Fiduciary Fixes

In the paper presenting proposed “best practices” for investment fiduciaries, from the Best Practices Board of the Institute for the Fiduciary Standard, the very first paragraph declares that the best practices are intended to be “concrete, verifiable, and understandable.” And the fourth paragraph declares that the proposed best practices are intended “to be understood by Main Street investors.”

From reading through the paper, and considering the training and tools offered by the organization that awards the certification of “investment fiduciary,” fi360, it appears that additional rules and revisions are required to meet the paper’s stated intentions. Following are some additional or replacement rules to do so.

“Expected return” and “return” – In assessing what fiduciary investment advisors are trained to do, the first thing to look at is how they are trained to guide a client toward his best interest – his goal. For this, fi360 says the advisor should have found the “expected return” to meet the goal.

This is not good. “Expected return” is professors’ code for a future return that is not expected. Generally it means there is no such thing – future return is uncertain, and therefore viewed in probabilities, with no particular return likely enough to be expected. Worse, as investment years go by an investment’s actual result is expected to lag further and further below what its so-called “expected return” would deliver; and results become more and more uncertain, with increasing risk of lagging much further below.

So if the advisor tells the client his investment has an “expected return” to meet his goal, he is leading the client to expect a goal result his investment is expected to fall short of.

This is not fiduciary. It is not good for the investor, but better for the advisor because it makes the client more content and placid.

Despite its statement that investment advisors’ communication to clients should be understood by Main Street investors, the best practices paper says nothing about the blatantly misleading use of the term “expected return.” Often, in place of “expected return” the shorter term of just “return” is used which is even worse, suggesting no doubt at all.

Rule A: For an investment’s uncertain future return, an investment advisor should never use the term or label “expected return” or “return.”

“Risk” – In the investment-portfolio comparison that fi360 presents as the basis for selection, one of the two comparison measures is labeled “expected return,” discussed above. The other is “risk.”

Of course, for a client investing for future goals, such as income in retirement, the risk is falling short of those goals – such as running short of money when you’re old.

Clients are commonly inclined to be diverted from that far-future risk to short-term investment-return variations. A major part of the fiduciary investment advisor’s duty is to work to keep the client focused on his long-term goal and risk.

But instead, in its use of the fear-word “risk,” fi360 trains and arms investment advisors to do the opposite – to use the powerful word “risk” for a measure of short-term return-rate variation, potentially inflaming the client’s short-term fear and diverting his focus from his future best interest to the individual year.

This is not fiduciary. For the investor it is not good for his best interest, but for the advisor it is better because with the investor focused on the individual year he cannot see the long-term cost of the advisor’s fees.

Rule B: With respect to investments’ future results, the emotionally-powerful word “risk” should be used only in reference to dollar results for an investor’s goals, not to investment-result variations along the way.

Client’s best interest – The best practices paper states that the fiduciary standard requires the investment advisor to serve the client’s best interest. But it does not say how to communicate assessment of choices for the client’s best interest or even anything about what a client’s best interests are.

In proposed best practice #2 it says documentation should include the analysis applied, but provides no indication of what the analysis should be or reveal.

For almost every investor, the investment result that counts for his best interest is spendable dollar value in years of his future needs and goals. And compared to other investment measures, dollars and years are investment-assessment measures best understood by most investors.

So as a nearly universal rule, a client’s best interest should be defined, assessed, and communicated in net-purchasing-power dollars for future years of his needs and goals.

In view of the uncertainties of investments’ future performance, these should be assessed and communicated in terms of probabilities or other indications of uncertainty and ranges of possibilities.

The analysis that fi360 provides as the basis for investment selection is a comparison of asset-class-mix portfolios, which provides a good range of choices with superior grounds for estimating their future-performance probabilities with less uncertainty than other investments. But the comparison does not reveal or even address how the choices compare for the investor’s future dollar needs and goals. In fact, it does not give any consideration to dollars or years or effects of compounding along the way.

For almost every investor, and almost every advisor, it’s impossible to see from the fi360 analysis-and-comparison which of the investment portfolios are best for the client’s best interest, result probabilities for dollars for years of his future goals. The measures for that fi360 comparison are labeled “expected return” and “risk.” But they are actually respectively return-rate arithmetic mean and return-rate standard deviation, two technical measures of percent return rate for the individual year. What these mean as to probabilities for dollar results for a client’s goals of future years is impossible for almost anyone to see from this fi360 comparison.

This investment comparison is not fiduciary. It’s better for the advisor than for the investor in two ways. It leaves the investor uninformed for judging best choices for the future, and thus feeling wholly dependent on the advisor. And it focuses his attention on the individual year where he cannot see the long-term cost of the advisor’s fees.

Rule C: In almost every case, to pursue an investing client’s best interest the investment advisor should seek choices that offer best prospects for net-purchasing-power dollars for the future years of the client’s goals, assessed in terms of probabilities or other indications of uncertainty. The analysis should assess and compare choices in these terms for communication with the client.

“Asset-class investment” – Commonly a client’s asset allocation is chosen from a range of mixes of whole asset classes defined and performance-measured by indexes. Across the range, compared to other investments these have major advantages for estimating their future-performance probabilities with least uncertainty and risk: decades of return-rate history, and best diversification to minimize dependence on potentially poor performance of any particular business or investment manager.

The client’s asset allocation portfolio is one of these. The way to place the client’s money in his chosen asset allocation is to invest it in those asset classes. This is done by investing in index funds or ETFs designed to match the performance of the indexes that represent the asset classes.

But fi360 encourages investment advisors to, for placement of the client’s money, switch from the client’s selected asset classes to choose from thousands of investments within the asset classes such as less-diversified, shorter-history riskier actively managed funds with higher fees-and-expenses.

Fi360 leads investment advisors to present this switching as if it were faithful investment of the client’s money in his selected asset classes.

And fi360 sells investment advisors short-term data and “scores” on tens of thousands of investments to consider for such switches.

The proposed best practices paper appears to endorse this switching in its proposed best practice #10, which reads as follows: “Have access to a broad universe of investment vehicles that provide ample options to meet the desired asset allocation and in consideration of widely accepted criteria.”

Presenting this switching as faithful investment in the client’s chosen asset classes is dishonest.

In most cases this switching is not fiduciary. It is not in the client’s best interest, subjecting his investment to greater risk and higher fees-and-expenses. But it is favorable for the investment advisor, enabling him to present the work of dealing with vast numbers of potential investments as grounds for magnitudes of his fees.

Rule D: After selection of an asset allocation based on asset classes defined and performance-measured by indexes, the standard accepted vehicles for execution of the selection are funds designed to match the performance of those asset classes as measured by their indexes. Switches from these asset class investments to other investments require full explanations and justifications, including comparison of the investment to be switched-to with the asset class investment being switched-from in performance history, length of performance history, and fees-and-expenses.

Fees-and-expenses – For the client investing for goals of future years, what counts about fees-and-expenses is their cumulative effect in reducing dollar results for the goals. When fees-and-expenses are viewed for just the individual year, they commonly appear insignificant compared to their effects on results for long-term goals. For example, annual fees-and-expenses of 2% can reduce results for long-term goals by a quarter or third or even half.

In proposed best practice #4, requirements for reporting fees-and-expenses are detailed, but require such reporting only for the individual year.

This proposed best practice for fees-and-expenses are not fiduciary. By failing to reveal to the client the long-term cost to him of the advisor’s fees, it is more favorable to the advisor than to the investor.

Rule E: In his annual reporting of fees-and-expenses, the advisor should include a projection of the effect on dollar results for the client’s goals if fees-and-expenses are continued at the same rates calculated the same ways throughout the life of the client’s investment plan to his final goal.

When a switch is proposed, from investment in a client’s selected asset class to some other investment, the appropriate fees-and-expenses comparison is between the investment to be switched-to and the asset class investment to be switched-from. Commonly, fees-and-expenses for other investments are much higher than those for index fund and ETF investments in asset classes.

In proposed best practice #11, investment advisors are told that for a proposed switch, the appropriate fees-and-expenses comparison of the investment to be switched-to is with the population of other investments, which are generally much higher than those of index fund and ETF investments in asset classes to be switched-from.

This proposed best practice is not fiduciary. It is adverse to the investor, and may benefit the advisor, by failing to reveal the relevant fees-and-costs effects of switches, which the advisor may be using as basis for the size of his fees.

Rule F: When a switch is proposed from investment in a client’s chosen asset class to some other investment, the fees-and-expenses comparison to be made is between the investment to be switched-to and the asset class investment to be switched-from.

Dangerous appearance

In their present form, without the additions and replacements presented above, the proposed best practices are remarkably consistent in favoring the interests of investment advisors over those of investors. This is not fiduciary. It conveys an impression of desire to make the benefits of the fiduciary standard go to an empire of well-meaning but mis-trained investment advisors instead of investors.

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