Interesting Note from a Reader

Here is a message I received from an investment professional with over 15 years of experience in the financial services industry:

"There is no question that mutual funds a) act primarily as asset gatherers and b) walk a tight ethical line between fiduciary responsibility and profit generation (ie 12b-1 fees). These are prehistoric, inefficient entities whose mandate is too slightly outperform indexes, all the while creating new gimmicks to source more capital.

"However and unfortunately, these “asset managers” are the only ones with the scale to manage our money. While new competition from the banking industry and new products, like ETFs, are beginning to take market share, the foothold mutual fund have is fairly secure. As such, customers will continue to overpay for under-performance and be subjected to watching more television commercials showing an old married couple riding bicycles as a voice over talks about target date fund benefits.

"The Obama Administration has a full plate, but hopefully they will get around to taking a look at mutual fund practices. There are plenty of rumblings and hopefully, the momentum continues, even as the asset markets rally. With the baby boomer generation wanting and deserving to retire, retirement fund disclosure, clarity and fairness need to be continually addressed. It’s arguably more important than credit card consumer protection efforts.

"The simple matter is that given our few choices for retirement asset distribution, we are forced to overpay for under and lazy performance."

Financial Reform Efforts Gaining Momentum

The effort to enact financial reform seems to be gaining momentum nationwide.

The new energy comes from the deepening recession, continued focus on the results of the bailout of major investment banks and the growing awareness that millions of Americans will not be able to enjoy a secure retirement.

This is the result of the global recession, but there is a difference. The majority of Americans only have Social Security, 401(k) plans and savings to generate their retirement wealth. Housing equity has evaporated and along with it, goes a major source of wealth, which cannot be replaced.

This means there are very limited financial resources for people to retire. In effect, it essentially means millions of people will not be able to retire, or certainly not retire in the style they envisioned.

Hence the need for financial reform, since it affects how America as a society views its citizenry.

As a result, it's appropriate that that the need for reform was advanced by President Obama. In his speech, delivered across the street from the New York Stock Exchange, he called for more responsibility on the part of the financial services industry. But more is needed.

Groups Advocating Reform

Here are some links to key groups which are pushing for reform of traditional financial service industry practices which are working against the average investor and putting the national financial system at risk.

--President Obama's Speech on "a failure of responsibility" and the "structural problems" in the U.S. financial system.

--Aspen Institute paper on "Shot-Termism and U.S. Capital Markets"

--A proposal by House Financial Services industry Chairman Barney Frank to create a Consumer Financial Protection Agency

--The Committee for the Fiduciary Standard which seeks to raise the level of broker accountability and minimize the potential of conflicts-of-interest between brokers and their investment clients. This proposal would improve mutual fund sales standards.

--A proposal by the Corporate Values Strategy Group of the Aspen Institute.

--An innovative approach to local investing, which can be fueled by a philanthropic approach, called the Slow Money Movement also deserves attention.

Mutual Fund Reform and the Law of Unintended Consequences

In a complex society, rules and regulations have an impact far beyond their initial intent.

This would become the case if a reform is enacted which would make brokers follow fiduciary standards.

As cited from the post below ("Do Shareholders Deserve an Even Break?") a fiduciary puts the investor’s interest ahead of their own. In practice, this means a broker would recommend a mutual fund which is most appropriate for a specific client in terms of risk, performance, costs and the thorniest issue, commissions, revenue sharing deals and other under-the-table rebates.

The downside of too many client-financial advisers’ relationships is that are tainted by conflicts of interest. As shown in detail in the Deception Series on this Web site, one fund company paid a revenue sharing commissions to advisers to sell its proprietary fund, in addition to paying them 12b-1 fees. This double commission arrangement has been in effect for a decade and it skirted the issue of authentic, forthright disclosure, as defined in Webster’s.

As ethicist Julie Anne Ragatz, a fellow at the American College Center for Ethics in Financial Services in Bryn Mawr, Pennsylvania, noted, this revenue sharing deal (aka the Advisor Paid Fee), created an unnecessary conflict-of-interest between the investor and their financial professional. This conflict was in addition to the one which existed due to 12b-1 remuneration.

According to Knut Rostad, a member of the Committee for the Fiduciary Standard, this is the right time to advance the adoption of the fiduciary standard for brokers so that investors’ interests can be put before those of the investment professional and the mutual fund company.

As cited by Kathleen McBride, editor of Wealth Manager magazine, and a Committee member, the five core fiduciary standard principles are:
• Put the client’s best interests first;
• Act with skill, care, diligence and good judgment of a professional;
• Do not mislead clients; provide conspicuous, full and fair disclosure of all important facts;
• Avoid conflicts of interest;
• Fully disclose and fairly manage, in the client’s favor, unavoidable conflicts.

Fund Reform and The Law of Unintended Consequences
If this reform, or others which have a similar intent, become part of the financial reform movement, it will re-shape the way load funds are sold.

This is because load-funds largely rely on national sales networks which push proprietary product fueled by revenue sharing deals and 12b-1 fees. Both of these types of compensation create a conflict of interest between brokers and their clients. With a fiduciary standard in place, load-fund wholesalers would have to re-think their business function.

Similarly, what would happen to the practice of revenue sharing if brokers had to present the best possible fund which would also be the best match for their clients? Could they conduct business, while adhering to the fiduciary standards outlined by the Committee for the Fiduciary Standard?

The answer is that business could be done, but in a way which is entirely different from the way it is being conducted today.

Under the current sales-driven load fund sales model, fund wholesalers and their broker reps get the largest share of attention from the mutual fund company's marketing department, while shareholders get the least. This relationship would be reversed if the financial reform debate in Washington heats up.

As this debate become more public, it will also push the mutual fund industry closer to a crossroad. At the junction, the load-fund industry can choose to do business as it has in the past and act as if no recession ever occurred and that actively-managed load mutual funds, including the touted target-date funds, successfully withstood the market's decline through intelligent defensive measures. Or, it can act as if nothing ever happened.

The other choice, which presents itself to a few intrepid mutual fund marketing senior vice presidents who want to think outside the box, is to become pro-active and admit that the load fund business has to decide whether it will act on behalf of shareholders or work to preserve the status quo. That's a choice which will re-shape the industry.

The Lost Decade

Hemingway fans will recall the Lost Generation, which after World War I ended, began to re-evaluate society after the carnage of World War I, the War to End All Wars.

Today, we have the Lost Economic Decade, which as government economists noted in this latest report shows that the average American worker did not show any income growth from about 2000 until the present. In essence, Americans are working for the same wages as they did in 2000.

This raises some serious questions for policy planners, and as we have discussed on this blog, it raises key questions about the load mutual fund business' ability to actively manage risk.

What Are Shareholders getting for their 12b-1 Fees?
It also raises the logical question which investors and corporate 401(k) plan administrators should be asking: If we are paying 12b-1 fees, what are we getting?

President Obama's health care speech yesterday before Congress raised some important issues about how American society wants to handle the welfare of its citizens.

The load mutual fund business should take the initiative and ask questions about its own business practices, especially about ways to make funds more effective, cheaper to shareholders, and demons rate the benefits of active management by becoming more defensive. Then, the load fund companies should do a better job of explaining what they do to their shareholders in plain English.

If not, any shareholder whose load mutual fund, or a hot target-date fund, suffered a loss of around 20% should consider a change to an index fund. Simple enough.

Taking Lessons from California and Florida
Load funds can take a lesson from the states of California and Florida which allow insurance brokers to share revenues with policy holders. This allow a commission reduction for an insurance purchaser in those states.

Revenue sharing and 12b-1 fees cannot be discussed publicly in most load mutual fund companies. they are terrified of the discussion, and rightly so. After all, which load fund CEO wants to explain before a TV camera what they fees actually buy, and how they work to reduce investor expenses. (Remember, 12b-1 fees were originally allowed to be used for that specific purpose.)

Lowering 12b-1 fees, allowing fund companies to share revenue with their shareholder or else reduce overall expenses would revitalize the load fund business. As it stands today, any investment professional knows there are too many load funds which are undifferentiated. Load funds are commodities and should be priced as such.

Instead, the load fund company marketing heads are avoiding some glaring, inevitable questions. These issues should be raised by shareholders themselves, and 401(k) plan corporate administrators. They are the ones who can push for change. There is no better time than the present since it is overdue to try and recoup some of the income losses incurred over the past decade.

Do Shareholders Deserve An Even Break?: It's Time for Brokers to Become Fiduciaries

When an investor buys shares in a mutual fund, how do they know they are getting objective advice from their financial adviser?

They don’t. And that is the root of a serious reform movement which wants to hold broker-deal registered reps to the fiduciary standard. If this new standard is adopted, broker-dealer registered reps will have to alter their first level of loyalty from their firms to their customers.

They also will have to demonstrate that an investment recommendation is both suitable and in the best interests of their clients. Currently, registered reps use a suitability standard which does not manage conflicts of interest on behalf of the investor.

While this may seem like a subtle semantic distinction for most individual investors, investment advisers already must abide by the fiduciary standard.

It is the registered reps of broker-dealers who are generally not following the higher standard which calls for disclosing and managing conflicts of interest which arise when selling investment products.

Basically, a fiduciary puts the investor’s interest ahead of their own. In practice, this means a broker would recommend a mutual fund which is most appropriate for a specific client in terms of risk, performance, costs and the thorniest issue, commissions, revenue sharing deals and other under-the-table rebates.

The downside of too many client-financial advisers’ relationships is that are tainted by conflicts of interest. As shown in detail in the Deception Series on this Web site, one fund company paid a revenue sharing commissions to advisers to sell its proprietary fund, in addition to paying them 12b-1 fees. This double commission arrangement has been in effect for a decade and it skirted the issue of authentic, forthright disclosure, as defined in Webster’s.

As ethicist Julie Anne Ragatz, a fellow at the American College Center for Ethics in Financial Services in Bryn Mawr, Pennsylvania, noted, this revenue sharing deal (aka the Advisor Paid Fee), created an unnecessary conflict-of-interest between the investor and their financial professional. This conflict was in addition to the one which existed due to 12b-1 remuneration.

According to Knut Rostad, a member of the Committee for the Fiduciary Standard, this is the right time to advance the adoption of the fiduciary standard for brokers so that investors’ interests can be put before those of the investment professional and the mutual fund company.

As cited by Kathleen McBride, editor of Wealth Manage magazine, and a Committee member, the five core fiduciary standard principles are:
• Put the client’s best interests first;
• Act with skill, care, diligence and good judgment of a professional;
• Do not mislead clients; provide conspicuous, full and fair disclosure of all important facts;
• Avoid conflicts of interest;
• Fully disclose and fairly manage, in the client’s favor, unavoidable conflicts.

Adopting this higher standard of professional conduct is more important now than in the past since individual investors deserve some objective advice as they resurrect their investment portfolios. Without objective advice, investors can easily be convinced that more expensive, under-performing funds are better suited to their needs than a no-load fund or ETF simply because the investment professional is getting a larger commission to push one fund over a better-suited alternative.


Give the Client a Break
Fiduciary standards are not new. They were originally developed during the Crusades to protect the property of knights who went to recapture the Holy Land. Yet while they were on a religious quest, those who were entrusted to manage their estates during the years they were away from home succumbed to temptation. Their trustees sold the knights’ properties or refused to return them. These bad practices earned the attention of the King of England who pushed for conduct that eventually became the fiduciary standard.

Flashing ahead, fiduciary standards were most visibly injected into the investment business as part of the landmark ERISA legislation in 1973. As a staffer at the Teamsters Central States Pension Fund in Chicago during the mid-1970s, I saw ERISA standards at work first-hand. In one case, pension fund trustees attended a board meeting and as part of their entertainment, changed some golfing items on their hotel tabs, which were eventually paid by the pension fund. This was a clear ERISA violation. It activated an investigation by the U.S. Justice Department, U.S. Treasury, and U.S. Department of Labor.

Years later, a fund company employee saw mutual fund wholesalers charge items which became their personal property on their corporate charge cards to the mutual fund company. These charges were eventually paid from 12b-1 fees, yet this activity was considered perfectly appropriate. Why the double standard?

Here are the specifics of the Committee document, and also a petition to sign which will be sent to the appropriate federal regulators.

Comments can also be directed to Ms. McBride at kmcbride@wealthmanagerweb.com

The Fog at the End of the Tunnel

It was the French social philosopher Alexis DeToqueville who noted around 1835 that Americans are especially optimistic.

Today, as calls are becoming louder that the recession is over and the recovery is underway, we can ask whether this optimism is premature.

We can also question whether the optimists are wrong when they infer that the post-recession economy will resemble ones we had in years past.

What seems to be missing is whether the optimists have addressed the root causes of the sub-prime credit bubble, which led to the current deep, consumer-led recession.

These root causes are part of the systemic excesses which existed in the banking system, the failure of financial self-regulation, and shortcomings in the active management and derivatives use among mutual fund managers.

It is these managers who have been entrusted to increase the retirement wealth of millions of Americans, yet the portfolio declines clearly indicate that something failed to operate properly.

The New List of Problems
In an interview with Nobel Prize economist Joseph Stiglitz of Columbia University, Stiglitz noted that the Federal government’s financial stimulus package ends in 2011. Without a new program with spending in the range of $175 billion to $200 billion, Stiglitz said there is a “serious risk” of another “downward blip” in the economy.

He also said that state revenues should decline further, accompanied by continued softness in commercial real estate. The job market should continue to remain weak, which affects consumer spending. The combined effect is that prospects for a jobless recovery, diminished consumer optimism and volatile markets should make for a very uncertain future.

Then, there is the illusion of prosperity which is a goal of the Fed. But this illusion is being projected to American consumers just as the U.S. dollar continues to slide, and as China, India and emerging nation continue to recover faster than the U.S.

The Sunny Side
The financial industry, however, prefers black-and-white pronouncements, such as the “light at the end of the tunnel,” and “the inevitable turnaround.” These are all shorthand for encouraging investors to re-enter the market for the proverbial buy-and-hold, stay-long, retail strategy.

But the new, post-recession economy will not look like the past. There is a new list of possible forces which can delay any solid recovery:

Among these are:
• Prospects for increasing taxes;
• Shifts in major industries;
• Slow job growth;
• Demographic changes as unemployed people move to new locations nationwide;
• More market volatility due to sovereign debt funds and weaker central banks;
• Excessive reliance on China to hold U.S. Treasuries.

All of these can have an excessive impact on the domestic U.S. economy and portfolio returns.

Looking ahead, investors can expect lower rates of returns on their portfolios. We have already seen a new formula for calculating retirement wealth which includes lower property values (due to tighter mortgage standards and a huge backlog of unsold homes), lower wage growth, higher health care costs, and a lower savings rate.

More bad news comes from workers who have suffered reductions to their 401(k) plans in the form of delayed, eliminated or reduced employer contributions. This should be considered a decline in real take home pay which for most Americans is the only source of retirement savings they will enjoy.

Cutting Social Security and Medicare Benefits
As a result of the increased Federal debt, the elephant in the political room is cutting Medicare and Social Security benefits. In terms of paper debt, $11 trillion in total paper debt, plus Medicare and Social Security debts, the U.S. has never faced this size of financial deficit in US history, according to economist Kent Smetters, a Wharton professor and a former deputy assistant Treasury secretary and economist for the Congressional Budget Office.

The problem with delaying reform in Social adds about $2 trillion to the present value shortfalls in each program, so any delay in repairing these problems can double the existing deficit, Smetters said.

While some have talked about increases taxes on the wealth, raising Social Security cap limits, and taxing fringe benefits, the fact is that the benefits are increasing faster than inflation which makes the system unsustainable.

The biggest problem is Medicare which has 67 times the size of a shortfall than in Social Security. Medicare is a crisis”, he said, and creates a shortfall which is twice as large as all the non-perishable assets in the U.S. And 80% of this shortfall is attributable to Medicare.

Another problem is that Medicare is paid in-kind, which means that medical services are paid for as they are provided. As a result, Medicare is not geared towards paying for half an appendectomy, for instance. This raises the touchy issue of medical rationing, and it has nothing to do with the current debate about the Obama administration’s medical costs proposals.

Hard Choices
Medical rationing is probably the most inflammatory issue in politics. Rationing takes place when people have to decide whether the costs of providing an extraordinary treatment, such as a triple-by-pass to an 85-year-old person is worth the price versus the benefits it can deliver. This is a social-political and ethical problem, which also has a consumer education component where people have to be taught about the lower-cost alternatives versus the costs of receiving extraordinarily expensive medical services.

This bleak scenario should take place in about 20 years, which is beyond the timeframe of most politicians who are most concerned about winning the next election. This will force the educational effort to citizens groups.

The change also will result in a benefit reduction, most likely to high-income individuals who will receive smaller Medicare benefits. This could mean that Medicare and Social Security become flatter in terms of the benefits received versus the amount of money paid into the system, Smetters said.


So what’s the bottom line?
Taxes should increase, accompanied by an increase in government debt, and a corresponding reaction by foreign government debt holders who may re-thing their decision to hold Treasuries as we realize the implications of this debt increase.

This realization will produce a decline in 30-year Treasury yields, an increase in inflation, and a decline in Treasury prices. This decline will affect the Chinese, Japanese and UK investors, as well as future American retirees.