January 26, 2017
What We’re Reading This Week
There are two hurdles in understanding the fiduciary standard. 1) You have to know what the fiduciary standard is and 2) you have to know how it affects you. Simple explanations are best at explaining what it is but fail to illustrate the how it affects you. That part sort of requires imagination and experience in the financial services industry. One can say, “A fiduciary standard is when your financial advisor is obligated to act in your best interest,” but the antecedent thought is typically, “I think my advisor does that…” Having worked as an advisor that wasn’t obligated to act in a client’s best interest (but chose to) I can tell you: your advisor is not acting in your best interest. Even if they want to. An advisor is only as good as the resources available to them and, for many, a large firm controls those resources. Case in point: Morgan Stanley is rumored to have asked ETF providers to pay them distribution fees or be blocked from their platform. What does that mean? In the typical world of retail investing there are three roles: investor, trader, seller. Obviously, this is a vast simplification but really, those are the big three. So how does the transaction work? Typically, the investor (you) pays the seller… and the trader, too. The trader also pays the seller in the form of distribution fees or revenue sharing agreements, although this money actually comes from the investor. So the investor pays the seller twice. This is easy in a mutual fund as they typically have large enough internal expenses to cover all the payments they need to make. Lately investors have gotten together and said, “After my mutual fund pays everybody my returns were barely (if at all) above a simple index. I should have just bought the index.” As such, ETFs became more popular but ETFs also do not have large internal expenses and do not pay revenue sharing. To go back to our model, the trader stopped paying the seller! As a seller, Morgan Stanley has decided they want to have their cake and eat it too. They want investors to pay them for advice and they want traders (ETFs) to pay them for being part of that advice. Let’s bring it home. An individual advisor at Morgan Stanley may really want to do the best thing for their clients but the firm itself will remove lower cost investments from their platform and only allow investments that pay fees to Morgan Stanley. Fees that are ultimately paid by the investor.
More on Funds
If you say the heading quickly it sounds like “moron funds.” Go ahead, I’ll wait. As long as we’re talking about mutual funds and ETFs let’s discuss another difference – taxes. This comes up in meetings all the time and I can say that most people have no clue how mutual fund taxes work. I can remember explaining this to new advisors and their typical response was, “Wait, what?” When you buy almost anything except a mutual fund, you pay taxes when you sell it. That’s called a capital gain. When you sell a mutual fund you also have that capital gain. Here’s where it gets tricky: the manager of the mutual fund also has capital gains because they will buy and sell securities throughout the year. In practice, an investor could have a loss on their investment but still have a capital gain. Because these gains are distributed to the shareholders in November and December, you could buy a fund and hold it for one month but still be responsible for 12 months’ worth of taxes. Let’s not even talk about capital loss carry forwards. ETFs don’t work this way, they work the other, normal way. This makes fund companies wish they were ETFs and they try to turn their funds into ETFS, which results in a weird alchemy-like process. So here’s a story about JP Morgan wanting to do something like turn a fund into an ETF. They mostly talk about how JP Morgan doesn’t want to be transparent. Funds are inherently complicated but ETFs are not and one of the primary concerns that fund managers have is that their secret, proprietary trading methods would be exposed if they were an ETF because they would have to disclose their positions daily. This is a big concern for fund managers but feels wildly exaggerated to me. It reminds me of that person that always makes sure their car door is locked even though they drive a Honda Civic (I am this person). My wife teases me, “Do you really think someone is going to steal your dry cleaning?” My response is always yes. I am afraid of that. I’m not really sure what these guys are afraid of; I guess maybe they are concerned that someone will develop “generic” brand funds? Like instead of Cheerio’s they have Oat Rounds or something equally silly but for investments. That sounds really great. Mostly because I would really like to see a brand loyal investor – I’m not sure what that would look like.
GM just settled with the Justice Department over the ignition switch recall fiasco of 2014. If you recall, in February of that year GM recalled ignition switches in Cobalts and G5s because they would shut off the engine while driving and sometimes disable airbags during a crash. The trouble was that they figured out the problem in 2012. Discriminating readers will note that 2014 is after 2012. That’s a problem for drivers and ultimately the Justice Department had an opinion about that – the fine was $900 million. Interestingly, the SEC also had an opinion. Admittedly, it was a slightly different opinion than the Justice Department. GM knew about the defective switches in 2012 and they told their accountants about it in November of 2013, which was a little late to the game, in terms of the recall. See, what the SEC is saying is that GM didn’t give the accountants enough time to measure the impact of the recall before announcing it. While at first blush it seems like GM waited too long to tell drivers that they could be killed while driving a Cobalt, the SEC is of the mind that they should have waited longer. Now, to be fair the SEC disclosure does not read that way, mostly because it would sound monstrous, but that is the message. The actual wording penalizes GM for failing to “consider relevant accounting guidance when it came to considering disclosure of potential vehicle recalls.” See? They needed to consider their considerations. The fine was only $1 million and so it sort feels like the SEC just had a bill to pay or something so they threw a fine at GM. For a company in this position it probably just seems more affordable to pay the fine rather than an attorney (team of attorneys). Thanks SEC!
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