As advisors and brokers amongst you are well aware, the D.C. Court of Appeals recently hosted the regulatory equivalent of pro wrestling’s “Smack-Down”.  The result – a defeat for the SEC – was hailed by some as a “long-shot victory” and a “stunning reversal of events“.  And the SEC’s decision not to appeal a court decision put a final nail in the coffin of the controversial “Merrill Rule” just last week.  The result is a clearer delineation between brokers and financial planners, thus removing one common barrier to alpha-centric investing for many retail investors – confusion.

The rule was initially adopted by the SEC in 2005 to allow broker-dealers to offer fee-based brokerages accounts without the requisite fiduciary responsibilities faced by fee-based financial planners (although certain other requirements were mandated in the place of those fiduciary responsibilities).  Naturally, trade groups like the Financial Planners Association (FPA) cried foul, arguing in their capacity as de facto “advisors”, these broker-dealers faced a conflict of interest between their role “advising” clients and their role selling securities on a commission basis.

Going toe to toe with the FPA was the Securities Industry & Financial Markets Association (SIFMA) which was “outraged” at the SECs decision not to appeal the ruling.  You can see from SIFMA’s statement just how P.O.’d they were at the SEC’s decision not to get up off the matt:

“SIFMA today expressed its outrage when it became known (that) the Securities and Exchange Commission would not ask for a rehearing in the case…”

The broker-dealer industry says it now has to convert over one million fee-based account clients either back to traditional commission-based accounts or change those accounts to a properly-registered advisory subsidiary (various examples) .  To give them a hand with this mammoth task, the SEC recently asked the courts to issue a brief stay of execution for the rule.

To show that there are no hard feelings, the FPA and its financial advisory compatriots sent the SEC a list of recommendations for what it should do now.  For starters, says the group, the SEC shouldn’t allow broker-dealers to exploit a loophole whereby financial advisory services are deemed only “incidental” to brokerage services.  (It’s not clear if the SEC welcomed this kind advice.  But if so, it would have been sort of like little-leaguers shaking hands with the opposing team and muttering “good game” after getting creamed 20-0.)

One of the signatories to this make-up letter was the National Association of Personal Financial Advisors (NAPFA).  This group minces no words as it describes its view of the world on its website:

“A financial planner who has a financial stake in the course of action that he/she recommends to a client faces an inherent conflict of interest and cannot be considered objective and unbiased. This is true even if the planner truly believes that he/she has only the best interests of the client at heart. Unfortunately, the vast majority of financial advisors in the United States are sellers of financial products.”

Planners argue that this decision reduces potential conflicts of interest.  But we are also sympathetic to NAPFA’s position on more mercantile grounds.  Generally speaking, fee-based planning enables greater investor choice by removing indirect compensation from the equation.  And by “greater choice”, we mean more ETFs and alternative investments and less high-priced, high sales commission, index-hugging mutual funds.

While brokerage commissions on advisory accounts represents just one form of indirect compensation, any form of compensation not directly paid by a client (such as trailers, commissions, 12b-1 fees) has the potential to confound alpha-centric portfolio management by making overpriced beta just too lucrative for advisors to avoid.  Research shows that many mutual fund companies have morphed into providers of beta over the past few decades.

Advisors know this - but what advisor wants to get off the trailer-powered gravy-train and put her clients into less lucrative ETFs? I had lunch recently with several large advisors who fully believe in alpha/beta separation, but who expressed frustration that adopting an alpha-centric mentality would entail sacrificing a significant portion of their commission income.

But for those able to adopt it, fee-only business is also more defensible one in the long run.  When fees for advice are transparent and not buried within other charges, advisors can rest assured that they will always be compensated directly for what they do – advise.  And in doing so, they could sell both pure passive (e.g. ETFs) and pure active (e.g. hedge fund) investments without worrying about which one pays more.  (See related posting on similar phenomenon in the travel industry).

So while the striking down of the Merrill Rule certainly doesn’t solve all of these problems, it’s a step in the right direction.

View FPA “Fact Sheet” on the Merrill Rule