The US Securities and Exchange Commission (SEC) has kept their promise to take up the retail investor protection baton from the Department of Labor and the SEC’s proposed Regulation Best Interest may be another tailwind to US ETFs.
The SEC has been positioning itself to take up the mantle on retail consumers “best interest” for some time now. The need to act became more pressing in March, when a US appeals court vacated the Department of Labor’s (DoL) Fiduciary Rule. In doing so, the court explicitly criticized the “best interest” clause, a key provision of the overall DoL proposal. Now, the SEC has released their own proposal, dubbed “Regulation Best Interest” (SEC RBI), introducing a new best interest standard.
The SEC proposal has a much wider scope than the DoL’s Fiduciary Rule as it covers all retail investment accounts whereas the DoL, due to its regulatory remit, was limited to retirement accounts only. The SEC already holds its registered advisors to the proposed best interest standards, but the proposal extends scope to broker-dealers and so called “hybrid advisors.”
While the SEC RBI proposal does not seek a uniform fiduciary standard, we believe the “best interest” standard will retain many areas of focus found within the DoL version of the rule. Advisors and broker-dealers will likely continue to seek out transparent products with lower fees and less complexity, thus favoring ETFs and index-based mutual funds.
Only at the Start Line
This initial proposal from the SEC is the start of what is likely to be an extended debate. Initial industry sentiment to the proposal has been positive. The general consensus is that in framing the initial proposal, the SEC has struck the right balance between protection of retail consumers and the pragmatism requested by industry participants. This gives the rules a greater probability of implementation.
With that said, there are 916 pages of text to wade through and as always, the devil is in the detail, so we expect comments to be plentiful and provocative within the 90-day public commentary period. Just prior to the SEC vote on the proposal, several comments from the SEC commissioners expressed reservations on elements of the proposal, however, given the time-critical nature of addressing “best interest,” they needed to get the ball rolling without further delay. Ultimately, the proposal was approved 4 to 1. The commissioners will reconvene after the public comment period to amend their proposal based on industry feedback before ultimately voting on whether to make the rules binding.
The SEC’s hardest task will be to form broad consensus, workable definition, and appropriate enforcement of “best interest.” There is much to be done before the rule is finalized, which we expect to occur in 2019.
Best Interest of ETF Providers
The DoL Fiduciary rule lead to much debate about the acceleration of the shift to fee-based models and increased allocation to lower-cost products in retirement accounts. Given the approach taken thus far by the SEC, namely more disclosure, alignment of incentives, and greater clarity on how advisors and brokers are compensated, we anticipate the following areas will come under greater scrutiny within assessments of the SEC RBI:
- Fee Models – Incentive for certain advisors to move from commission-based to fee-based account business model
- Expense Ratios – Likely to result in additional demand for lower-cost products to keep total cost of advice down for retail investors
- Safe Bets – A rising standard of care in the form of “best interest” for broker-dealers will likely result in greater usage of low-cost products, such as ETFs, as a simpler path to meet the “best interest” standard
- Managing & Disclosing Conflicts of Interest – Vertically integrated providers (those who primarily sell their own family of funds) may maintain their business model under the SEC proposal, but may face greater pressure to move to open architecture and provide a wider range of third-party funds from their retail base
- Transparency – SEC proposal to maintain separate standards of care for broker-dealers and advisors is may result in a larger migration of assets from broker-dealers to advisors as customers are better able to understand the different business practices and offerings
- Clean Share Classes – Industry likely to see “clean share class debate” reemerge within the SEC RBI debate as loads, 12b-1 fees, and revenue sharing programs come under scrutiny.
Many of these trends were underway prior to the DoL rule. We expect the SEC’s proposal may propel the trends forward.
What Comes Next?
The period of public commentary will be lively and worth monitoring. We expect defining and clarifying “best interest” will be the primary focus, and we anticipate many suggested changes to the initial proposal to come from industry stakeholders.
The continued focus on “best interest” standards, in the US and globally, represents a fundamental shift in how and what investment products are used to manage retail client assets. Policymakers are ever more focused on investor protection, managing complexity, and increasing cost transparency. ETFs are at the core of this debate and are likely to benefit from this policy focus.
This article was written with contribution from BBH Vice President with Global ETF Services Ryan Sullivan.