By Randall Smith
In recent years, investors have been flocking to low-cost index
funds, driven by their long-term record of outperforming
higher-cost actively managed funds.
But the trend isn't quite as strong for clients of Wall Street
brokers.
The difference is fairly clear-cut. A report released last month
by Cerulli Associates shows brokers at four major Wall Street firms
have just 29% of their clients' managed-fund assets in passive
index funds -- well below the 45% passive rate for independent
investment advisers.
The gap is even wider for regional and independent brokerage
firms, which have smaller average account sizes and passive
percentages of only 22% and 20%, according to Cerulli, a research
and consulting firm.
By comparison, passive funds account for about 40% of all mutual
funds' and exchange-traded funds' assets, and in August they topped
50% of all U.S. stock funds' assets, according to Morningstar, the
fund-research firm. The four big firms in the Cerulli surveys are
Morgan Stanley, the Merrill unit of Bank of America, UBS and Wells
Fargo & Co.
Securities-industry experts say the difference can be explained
partly by Wall Street's historical sales culture, with brokers
wanting to show clients their skill in picking money managers. In
addition, there's the raw fact that some brokers and their firms
can still get paid more in commissions and other compensation with
active funds than passive ones.
Some critics go further, noting that independent advisers,
formally known as registered investment advisers, are largely paid
by fees, not commissions, and they are held to a higher "fiduciary
duty" standard requiring them to put clients' interests ahead of
theirs. Meanwhile, brokers paid by commission have only been
required to recommend investments that are "suitable" for
clients.
That means, critics argue, that some brokers might be more
inclined to pick higher-cost investments that generate commissions
but that might not perform as well.
"It's definitely possible that registered investment advisers'
being subject to a fiduciary standard would lead them to choose
index funds more often than brokers who do not have the same
standard," says Nicole Boyson, a finance professor at Northeastern
University business school in Boston. Dr. Boyson notes that index
funds have historically tended to outperform actively managed
funds. Yet active-fund investors pay 4.5 times in fees what
passive-fund investors pay, Morningstar says.
The 2019 Cerulli survey is based on responses from 1,200 brokers
and advisers. The active/passive percentages apply to client assets
run by outside managers -- mutual funds, exchange-traded funds,
commingled funds and separately managed accounts. But the
percentages don't apply to the individual stocks and bonds chosen
by the clients or their advisers.
Bing Waldert, managing director in charge of research at
Cerulli, says the big-firm brokers have raised their passive
percentage "significantly" from much lower levels 10 to 15 years
ago. Indeed, for 2018, the big-firm passive percentage was even
lower at 24%.
While they are becoming more comfortable putting clients' U.S.
stock-market assets in index funds, Mr. Waldert says, they still
prefer active funds for international stocks, bonds and
"alternative" investments. Some fund categories, like municipal
bonds, are still predominantly active. Alternatives carry even
higher fees, more than double the average active fund.
Commissions' influence
Many brokers still get paid with commissions, and 28% of all
active mutual funds sold to individual investors can still generate
commissions, according to data from ISS Market Intelligence, a
money-management research division of Institutional Shareholder
Services. Fewer index funds are generally sold with
commissions.
Registered investment advisers, by contrast, are mainly paid via
an annual fee, usually a percentage of client assets. Cerulli says
commissions represent 32% of big-firm brokers' pay, and even more
at 40% to 41% for brokers at smaller firms -- but only 5% of
independent advisers' pay.
While many big-firm brokers paid by commission aren't held to
fiduciary standards, those paid by annual fees are considered
fiduciaries. The Obama administration sought to hold brokers
advising on retirement assets to a fiduciary standard, but the
Trump administration has instead adopted a new yardstick, effective
next year, requiring all brokers to act in the "best interest" of
clients.
Wall Street advocates say it is perfectly natural for brokers to
favor actively managed funds at times. "Brokers are trying to
provide added value," says regulatory and capital-markets lawyer
Mark Knoll, whose firm, Bressler Amery & Ross, represents Wall
Street firms.
"They may recognize that it's tough to beat the index, but many
will look to do better" if that matches the client's goals and risk
tolerance, Mr. Knoll says. "Maybe you have a bigger appetite for
risk and you want a broker who's going to help you try to find that
diamond-in-the-rough stock."
Doug Black, founder of SpringReef LLC, which evaluates financial
advisers for wealthy families and nonprofits, says the big firms'
active tilt partly reflects a legacy Wall Street sales culture
where brokers have "built relationships with their clients around
these outside managers." He also notes that higher-fee active
managers often make "pay to play" payments to big firms for access
to information about their brokers and clients.
Indeed, the two largest Wall Street firms, Morgan Stanley and
Merrill, curtailed their brokers' use of mutual funds from the
largest index sponsor, Vanguard Group, a few years ago, after
Vanguard balked at making such broker-access payments to the two
firms. (Vanguard declined to comment.)
None of the four Wall Street firms would say what percentage of
their client-fund assets are in passive vehicles, or comment
directly on the Cerulli data. Wells Fargo says its advisers offer a
mix of active and passive funds "designed for each client's unique
needs."
Large brokers acknowledge the passive tsunami, but still argue
for active. "While passive investing has grown in popularity over
the last few years, Morgan Stanley Wealth Management has found that
in many cases active management may help investors improve their
risk-adjusted returns, " especially in periods of market stress,
Morgan Stanley investment strategist Dan Hunt said in a March
article on Morgan's website.
Addressing the Cerulli numbers, Wall Street executives generally
don't dispute the reported gap. Instead, they say active funds can
play a key role in successful strategies. Using more passive funds
doesn't by itself show greater adherence to fiduciary standards,
they add.
Some clients might even be drawn to the biggest brokerage firms
precisely for their wider menu of top active funds, one official
says. Active funds, even with commissions, could be cheaper in a
buy-and-hold Wall Street brokerage account without an annual fee
than index funds held with a registered investment adviser and an
annual fee, another says. And Wall Street's own fee-based advisers
don't benefit from choosing active funds, one notes.
Despite the arguments that big brokerage firms make about the
benefits of active management, they are going against the tide. The
flows of new investor dollars into passive index funds have swamped
actively managed funds for the past decade, accelerating in the
past five years.
From 2014 to 2018, investors pulled $738 billion from active
funds and sent $2.5 trillion into passive, according to Cerulli and
Morningstar. However, active funds still hold 60% of the $19
trillion universe of all U.S. mutual funds and ETFs -- the cousins
to mutual funds that trade all day like individual stocks.
Jennifer Ellison, an independent adviser at Bingham, Osborn
& Scarborough in San Francisco, sees about 10 portfolios a year
of new clients with accounts formerly at big Wall Street firms.
Those accounts commonly have just 10% to 25% in passive funds, she
says, with the remainder allocated to outside managers and funds
with commissions and marketing fees "which compensate the
adviser."
Embracing 'passive'
Another fund-industry consultant, Broadridge Financial
Solutions, found a similar pattern in which independent advisers
put more client funds into passive vehicles than big-firm brokers
by a margin of more than 2 to 1 in the 18 months ended in June
2019. Data from ISS Market Intelligence also shows brokers use
passive less often than registered investment advisers.
Independent advisers "were the first to embrace index funds,
since they aren't paid by commission," says Andrew Guillette, head
of U.S. Insights at Broadridge. Wall Street brokers have been able
to follow, to a lesser extent, as many of them have adopted
fee-based pricing as well, he adds.
David Peltz, a registered investment adviser at Joel Isaacson
& Co., says brokers will often tell clients that individual
stocks in separately managed accounts, or other active funds, can
offer clients "more control over capital gains" and the resulting
tax exposure.
And Dr. Boyson, the Northeastern finance professor, notes that
some brokers might fear losing a client who is put in a passively
managed Vanguard fund, especially since Vanguard has grown more
aggressive in pitching its own advisory service. "If the client
sees a Vanguard fund, they might think, 'Oh, I can just go to
Vanguard and save a lot of money.' "
Mr. Smith, a former financial reporter for The Wall Street
Journal, is a writer in New York. He can be reached at
reports@wsj.com.
(END) Dow Jones Newswires
October 06, 2019 23:11 ET (03:11 GMT)
Copyright (c) 2019 Dow Jones & Company, Inc.
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