By Cliff Asness of AQR Capital
The Department of Labor’s Fiduciary Rule, which is applicable to retirement plans subject to ERISA such as 401(k) plans and to certain other retirement plans such as IRAs, is set to go into effect in April 2017. What the rule does is extend a fiduciary duty or standard to a broad set of investment advisors (many, particularly at broker-dealers, who were previously exempt) who provide recommendations to such plans. A “fiduciary duty” is the highest standard of care recognized in American law. Among other things it means that you must act solely in the best interest of the client at all times.1
That seems like a no-brainer, right? I mean, who could argue with an advisor having to act in the best interest of his or her client? Well, I’m indeed going to argue that it’s at least less obvious than it first appears. Even if the rule turns out to be a net positive, I’m going to argue that there are potential large unintended consequences to worry about. This is not a screed against such a rule.2 It has some very good qualities (higher standards are a good thing!). It’s just not the no-brainer it first appears to be. Wherever you come out on it you should consider all the arguments, not just the seemingly obvious headlines. After first blush some, hopefully many, may ask themselves something like this: “What’s different here than with many other businesses? I conduct business all the time with people who aren’t legally bound to have my best interest at heart. I count on market forces and my own abilities and vigilance to protect my interests. On net, I think competition and my being an intelligent consumer delivers me a pretty good result.”
Some would say these last comments are naïve and perhaps only apply to “simpler” transactions (the mobile phone salesman is not assumed to be a fiduciary; at least I hope you guys aren’t assuming that she is!). In contrast, I do think markets and competition can handle some fairly complex situations. There are no easy answers here, but there are issues to consider beyond the superficial “hey, it’s great to make people legally promise to act nice!”3
Legislation or regulation that says people must be good doesn’t actually ensure they will be good. In this case the main practical change is to make it easier to sue advisors after-the fact; to lower the burden of proof that they took advantage of you or gave you provably horrible (in a legal sense) advice. Now, surely making it easier to sue advisors for not acting in your interest will indeed make them act more in your interest, right? Well, again, maybe. Perhaps even probably. But still far from definitely. Why not? Well, for one thing, to make this all work we need to generally agree upon what it means to act well or poorly! If you can’t define what is and what is not in an investor’s interest it becomes hard to make things better with this rule. Do we all agree enough on what’s actually in an investor’s best interest to make this rule a fair and equitable way to judge advisors? Investing is a very contentious field with lots of disagreement over even the very basics and it has lots of randomness, so this is not a no-brainer.
Now, there are some possible actions that would “not be in a client’s best interest” that seem staggeringly, obviously bad. For instance, a very large amount of “churning” of a client account at high fees and/or commissions might qualify (though we still need to define when churning kicks in). Putting all of an old widow’s nest egg in a single tech stock seems provably horrible. I would certainly agree. But the more obvious the offense the more likely it would’ve met the old standards of malfeasance (i.e., you could always sue for clearly fraudulent or outright thieving actions without this upgraded fiduciary standard). All of the action, all of the intellectual and legal dispute in the new proposed rule versus the old way, occurs in the much more difficult cases to judge. We all probably agree on the obvious ones and they are not the examples we should look towards here as little is changing for those cases under the new rule.4
So, what do I worry about? What are the more ambiguous cases that might turn out differently under a fiduciary standard versus the regular old one? Meaning, in what instances might we now hold an advisor liable for “not acting in a client’s best interest” but wouldn’t have under the old suitability standards? More important to my argument, in what ways might upping and broadening the standard instead create other problems for investors? I can think of four prominent possibilities. First, judging investments too much by ex post performance. Second, not judging investments in a portfolio context. Third, over-emphasizing low fees as always being in the client’s best interest.5 Fourth, judging innovative investing approaches more harshly than conventional ones. On this last point, a strong analogy can be made to our very litigious society requiring doctors to practice “defensive medicine” — that is not done to protect the patient’s interest but to protect the doctor’s. I don’t predict this will happen here, I simply fear the possibility.
Being a fairly quantitative person, I will posit a simple example to kick off my point. Imagine you are presented with an investment for possible addition to your portfolio. It has a 2/3 chance of doubling your money but a 1/3 chance of losing it all. And which outcome occurs also happens to be absolutely unrelated to anything else in the world (i.e., “it’s uncorrelated to anything”). Would you add such an investment to your portfolio? Well of course you would. How much is a real and separate question, though. Most of us wouldn’t put in all, or even a very large fraction of our wealth in such an asset as the “1/3 chance of losing it all” is just too great. But everyone would probably add at least a little because the expected return is so great.
So where does such an investment possibly run headlong into a fiduciary standard? Well, 1/3 of the time you lose all your money! If investments are judged at all ex post, and I hope we can all agree they often are, a perfectly rational investment could be considered “not in a client’s best interest” after the fact and the hired manager be placed in jeopardy for doing what was clearly rational and, at the right size, advisable.6 Note there are two investing errors going on here. One is the obvious ex post evaluation of something that was clearly a good idea ex ante. The other is subtler but ubiquitous. It’s not judging something in context of an overall portfolio. Putting 100% of a client’s wealth into even the wonderful gamble I’ve presented may very well be “not in their best interest” even ex ante (and even if it works ex post it was not in the client’s best interest