In most movies, it’s not hard to spot the villain. After the obligatory introduction of the beleaguered hero, the scene shifts and the ominous music kicks in. There stands a haughty figure, destroying lives just for the fun of it, and it’s readily apparent that this is the film’s bad guy. If only it was so easy in real life. In everyday circumstances—particularly when it comes to complex endeavors such as investment management or legal matters—the true villain is rarely so obvious. More often, the apparent bad guy is actually the scapegoat. It’s human nature for the actual bad guy to remain hidden, after all.
Take, for instance, the average Registered Investment Advisor (RIA). It seems as if they’ve become the punching bag of the investment world lately. Forced to navigate mounting compliance obligations due to changing standards while also dealing with the regulatory and legal fallout from peers failing to meet their obligations, RIAs are subject to increasingly prescriptive rules that impact how they run their businesses. In the old days, things were easier. The sheer availability of investments was different and more institutionalized, meaning the role of the SEC and DOL was different, as well. As the investment landscape experienced a democratization of information, however, the scope of the regulator’s purview also expanded and changed. In turn, advisors were forced to keep up with new regulations. These can pose a significant strain as advisors are increasingly required to dedicate more time and resources to compliance-related issues while also trying to provide the best investment advice they can.
Meanwhile, lawsuits, regulatory actions, and industry-wide sweep examinations are constantly evolving these obligations, as well. Over the past 10 to 15 years, not only have advisory firms seen more regulations added to the books, but the regulatory bodies charged with enforcing those regulations have appreciably increased their enforcement activity. Even in cases where an advisor has done nothing wrong, an unsavory headline can result, regardless of the eventual outcome of the regulatory action or trial. This is human behavior at work, of course—shocking headlines sell and people often believe the first thing they read, regardless of the truth.
In a World with such a Rugged Investment Landscape…
It’s a modern problem with historical roots. Investment advisors have been held to a federal fiduciary standard at least as far back as 1963. This fiduciary standard imposes upon advisors an, “affirmative duty of ‘utmost good faith, and full and fair disclosure of all material facts,’ as well as an affirmative obligation to ‘employ reasonable care to avoid misleading’” their clients and prospective clients. Fundamental to the fiduciary standard are the duties of loyalty and care. The duty of loyalty requires an advisor to serve the best interests of its clients, which includes an obligation not to subordinate the clients’ interests to its own. An advisor’s duty of care requires it to make a reasonable investigation to determine that it is not basing its recommendations on materially inaccurate or incomplete information.
While the overall scope of these principles is relatively clear, the application of these principles in real life was not always as easy to predict. Regulatory bodies were forced to oversee an ever-evolving investment landscape and advisors, in turn, needed to respond as best they could. This uncertainty resulted in sporadic guidance on these duties over time through rules, interpretive statements, and orders issued in enforcement actions. This form of regulation-through-enforcement led to confusion among advisors as to how exactly they needed to behave.
As an example, broker-dealers have historically been held to a different standard (a suitability standard). Naturally, investors were confused about the distinctions in the duties owned to them by investment advisors, financial advisors, brokers, financial planners, investment planners, wealth advisors, etc. Regulators attempted to address the confusion, with the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). And next, on January 22, 2011, the SEC submitted to Congress a staff study recommending the adoption of a uniform fiduciary standard of conduct for broker-dealers and investment advisors.
Then, on June 5, 2019, the Securities and Exchange Commission adopted a package of rulemakings and interpretations designed to enhance the quality and transparency of retail investors’ relationships with investment advisors and broker-dealers. Individually and collectively, these actions were designed to enhance and clarify an advisor’s standards of conduct and help retail investors better understand the services offered. While beneficial, they represented more hurdles for the average RIA.
Further complicating matters were new requirements in 2020 concerning Environmental, Social and Governance (ESG) investing. Suddenly, it wasn’t enough for a client to be interested in a company’s governing principals—advisors needed to ensure that such an investment would perform as well as a non-ESG related alternative. Depending on one’s interpretation, this might’ve spurred on ESG investment or significantly curtailed it. These remain very much a work in progress.
Add it all up and RIA’s heads were left spinning just trying to figure out what rules and requirements applied to them. Suffice to say: as a result of all these changes and new pronouncements, RIAs are now spending a lot of energy heading off compliance risks and looking over their shoulder.
New Twists in the Investment Storyline
Yet the RIAs’ travails don’t end there. You see, there was a reason RIAs are held to the higher fiduciary standard of loyalty and care than the suitability standard traditionally applied to broker-dealers: recommending a suitable security is a very different process than providing wholesale investment advice based on a client’s total needs. Yet that difference is, nonetheless, gradually blurring. With the emergence of discount brokerages and technology-dependent options, investors now have the chance to bypass advisors entirely. It can be debated whether this is for the betterment of the investor or not. But the point remains that the premium paid for their advice is being eroded. It’s as if RIAs are in a fight for their lives with one arm tied behind their back.
So, if RIAs aren’t the real villains, does that mean the SEC and the DOL are? Well, no. They definitely aren’t. Their duties and resultant regulations are well-intentioned and, often, truly needed for individuals or firms who can’t or won’t govern themselves properly. If not them, then what about discount brokerage options? Are they the bad guys? No, they aren’t either. So-called ‘robo-advisors’ simply represent a technological shift that might prove beneficial or foolhardy with time.
Avoid the Real Investment Villain
The real villain? Just like in the movies, the true villain is obvious in retrospect.
It’s risk. Pure and simple.
Think of it this way: new regulations and lawsuits usually only come when an advisor loses money. Otherwise, everything’s fine. Similarly, the pressure discount brokerages are applying to advisors exists principally during a market upswing, not when everyone is losing their shirts. So, taking these concepts one step further, it seems as if adverse outcomes merit a particular caveat for an advisor: new regulations and lawsuits usually only come when an advisor loses money…and when he or she can’t answer WHY they lost money.
It’s also an age-old problem. This shift from explaining what investments were made, to why they were made is a colossal difference. And it’s a test that many RIAs fail. This is human behavior at work, as well, just like the theater goers who failed to discern the actual bad guy in the film. And it’s because these advisors have an improper understanding of how the hero and the villain operate in the course of a tale. It’s easy to be a hero—everyone loves a person that’s making them money. But when one is cast as the villain, the messaging becomes vitally important.
Nowadays, to avoid being the villain, RIAs need to show their clients something they haven’t seen before. And, if that investor loses money, it’s critically important for the advisor to explain exactly what happened. It’s not enough to say that other people also lost money—a justification often used for passive investments with low fees. That investor is paying that advisor a different set of fees for their advice and those fees need to be justified.
So, what explanation can turn a villain into a hero? A successful RIA must rethink risk entirely. In years past, an advisor could rely on track record as a crutch. In order to steer clear of potential trouble with the SEC or DOL, an advisor could point to an asset manager’s history beating the benchmark in, for example, three out of five years. It perfectly satisfied the “what?” question. But nowadays, if pressed on the “why?” question, advisors would likely be at a loss to explain. Compare it to how an investment in CDOs was viewed in 2006 to how it was viewed in 2010. In the former, track record was the perfect justification as the investment continued to notch higher. In the latter, however, such an explanation falls apart in the face of the market meltdown. Advisors who couldn’t explain the “why?” looked like fools.
Today, RIAs must demonstrate a thorough understanding of the products they’re recommending. They must be prepared for potential bad times and be ready to explain exactly what happened. Track record is no longer enough. A random guess on a coin flip can occur three out of five flips but that gives no assurance about the result on the sixth—past performance may’ve been the result of luck, market mania, or sheer randomness. In effect, a back test with a solid thesis to support it is more valuable than a track record without one. That way, if public perception tries to cast that RIA as a villain, such efforts might be akin to throwing barbs at an anti-hero like Severus Snape. He or she may seem like an easy target, until it comes to light just how prepared and well-intentioned that advisor truly was.
Investment Hero or Market Villain—Which One Are You?
In our view, the entire asset management business needs to be re-imagined, starting with how we think about risk. Human behavior is impacting the market in unexpected ways more and more every day. Traditional risk metrics are outdated, however, and leave investors vulnerable to newly created risks involving retail investors, herd mentality and the democratization of information. A company’s beta, P/E ratio, or price-to-book wouldn’t have saved investors from monumental losses on wild short-squeeze swings created by such human behavior.
At New Age Alpha, we provide solutions with advisors in mind. We offer a unique investment story that works across asset classes and geographies. Using an actuarial process similar to the insurance industry’s approach, we focus strictly on known information rather than unknown information. Think of it this way: insurance actuaries don’t ask if you intend to go to the gym or if you intend to quit smoking. They simply ask if you smoke or if you go to the gym. They underwrite risk only on known available information. Similarly, we seek to avoid companies that will fail to deliver the growth implied by the stock price. It’s just that simple. Utilizing this approach, we crafted an innovative tool that offers advisors and investors the hands-on ability to see our methodology at work. The tool lays out the investment story and thesis in an easily comprehendible design that can be envisioned together or independently. In essence, it’s an advisor’s thinking…but with our solutions.
At the end of the day, an advisor’s role now comes down to the “why?” more than the “what?” Why did you pick that specific investment? Why did it carry those expenses? Why couldn’t you find a better one? Because, if you as an RIA can’t answer those questions, the swerve from hero to villain might be out of your control.
New Age Alpha is a global leader in building actuarial based asset management solutions that aim to inure investor portfolios against an idiosyncratic risk caused by human behavior. Investors are unaware of this risk that leads to loss, cannot be diversified away, and don’t get rewarded for taking it. Unlike firm specific risk, that can often be diversified away, this risk affects stock prices specifically and we believe is caused by human behavior. Through our research we have identified a differentiated source of alpha that is uncorrelated with traditional risk factors and managers, and as the foundation to our investment approach, we have built a range of actuarial based asset management solutions that aim to mitigate and inure investors’ portfolios against this risk.
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