is crucial to recognize that each of these segments receives different value from a wholesaler, and demands different types of products and services. Because if an advisor is an asset gatherer, they are going to want to see a product that can easily help them gather assets... but if they are needs-based sellers, they will want planning strategies and sales ideas... and if they are an investment manager, they will want products that they can manage to demonstrate their own expertise (without outsourcing to other active managers!)... and if an advisor is a fee-for-service financial planner, they will want solutions that help them simplify investment management to free up time to service clients and focus on planning. Thus, investment managers (which might be an RIA or a Rep-As-PM at a broker-dealer) tend to use stocks, bonds, and ETFs, but asset gatherers (which might be RIA or at a broker-dealer) are more likely to use multiple TAMPs and SMA, and fee-for-service financial planners (usually RIAs) will typically just use one TAMP for all of their assets and be uninterested in individual investment products at all!

The bottom line, though, is simply to recognize that the whole advisory industry is in the midst of reorienting itself, and trying to segment financial advisors by wirehouse, broker-dealer, and RIA industry channel no longer works. Advisors are reinventing their value propositions and where they focus, while DoL fiduciary further forces firms to re-draw their lines and tech innovation accelerates these trends. Which means, if wholesalers want to reach financial advisors and add value to them, wholesalers need to pay attention to the four different types of financial advisors!

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