Fiduciary rule threatens fee base

Stricter standards will squeeze demand for some actively managed funds
Best of intentions: US Labor secretary Thomas Perez and House minority leader Nancy Pelosi attend a news conference on the fiduciary rule last April © Getty

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Prompted in part by mounting concern over potential litigation, retirement financial advisers are expected to shift the weighting of assets committed to defined contribution retirement plans still further towards cheaper investment products.

The pattern is going to make actively managed funds that attract higher management fees a harder sell to clients in the foreseeable future.

The US Department of Labor’s new fiduciary rule, which takes effect in April next year, requires that retirement financial advisers put their clients’ best interests before their own.

Independent broker-dealers, who were previously held to a suitability standard — which required that their investment advice merely be suitable to the client — will experience more disruption compared with registered independent advisers, who were already held to a higher fiduciary standard.

The new rule aims to quash attempts by advisers who may have been prioritising their own interests over their clients when they direct them towards products that charge higher fees. That kind of conflict of interest has cost US families an estimated $17bn a year, according to a White House statement made when the rule was announced in April.

“Anything that potentially has the appearance of a conflict is going to be seriously scrutinised,” says Chad Larsen, chief executive of Denver-based MRP, which advised on DC plan assets worth about $3.3bn at the end of 2015. Mr Larsen is among this year’s FT Top 401 Advisers who specialise in such plans.

Index-based equity mutual funds, which are cheaper than actively managed funds, are expected to gain most after the fiduciary rule is implemented.

More than a quarter of 281 FT 401 advisers who were surveyed from June to August by Ignites Retirement Research, a sister company of the FT, say they will increase their use of these investment products because of the fiduciary rule.

The switch away from actively managed funds is already under way — FT 401 advisers increased their clients’ investments in index-tracking US equity funds from an average of 8 per cent in 2014 to 9 per cent in 2015. In contrast, FT 401 advisers reduced their clients’ investments in actively managed US equity funds from an average of 28 per cent of the total to 25 per cent across the same period.

Products that mix active and passive strategies, index fixed-income mutual funds, exchange traded funds and target-date funds — designed so that a portfolio becomes more conservative as a retirement deadline gets nearer — complete the top five ranking of investment products that FT 401 advisers plan to add to their clients’ portfolios.

In contrast, target-risk funds — designed to maintain investment portfolios at a particular level of risk and reward — are expected to suffer the most, with 9 per cent of the FT 401 respondents saying they will reduce their use of these products because of the fiduciary rule.

Variable annuities (offering retirement income pegged to investment performance), actively managed equity mutual funds, brokerage windows (which offer some ability to trade in assets to scheme participants) and accounts managed by individual investors complete the top five investment products that FT 401 advisers plan to scale back.

The higher price of actively managed equity funds is not the only reason they are expected to experience outflows. To a lesser extent, disappointing performance is also to blame.

“At this point, pricing is the driving factor, but if the performance is good, people will not be questioning the price,” says Steven Dimitriou, managing partner at Boston-based Mayflower Advisors, which advised on around $1.6bn in DC plan assets at the end of 2015.

But many actively managed funds are failing to beat their index-tracking equivalents. In the five years to the end of 2015, 84 per cent of managers of large-cap funds, 77 per cent of managers of mid-cap funds and 90 per cent of managers of small-cap funds underperformed the S&P 500, the S&P MidCap 400 and the S&P SmallCap 600 indices, respectively, according to S&P Dow Jones Indices.

“Every year the S&P Index happens to do well will lead to more and more outflow from actively managed equity mutual funds,” says Mr Dimitriou, also among this year’s FT 401 advisers.

Actively managed equity funds will not always underperform their benchmarks — and some individual funds stand out even while the general trend has been bleak in recent years, notes the head of the DC division at one asset management firm. Once actively managed equity funds outperform their benchmarks, pricing may be less of an issue, he adds.

The fiduciary rule does not ban commissions or revenue sharing, but it requires advisers who engage in these fee structures to sign a best interest contract exemption (BICE) and have their client sign it as well. BICE documents and policies must be in place by January 1, 2018.

The majority, or 59 per cent, of the Top FT 401 advisers surveyed by Ignites Retirement Research say any actively managed equity fund with an expense ratio of more than 100 basis points (bps) will raise alarm bells; the threshold is lower at 75 bps for 14 per cent of the respondents.

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