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Sometimes advisors fail as fiduciaries. Sometimes they fail spectacularly.
The process by which advisors select a turnkey asset management provider (TAMP) is the latest illustration of fiduciary failure, and the SEC has responded with ominous rulemaking that will have questionable value to our profession.
A good example of that failure is the use by advisors of high-fee mutual fund share classes when another share class with lower-fees is available. Not that long ago, advisors were regularly pocketing 12b-1 fees at the expense of their clients.
The practice was so pervasive the SEC went on the warpath to clean it up. It launched a months-long amnesty program that allowed offenders to give themselves up and initiated a wave of high-profile enforcement actions to punish scofflaws who didn’t take advantage of it.
Did it succeed in eradicating the practice? Hardly, but it eliminated many egregious cases and contained the practice by making examples of those who harmed their clients.
Why did the SEC need to take these actions? It was such an obvious breach of fiduciary duty to load a client’s portfolio with funds that harm the client and benefit the advisor.
The SEC outsourcing rule
A new version of the same story is now unfolding.
Selecting a TAMP to manage your clients’ assets is a fiduciary decision. This is obvious.
TAMPs manage client assets just like mutual funds and ETFs. Advisors have a fiduciary duty to perform due diligence on any fund they put in a client portfolio, so why wouldn’t they have the same duty in selecting a TAMP to manage their clients’ assets?
Apparently, many advisors either failed to see this or just didn’t care enough to do anything about it. The problem was so obvious that I made a prediction last year in this publication:
Soon – within the next two years – the SEC will wake up and start holding financial advisors who use TAMPs to the same fiduciary standards they hold them to in selecting mutual funds, ETFs, and other investment products. When it does, many advisors will be in trouble.
Both parts of my prediction came true. The SEC woke up and many advisors will be in trouble.
Rather than launching an amnesty program, issuing a risk alert, or initiating a wave of enforcement actions, the SEC issued a proposed rule on outsourcing by investment advisors.
The proposed rule is quite broad. It covers outsourcing to TAMPs and to a range of other service providers.
The proposed rule requires advisors to:
- Have processes and procedures in place to manage due diligence activities;
- Perform a thorough due diligence examination before hiring a covered service provider;
- Outsource to a service provider only when it is in the best interests of the client;
- Monitor the selection on an ongoing basis to ensure it continues to benefit clients; and
- Keep books and records to document and justify the process.
The rule, if enacted, will be burdensome to advisors who outsource. Approximately 32% of RIAs and 50% of IBD reps outsource some portion of their investment management according to a recent survey. The percentage that outsource one or more other covered services is even greater. All outsourcers will be saddled with the rule’s detailed requirements.
All manner of industry groups and advisory firms have raised objections to the perceived overreach by the SEC. They see it as a rule in search of a problem.
They are correct in saying the rule will be burdensome and adversely impact many advisors who are doing nothing wrong. But they are wrong in saying there is not a problem that needs addressing.
The nature of the problem
Thirty years ago, when I started in the TAMP business – long before the term “TAMP” had been coined – the outsourcing of portfolio management was a straightforward proposition. A handful of firms that saw themselves as investment management organizations offered to use their expertise to manage portfolios for financial advisors who either weren’t skilled at portfolio management or wanted to focus on other activities like client service and acquisition.
As competition in the TAMP space increased, players sought to differentiate themselves. Some developed “supermarkets” that offered the portfolio management services of a variety of managers. These organizations were not so much investment management organizations as they were distribution vehicles for other managers. They catered to the crowd.
Others developed extensive offerings of “value added” services for advisors. Those included practice management training, marketing support, web development services, and a range of other services that benefited advisors who brought their clients to the TAMP, but were of questionable benefit to the clients who were paying the TAMP’s fees.
Later came the robo-advisors, who emerged from the technology world, not the investment management world. They brought tremendous efficiency and ease of use to the TAMP world, but their ability to serve as a fiduciary to their clients was questionable. They never met nor spoke to their prospects before or after they became clients. They just plopped them into a portfolio based solely on the answers to an eight- to 10-question risk tolerance questionnaire.
As more advisors experienced the benefits of outsourcing and it grew in popularity, TAMPs proliferated. Many of the newer firms have questionable investment credentials, offer risky investment strategies and portfolios with high expenses, and charge high fees for their services. Yet they hold themselves out as fiduciaries qualified to manage assets for the clients of financial advisors. And advisors bring their clients’ assets to them.
Advisors have also contributed to the problem. Many who use TAMPs don’t treat the TAMP selection process as a fiduciary decision. They don’t conduct adequate due diligence when they select a TAMP and those that do often don’t update their due diligence files.
I’ve been in the TAMP business for quite a while. I can’t tell you the number of times an advisor has said, “I love your firm, but repapering all my client accounts is just too much work.” Or, “I love your firm, but I don’t want to discuss a change with my clients – let sleeping dogs lie.” Or, “I love your firm and, yes, your fees are lower, but switching is a lot of work and I don’t benefit from your lower fees – my clients do.”
It is into this environment that the SEC steps, looks around, and says, “Let’s clean this mess up.”
Being a fiduciary
Being a fiduciary is about values and attitude. It’s not, and shouldn’t be, about rules and regulations. But the SEC can’t change anyone’s values or attitude. It can only make rules and regulations. It’s a poor substitute, but the commission has a limited tool set.
If the outsourcing rule becomes law, it will be unduly burdensome and will increase the costs of doing business, especially for small advisors. It will be bad for clients in that it will discourage some advisors from outsourcing who really should be putting investment management decisions in the hands of experts. Worst of all, it will transform the fiduciary standard, which should be a principles-based standard, into a crude, one-size-fits-all rules-based standard.
Many in the TAMP industry and many TAMP users invited this problem. Yes, being a fiduciary is hard work and occasionally means making a little less money. But we can’t expect the SEC to sit on the sidelines if we don’t live up to the high standards expected of fiduciaries.
If our industry glorified honor, integrity, hard work, and client-focus more than it glorified bigness, growth, and making a buck, we wouldn’t find the SEC helping us in the kitchen.
Scott MacKillop is CEO of First Ascent Asset Management, the first TAMP to provide investment management services to financial advisors and their clients on a flat-fee basis. He is an ambassador for the Institute for the Fiduciary Standard and a 45-year veteran of the financial services industry. He can be reached at [email protected]
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