An Eruption of Creative Destruction?

It was in December of 2000 that Bloomberg ran the following headline: “Commentary: Today's Hottest Economist Died 50 Years Ago.” The article then read. “The world of economics has a new superstar: Joseph A. Schumpeter. Never mind that the Austrian-born Schumpeter has been dead for a half-century, that he was overshadowed while alive by John Maynard Keynes, and that he was famously wrong in predicting that capitalism would become a victim of its own success. Today he's more influential than ever – because the high-growth, high-risk New Economy is exactly the kind of economy he wanted.” It then explained, “Even people who have never heard of Schumpeter know the phrase he coined: ‘creative destruction,’ the process by which new products and production methods render old ones obsolete.”

An article published in Viewpointe in November 2005 elaborated on Schumpeter’s career. I wrote, “Ironically Keynes and Schumpeter were both born in the year 1883, Keynes in England, and Schumpeter in what was then the Austro-Hungarian Empire. Educated as a lawyer, Schumpeter, early in his career jokingly told friends he aspired to three goals: to be ‘the greatest lover of beautiful women in Vienna, Europe’s greatest horseman, and also the world’s greatest economist.’ He later would roguishly admit to having achieved two of his three objectives without identifying which two he believed he attained.

Creative Destruction

Although he wrote several books, his most important contributions were collected in one titled, Capitalism, Socialism and Democracy, published in 1942. It was here that he emphasized it was the entrepreneur who created new competition, new ideas, new technology, and new modes of organization. These innovations in turn upend the established order, unleashing a ‘gale of creative destruction’ that forces incumbents to adapt or to die. It is this ‘process of industrial mutation [that] incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.’”

Further proof of Schumpeter’s prediction of an “incessant” process might now be found in a recent radical rule by the Department of Labor. However, before we examine that action, consider one of the many cases that led to this new rule. What you read below is typical of the many similar catalysts that could result in, if not the creative destruction of the investment brokerage industry, at least in an avalanche of changes within it.

JP Morgan’s Fiasco

Just before the end of 2015, Reuters reported that “the largest bank in the United States, JPMorgan Chase & Co. agreed to pay $307 million to settle accusations by the U.S. Securities and Exchange Commission (SEC) that brokers and advisers in several JPMorgan divisions steered clients into its own, more expensive investment products over other choices without making the required disclosures to clients about conflicts of interest.”

JPMorgan also gave preference to third-party hedge fund managers who paid placement fees equal to 1 percent of the market value of invested client assets – so-called “retrocession” fees. While clients did not pay those fees directly, this type of arrangement ultimately hurts the investor because it puts a drag on performance.

Finally, the company chose mutual funds with more expensive retail fees over identical – but less expensive – institutional funds.

The Penalty Fit the Crime

The bank will pay $267 million to the SEC, and $40 million to the Commodity Futures Trading Commission, which also conducted an investigation. The SEC cease-and-desist order describes the violations as willful, fraudulent and deceitful, and identifies $127 million in ill-gotten gains generated through JPMorgan’s disclosure failure.”

From 2009 through early 2012, it invested as much as 51 percent of client assets in its proprietary funds; that figure fell to roughly one-third of assets by the end of 2013, according to the SEC order. Proprietary funds are notorious for their poor performance.

The bank admitted to wrongdoing, but no restitution will be made to customers. The bank said in a public statement “it’s only misstep was inadequate disclosure of what it sells to customers.” That statement is pure chutzpah.

Who’s The Patsy?

If you are an investor dealing with any of the large, well known brokerages, and believe the actions noted above are anomalies limited to J.P Morgan (and certainly not to your friendly personal broker), you are playing in a game described best by Warren Buffett as follows: “If you've been playing poker for half an hour and you still don't know who the patsy is, you're the patsy.”

In essence, if you have been dealing with a broker dealer who is not subject to a “fiduciary” prerequisite, that individual may not have your best interests in mind. As the law currently stands, broker dealers, insurance salespersons and advisors operating under the “suitability standard” are merely required to ensure an investment is suitable for a client at the time of the investment.  As an example, if your broker recommends one of several mutual funds, the one chosen may not be the “best” one for you, but could be the one paying the highest commission to him. Under the former rule, that was totally legal. So who do you think the patsy is in that relationship?

That type of legal but unethical activity can easily be avoided by dealing with a Registered Investment Advisor (RIA) who is required to observe what is known as a “fiduciary” prerequisite. For over six years the Obama administration has been working towards requiring all types of retirement accounts to be held to that fiduciary standard. The Dodd/Frank bill gave that authority to the Securities and Exchange Commission to initiate, but no action was taken. (The latest information is that something will be offered in the spring of 2017.) In April, the Department of Labor (DOL), that also regulates retirement savings, dramatically took that responsibility in its hands and implemented a fiduciary requirement for all brokers dealing with retirement funds.

The Fiduciary Rule

The DOL’s final fiduciary rule and related exemptions are intended to protect investors by requiring all who provide retirement investment advice to retirement plans and IRAs to abide by a “fiduciary” standard—putting their clients’ best interest before their own profit. The basic structure of the fiduciary rule is that financial advisors and institutions are not permitted to receive payments creating conflicts of interest with their retail retirement investors without meeting a prohibited transaction exemption. In other words, without the exemption, firms cannot continue to set their own compensation structures.

Although this rule seems to be perfectly logical and certainly beneficial to investors, both houses of congress voted to kill the rule, shortly after the rule was announced, led by almost unanimous action. Every Republican in both houses voted for the resolution and only three Democrat supported it. However, the vote was not strong enough to prevent veto action by President Obama. It had become obvious that it was his pressure that encouraged the DOL to implement the new rule. Unfortunately further litigation by congress and the brokerage industry continues.

Investment Industry News

Obama also commented on the rule, saying, “the Council of Economic Advisors estimated that conflicted investment advice currently costs savers roughly $17 billion a year.” The investment industry orientated website, Investment News headlined the following: “ The retirement-services space has reached the point of creative destruction, where innovation eliminates old businesses and creates new ones.” [I came across that line after I had written the headline above.]

Investment News issued the following comments about the impact the new fiduciary rules will have on the industry:

“Financial advisers are anticipating widespread changes in their industry as the Department of Labor's fiduciary rule is phased in over the next 18 months. The rule that promulgates a best-interest standard for all retirement advice will put billions of Americans’ retirement savings in motion, change the investment products advisers use, and hurt firm profitability, according to an Investment News research report sponsored by Legg Mason. About 1,700 advisers from all channels were polled for the report before and after the final rule was published.

Advisers expect the rule to put sizable amounts of assets into play as the compliance requirements and legal liability risk make servicing small retirement accounts untenable for some. Advisers are now grappling with how to adapt to the DOL fiduciary rule. About 40% of advisers said they will not, or probably will not, continue to service small individual retirement accounts — those less than $25,000 — once the rule takes effect, according to the Investment News survey.”

The Good News

Here are the really important beneficial consequences resulting from the fiduciary rules:

“A significant amount of assets also will be shifted from high-commission investment products into cheaper ones, the survey predicts. About 57% of advisers said they plan to use variable annuities less in retirement accounts, the Investment News survey found. Use of nontraded real estate investment trusts will fall 45% and private placements 37%, the report said. Meanwhile, advisers said they'll use more separately managed accounts, passively managed exchange-traded (index) funds and actively managed ETFs. Use of those will increase 16% to 30%, according to the survey. [As an indication of an intractable industry, those numbers should be 100%.]

“Passive, low-cost funds will set a standard against which many advisers' decisions are measured, as firms with variable compensation structures and parallel product offerings will have a higher burden demonstrating that they are acting in their clients’ best interests,” the report said. The rule also will impact the economics of advisory firms, especially in certain channels, as it’s expected to hurt revenue and increase compliance costs.

About 83% of advisers affiliated with independent broker-dealers and 82% of dually registered advisers expect the DOL rule to have a negative impact on the profitability of their firms. About 38% of registered investment advisers said the same.”

USA Today sums it up as follows:

Proponents, say the new rule will change the advice industry/profession for the better. Robo-advisers will likely start to serve the needs of investors who want low-cost advice that complies with the new fiduciary rules and who aren’t necessarily being served by advisers today. Brokerage firms will likely launch more fee-based accounts and start selling no-load variable annuities. Plus, it’s likely advisers who largely earn a living by not acting in their client’s best interest will exit the business.

While this may not be the creative destruction of the investment advice industry, it is certainly the most dramatic shake up in decades. It also means that you will no longer be the patsy in the retirement investment game. However, if you have a non-retirement investment account that is serviced by a broker dealer, one who is not a fiduciary, and you continue to allow that broker to do so, if you want to know who the patsy is in that game…just look in the mirror.