Graham Westmacott CFA

Portfolio Manager

Susan Daley CFA

Associate Portfolio Manager
  • T519.880.0888
  • 1.877.517.0888
  • F519.880.9997
  • The Marsland Centre
  • 20 Erb St. W,
    Suite 506
  • Waterloo, Ontario N2L 1T2

Fiduciary Alpha

What is a fiduciary and why does it matter for investors?

While sharing lunch with a competitor recently I spoke about some of PWL’s initiatives to promote fiduciary standards for independent investment advisors in Canada. A fiduciary standard is one that puts the client’s interest ahead of the advisor. His response was simply, “That’s great, but you can’t sell ethics.”

If I had been quick witted enough then I should have responded by noting that not everything of value is for sale, but I missed my chance. So, aside from the ethical argument of doing the right thing is there any evidence that a fiduciary responsibility is of benefit to clients? In the same way that funds that outperform their benchmark are described as having positive alpha, is there fiduciary alpha and, if so, where does it come from?

Into the ring steps the Office of The President of The United States with a report published in February 2015 titled “The Effects of Conflicted Investment Advice on Retirement Savings”. Conflicted advice is defined in the report as payments to the advisor that depend on decisions taken by the client based on recommendations by the advisor: commissions paid by mutual funds would be a common example. Advisors who do not accept conflicted payments may charge an hourly rate or a percentage of assets. The report reviews the academic literature comparing the behaviour of groups of advisors who have a fiduciary responsibility (Registered Investment Advisors or RIAs in the U.S.) with those who offer conflicted advice (brokers) and comes to a number of conclusions:

  • Conflicted advice leads to lower investment returns. Savers receiving conflicted advice earn returns roughly 1 percentage point lower each year after fees (for example, conflicted advice reduces what would be a 6 percent return to a 5 percent return).  
  • For a retiree, the impact of lower returns from conflicted advice can be measured either as a reduction in income or a reduction in the time the portfolio would last, compared to what would have been achieved with fiduciary advice. The report uses the example of a saver who takes constant withdrawals (adjusted for inflation) over 30 years. In this instance, the saver has to choose between suffering a 12 percent decline in income to maintain payments over 30 years or maintaining their income but suffering the prospect of running out of money after only 25 years.
  • The authors estimate the aggregate annual cost of conflicted advice in the US is about $17 billion each year. 

Other studies have estimated that the difference in cost between actively managed funds and passively managed funds in the U.S. is 0.77%. This suggests that three quarters of the cost of using conflicted advice could be avoided if conflicted advisors recommended passively managed funds. Of course they don’t do that because index funds don’t pay commissions so it is not in the advisor’s economic interests. Does that mean a conflicted advisor would recommend active funds to someone who was already invested in passive funds?

In a mystery shopper study in 2012, researchers sent hypothetical investors to financial advisors largely reliant on conflicted payments for their compensation to investigate the type of advice provided. The mystery shoppers presented one of four current portfolios to advisors. One was a diversified low-fee portfolio constructed from low cost index funds.

When presented with the client with the diversified low-fee portfolio, in about 85 percent of cases the conflicted advisors recommended a change.  The authors concluded that conflicted advisors “seem to support strategies that result in more transactions and higher management fees,” even when clients appeared to hold the optimal portfolio. 

Most people pursue their economic self-interest whether they are advisors or clients. So the surprise is not the behaviour of conflicted advisors, but the surprise is that their clients stick around when it is in their economic self-interest to move to a fiduciary.

We can do just fine selling ethics.

By: Graham Westmacott | 0 comments