A (very) short history of investment legislation.
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By John Rekenthaler | 02-17-17 | 06:00 AM | Email Article

Depression Babies
Wednesday's column on the Department of Labor's fiduciary rule sparked complaints about government encroachment. A new and sterner investment regulation, several readers stated, would be yet another lamentable example of the nanny state. The last thing this country needs is a fatter rulebook.

John Rekenthaler is Vice President of Research for Morningstar.

Wait now. Regulations aren't intrinsically good or bad. If they were the former, then we'd never stop writing them. (And no, despite what it may seem, we're not always writing investment rules; major changes only come around every second decade or so.) If they were the latter, then we wouldn't have laws in the first place--starting with the Constitution. For investors, what matters is not the principle, but the outcome. Will the new legislation benefit them or hurt them?

Consider the Securities Exchange Act of 1934. The twin blows of the 1929 Crash and the revelations of the Pecora Commission, which uncovered various frauds perpetrated by banks and securities dealers, had squashed public confidence in the financial markets. Main Street didn't wish to invest, aside from government securities. The 1934 Act set the stage for investors' return by addressing the worst of the problems. Since its enactment, there have been plenty of new market crashes, but none accompanied by the same level of scandal and causing so much damage to investor trust.

(Strangely, to modern ears, the Pecora Commission was established by Senate Republicans and opposed by Democrats, who accused the GOP of pandering to the public by pummeling Wall Street. Apparently, history does not always repeat.)

It would be difficult to argue that the 1934 Act was one regulation too far. Indeed, it would be rather easy to argue that the Act was among the most important laws of the past century--that without it, U.S. stock market performance would not be what it has become. Wall Street, perhaps, might not be the world's leading financial center. (That second sentence, admittedly, is a stretch, thus the modifier "perhaps.") Not everybody saw it that way at time, though, as 81 House of Representatives members voted against the Act.

The Investment Company Act of 1940, which governs mutual funds (as well as other forms of registered funds, such as exchange-traded funds and closed-end funds), was also a hit. By mandating legal structures that severely restrict the opportunity for fraud, requiring various forms of public disclosure, and prohibiting various exotic investment techniques (such as high leverage), the Forty Act created the modern mutual fund--an investment that now controls more than $10 trillion in assets, and with very few instances of illegalities.

Pension Laws
ERISA (the Employment Retirement Income Security Act), passed in 1974, is a more qualified success. ERISA was established to ensure that those who ran traditional pension funds did so solely on behalf of plan participants, and it gave participants legal teeth to punish violations. So far, so good. It's not in this country's best interests--or that of investors--to have plan officials acting as Communist Party leaders, using their power to extract personal favors from suppliers.

However, ERISA translates imperfectly to defined-contribution plans. ERISA was drafted to address defined-benefit plans; 401(k)s were added along the way. The results have not been completely happy. Specifically, ERISA overburdens companies that sponsor 401(k) plans. They are required to do too much work, and they face too much legal liability. The existing laws fail. Defined-contribution plans differ significantly from defined-benefit plans, and the regulations should be different, too.

ERISA requires tinkering. However, that additional legislation would remove regulations.

The DOL Rule
After reading two ringing defenses of investment legislation, and a muted defense of the third, you probably expect me to support the fourth and newest example, the DOL fiduciary rule. Particularly as Wednesday's column mocked the argument made against that law by the National Economic Council's chief, Gary Cohn. Good guess--but not entirely right.

In principle, I'm delighted with the rule. It is the commonest of common sense to expect that financial professionals, as with healthcare or legal professionals, be required to work in their clients' best interests. Nobody complains that doctors are expected to care only for their patients, or that lawyers work solely on behalf of their clients. Surely, financial advisors should be held to similar standards. Indeed, they would benefit from higher expectations. Public trust would improve; the occupation would become more prestigious.

Also, the public debate is a wipeout. In favor of the law are the Certified Financial Planners Board, Harold Evensky, and Jack Bogle; against are the insurance and brokerage-firm trade organizations. When it comes to advancing investor interests, one side has a distinctly better track record than the other. Then, there's Cohn's complaint that the new fiduciary rule would prevent advisory firms from selling "unhealthy food." With friends like that, the campaign against the rule needs no enemies.

(Bogle's comment: "Honestly, it seems counterproductive to go to war against such a fundamental principle [that clients come first]. It simply doesn't seem like a good business practice for Wall Street to tell its client-investors, 'We put your interests second, after our firm's, but it's close.' "

Industry observer Knut Rostad was even more trenchant. With Cohn's argument, "the case for 'Buyer Beware' candidly returns front and center. No apologies, no excuses, no defensive, 'Of course our clients come first' claims. It is instead a candid and blunt and enthusiastic embrace of putting clients second.")

But … the financial-services industry is moving in this direction already. The managed accounts that alleviate the fiduciary issues that can arise from commission-based sales are a better business model. What's more, investors want them. Most buyers see asset-based fees as being cleaner than the traditional scheme of a front-end sales charge. Also, managed accounts can hold a wider variety of investments, such as ETFs or indexed mutual funds.

Thus, I am of a mixed mind about the fiduciary rule. On the one hand, it is hard to argue against the proposition. Those in opposition have not convinced. On the other, passing that legislation has cost significant political capital. Perhaps that capital could have been used on other investment topics, ones that would not be largely addressed by market trends.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

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