The Labor Department’s “fiduciary rule” is widely expected to be a boon for the exchange-traded funds industry, with low-fee index-based products seeing the bulk of what could be trillions of dollars in inflows.
The question is, where does that leave other fund categories?
The standards set by the new regulation require that the financial advisers and brokers who handle individual retirement and 401(k) accounts must act in the best interest of their clients. While the rule will be interpreted differently at various firms, it is generally agreed that the cheapest and most transparent options must be recommended over other investments.
“Cheapest and most transparent” certainly applies to the kind of passive ETFs investors have been trending towards. Not only is this category constructed in ways that are easy to understand—the funds are pegged to specific and familiar benchmarks like the S&P 500—but major providers have dropped their fees for these products repeatedly, to the point where some view the market as being in a “race to zero.” Furthermore, research has shown that a vast majority of non-passive investments, including actively managed funds and “smart beta” products, underperform over the long term, even before the higher costs of those strategies are factored in.
The scrutiny is expected to be far greater on mutual funds and hedge funds, whose fees tend to outpace even the most expensive ETFs due to their structure, including multiple share classes, and tax inefficiencies. Still, the fact that non-passive categories tend to underperform while being more expensive could make them harder to justify.
Ryan Sullivan, vice president of global ETF services at Brown Brothers Harriman, said the Labor Department’s regulations would mean “added due diligence—on every investment product—to ensure that the adviser is acting in the best interest of the client.”
He added, “I don’t think this will mean shying away from smart-beta or active funds, but as complexity increases, there will be more demand for better education and a better of understanding of how these funds trade and what their risk/return proposition is.”
Active funds are where the components are chosen by an individual or team, while “smart beta” funds use rules that are designed to deliver a particular investing strategy like “low volatility” or “momentum.” Some variations on the typical market-cap-weighted strategy have demonstrated good results relative to their underlying benchmark, but questions remain over whether the coming regulation, which is slated to take effect in April, will limit or stall the widespread adoption of non-passive categories.
The Labor Department’s rules don’t define what level of fee would qualify as unreasonable, nor do they specify what time frame or market conditions should be used for determining whether an investment adds value. Analysts have said this creates a lot of uncertainty, noting that individual investors will have unique risk appetites, investment goals and time horizons. Because of this, there is a question of how or even whether non-passive funds should fit into a portfolio.
“There’s some denial by the people doing strategic beta, thinking that if they can keep up with their benchmark they’ll be fine. But after a while, people will ask how good that strategy is, and if it underperforms a broader-based strategy for five years, then you can’t claim that you’re adding value,” said Paul Ellenbogen, head of global regulatory solutions at Morningstar, which refers to smart beta as strategic beta.
Under the new rules “you can either be a good active manager, which means you can charge a higher fee, or you can be passive and therefore cheap. With strategic beta you’re trying to fudge the difference, and that could be dangerous.”
Thus far this year, passive ETFs have seen inflows of $156.59 billion in the U.S., according to Morningstar, bringing their total assets to $2.39 trillion. To compare, smart beta has seen inflows of $29.58 billion, bringing the category’s assets to $524 billion. Active funds, which only have $27.29 billion in assets, have only seen inflows of $3.89 billion this year.
While most analysts say smart-beta products will be within the range of fees that are justifiable, this issue is particularly acute for purveyors of active ETFs, which are expensive compared with index funds, although cheaper relative to similarly themed mutual funds or hedge funds.
The average expense ratio for an actively managed U.S. stock ETF is 0.868%, according to Morningstar. The average expense ratio for an index U.S. stock ETF is 0.345%, though many of the most popular funds offer ratios below 0.1%. For smart beta, the average expense ratio is 0.36%.
The average expense ratio for an actively managed U.S. stock open-ended fund is 1.205%, compared with 0.653% for U.S. stock index funds and 0.914% for U.S. stock smart-beta funds. Again, mutual funds also come with higher taxes relative to ETFs.
“A lot of scrutiny will come down on high-fee products that don’t produce significant outperformance,” said Eric Ervin, CEO of Reality Shares, which offers actively managed funds, the most expensive of which—the Reality Shares DIVCON Dividend Guard ETF —carries an expense ratio of 1.05%, or 105 basis points. “Once you cross the 100 basis points threshold, you’ll have a lot of explaining and justifying to do, even though 100 is nearly half the average fee of similar mutual funds, and definitely less than the average hedge fund.”
“No adviser ever got fired for reducing cost. That’s a hurdle we’ll need to get over,” he added.
Despite that, Ervin said the rules could create opportunities for those who work in the active space. “The advisers who don’t hide behind cutting fees and instead seek different strategies to either add value or reduce risk will be looking for products like ours,” he said. “The issue is that it just needs to be cheaper, which is why we do it for significantly less than in the mutual fund space.”