As the landscape of money management evolves with new regulations, technology, knowledge, and abilities, it is important to revisit two core industry concepts: the fiduciary standard and a prudent investment process. The fiduciary standard has always been imposed upon registered investment advisors by the Investment Advisers Act, but it is receiving new focus with the upcoming Department of Labor regulations. Although it is a single standard, it has various components that will determine whether a fiduciary duty is satisfied under the rules and regulations. For example, consider the following tasks often encountered as a financial advisor.
| The Requirements | The “Downside” | CLS’s Solution | |
| Collecting Commissions or Revenue Sharing | Soon, with the new DOL regulations, clients will have to execute a best interest contract (BIC) exemption, which (in short) states that advisors will act in the client’s best interest, disclose certain information and earn only “reasonable” compensation. | How will clients perceive being asked to sign such a contract? It may raise questions from clients as to why or whether the advisor was not already acting in their best interest. | CLS provides a fee-based model for advisors along with resources and education on how to transition from commission-based business. |
| Allocating trades for multiple client accounts | Section 206 of the Investment Advisers Act requires written procedures for trade allocations and disclosures to clients as to how trades are allocated. | Implementing procedures and maintaining internal controls to ensure they are followed, which takes time away from maintaining client relationships. | CLS has documented trade allocation procedures for our Trading Team, which are monitored by our Compliance Department. |
| Seeking best execution for client transactions | General fiduciary principals and Advisers Act Rule 206(4)-7 requires “best execution” in client transactions. This does not necessarily mean the lowest cost. Rather, it includes ensuring clients do not incur unnecessary costs and that the transactions are qualitatively the “best” for the client. | Establishing and monitoring documented processes for the best execution responsibilities. | CLS considers the full range of services offered by a broker: execution capabilities, commissions, ability to obtain volume discounts, responsiveness to CLS, etc. CLS’s Best Execution Committee reviews transactions on a quarterly basis. |
| Ensuring portfolios consistently meet client objectives | ERISA calls for a prudent man standard in establishing the investment process, which may include investigating a client’s goals and financial condition, establishing objectives, and creating a formal investment policy statement. | General knowledge of investment principles is not enough. An advisor must demonstrate how he or she has met the objective prudent man standard. | CLS manages risk by measuring it via the client’s Risk Budget. This budget is established by defining the investor’s investing time horizon, capacity for risk, and specific investment goals in our Risk Questionnaire. Our Regional Sales Teamscan provide investment policy statements for new accounts. |
| Providing services to clients with low account balances | A fiduciary must treat all clients fairly. | For smaller accounts, it may not make economic sense for the firm to use fee-based business models or expend compliance resources for the upcoming BIC exemption. | CLS Autopilot is a tool to assist advisors in providing services to accounts with balances that may be below current minimums. |
This list can go on, and with the new regulations, the spotlight on compliance with these concepts is becoming stronger. It can be an overwhelming task for an advisor take on alone. Read below to learn more about these concepts.
Fiduciary standard
Given the new DOL regulations, the term fiduciary has almost become a “buzz word.” Companies who operate under this standard highlight it at every opportunity, while those who still need to comply with the standard scramble to fully comprehend it. Overall, the fiduciary standard includes acting in the client’s best interest, placing the client’s interest first, and making full disclosure of all material facts and potential conflicts of interest. The standard gives way to further duties such as the duty to seek best execution, have a reasonable basis for recommendations, protect client data, and disclose material financial and disciplinary information.
It seems to be straightforward, and one might think “I’m a knowledgeable, ethical person and I file an ADV, so I must be a fiduciary.” But how does the standard look in a business setting? Is the advisor treating all clients fairly? Is there an equitable allocation of trades within multiple client accounts? Can the advisor “prove” he or she meets the fiduciary standard?
At CLS, we’ve always operated under the fiduciary standard so we don’t have to “catch up” or revise our services. By utilizing CLS, an advisor is placing his or her accounts in a setting where the fiduciary standard is not only met in practice, but is also embedded into CLS’s culture as a core value for the firm and its employees.
Prudent Investment Process
A fiduciary has the responsibility to manage a prudent investment process for clients. Financial professionals may automatically assume they have the knowledge, ability, and skills to manage and administer all aspects of the investment process for clients. But is time best spent creating, managing, and updating a prudent investment process when there are resources available to take this task off an advisor’s plate? A documented prudent investment process is vital and is a value that CLS can add to an advisor’s practice.
In issuing the new regulations, the Department of Labor (DOL) has noted that good intentions are not enough to establish that an advisor has a prudent investment process. “Prudence” is an objective standard that must be met, and simply having knowledge about investment principles may not be enough. To meet the prudent man standard of care under ERISA, a fiduciary must act “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matter would use.” Furthermore, the investments must be diversified so as to “minimize the risk of large losses.”
If (or when) there is a conflict of interest, a fiduciary is going to be held to a “particularly stringent standard of prudence.” To meet the standard, the advisor must establish and follow a process that shows why investments are recommended to an investor. At a minimum, a prudent process includes identifying the client’s goals and current financial condition. It also includes applying generally ‘[-=accepted investment theories and industry practices, and diversifying the portfolio.
Establishing a prudent investment process is not enough − it must then be documented and monitored. In practice, the time to do this takes away from maintaining client relationships and building a practice.
CLS’s investment methodology is based on Risk Budgeting. We seek to manage risk by measuring it via the client’s Risk Budget. This budget is established by defining the client’s investing time horizon, capacity for risk, and specific investment goals in our Risk Questionnaire.. With Risk Budgeting, the risk within the client’s portfolio remains constant while the investment environment may change. This helps to prevent style drift and keeps the portfolio in line with client objectives. By partnering with CLS, advisors are utilizing a firm that can provide the process and administrative elements that are required as a fiduciary to appropriately serve clients.
The requirements to serve clients’ accounts are continuing to evolve. While advisors may have the knowledge and capacity to “do it on their own”, by engaging CLS, advisors can better focus their time, skills, and energy on client relationships.