Reposting: We Need Some New Terminology

Sampler postings republish pieces previously available only to paid subscribers.
This was originally published in two parts, on December 14
and February 12, in the Investment Advisor category.
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Those outside of the investment industry — including most clients — usually don’t have the background to understand much of the jargon that is thrown at them by professionals about investments and how they work.  Bridging that communication gap is an essential skill to be covered in later postings; for now, let’s start with a very simple question:

What’s the difference between an investment advisor and an investment adviser?

Nothing, although (at least in the U.S.) the “advisor” usage is common among practitioners, while the “adviser” form is mostly the province of regulators and lawyers.  (That’s why you’ll see some of each in this posting; “advisor” is the normal usage on the site unless a publication is quoted.)

That taken care of:

What are the different kinds of investment advisors?

Oh, boy.  This got hard in a hurry.  The answers to the question will depend on whom you ask, what part of the business they are in, and the degree to which their business model is supported or threatened by proposed changes in the regulatory regime.

In a September 2021 posting, Michael Kitces provided the historical backdrop regarding the regulation of names and activities of would-be advisors — and a call to action, as you can tell from the title, “Why XYPN Is Petitioning The SEC To Implement Title Reform Under Section 208(c).”

Advisors and salespeople

The executive summary provides the basics, but Kitces offers much more in the way of details, tracing the path of regulation from before the Investment Advisers Act of 1940 to today.  The term “investment counsel” was the popular advice-giving term of the first half of the last century, to the point that the Advisers Act prohibited the use of that phrase by a person or firm unless the provision of investment advice was their principal business.

Thus, there was a “clear separation” between advisors and those who were in the business of selling product:

Which at its very core was centered on how firms marketed and held their services out to the public in the first place, with a regulatory framework that forced them to declare whether their primary or principal business was providing brokerage services (with only incidental advice), or providing investment counsel (as fiduciary advisors with no conflicted brokerage services).

This has been the playing ground for an industry tug-of-war ever since.

As brokerage firms changed their business models in response to May Day (when fixed commissions went away in 1975) and technological advances, “the use of the term ‘financial advisor’ suddenly exploded.”  Plus, the rise in popularity of financial planning added to the need for greater clarity regarding the regulatory framework for advisory services.

Then the story gets really messy.  See the Kitces piece for the blow-by-blow, but basically the SEC promulgated a rule in 1975 that was intended to clear things up, which was then vacated by a court, so the SEC responded with a different proposed rule, which never was adopted, leaving the necessary clarifications in limbo.

In 2019, Regulation Best Interest (Reg BI) was issued, which “explicitly chose not to unify the standards for investment advisers and broker-dealers as it was authorized to do under Dodd-Frank.”  (That being the 2010 Wall Street Reform and Consumer Protection Act.)  Reg BI creates a situation where a broker and an advisor are held to different standards for the same activity:

In other words, the current structure of Reg BI allows two “financial advisors” to engage in the same marketing of financial planning services, provide the same financial plan, recommend the same asset allocation recommendations, but implement with different (and in one case, more conflicted and higher cost) products.

And rather than recognizing that the delivery of advice and a comprehensive financial plan should elevate the standard of care on the recommendation of a proprietary product (because of the advice relationship of trust and confidence that has been created), instead the fact that a proprietary product would be sold at the end of the advice process allows the broker to “opt into” a lower non-RIA non-fiduciary standard of care, at the exact moment that a fiduciary standard of care is most intended and necessary to protect the investor from conflicted advice!

According to Kitces, this is an untenable situation, which has been exacerbated by the use of titles in the industry that are indicative of nothing in particular — and the proliferation of dually-registered firms, which can switch hats depending on the circumstances.  While “the founding principle of the Investment Advisers Act of 1940 was to assert a bright-line separation between sales and advice,” that often no longer exists in practice, although most clients aren’t aware that’s the case.

In response, the XY Planning Network (of which Kitces is a co-founder) petitioned the SEC for title reform and revised rules to clarify the standards that determine what constitutes the provision of investment advice — and therefore alter the dynamics of the industry as it currently exists.

About those “advisers”

Beyond the confusion around what to call and how to regulate those who provide investment services to individuals is the broader issue of what kinds of organizations are required to register as “advisers” in the United States.

To illustrate the problem, here are excerpts from the opening section of a Financial Times article, “Investment advisers surpass retail as biggest holders of US-listed ETFs”:

Investment advisers have eclipsed retail traders to become the largest owners of US exchange traded funds, highlighting how professional investors are increasingly using the vehicles to build portfolios.

Nearly two-fifths of US-listed ETFs by value are now owned by investment advisers, according to research compiled by Citigroup.  Wealth managers own 12.7 per cent, with other institutions, such as insurers and pension funds, holding a further 8.8 per cent.

Quick, what percentage is owned by the brokers and/or the registered investment advisors that are the subjects of the section above?  Are they the “wealth managers” that are referenced?  Or are they in the “investment advisers” category?

This kind of uncertainty underlies many press accounts — and industry analyses — because so many different kinds of organizations are lumped together under the rubric of “investment advisers” in the U.S. regulatory regime.

Vanguard is registered that way — or more precisely, several Vanguard entities are — as is the one-person shop on Main Street in a small town.  But size isn’t the only differentiator.

There are asset managers, who deal in individual securities and market their portfolios in a variety of vehicles (including private funds, which are their own special category).  And advisors who rarely “manage” securities themselves (although they may watch a legacy holding of a client), instead investing via those very asset managers.  And some who only do financial planning or provide consulting to institutional asset owners like pension plans and foundations.

A report from the Investment Adviser Association tries to capture the range of different entities using these four “typical profiles” that cover 85% of those registered:

You can see that even these aren’t discreet types.  (Another difficulty arises when trying to calculate the true total assets across a group of advisors or the industry as a whole, since the same asset can be double-, triple-, or quadruple-counted in the aggregate because of the levels of intermediation in the industry.)

While you can get a sense of an individual organization’s offerings from its filings (including its reported assets across certain prescribed categories), because advisors of different stripes are lumped together there isn’t a way to effectively analyze broad trends and issues.

As an example, refer back to the Financial Times article above.  Are asset managers using ETFs more, or advisory firms, or both?  It would be nice to know, since there are a variety of considerations involved, including the effect of shifts in the nature of the advice delivered, the resulting performance, and who gets what fees in the investment chain.  But that’s just one small example of what is lost in the mix when fundamentally different functions are treated as one.

Evolution and categorization

As covered in the posting on forces in the ecosystem, change is to be expected.  The evolution of the industry pressures the established order and the categorizations that have defined it.  But regulatory frameworks are slow to be updated, not the least because different industry subgroups try to protect their own points of view (and turf).

At a minimum, in trying to define and regulate the range of firms proving investment services, we need some new terminology.

[Part Two]

The first part of this look at fuzzy terminology in the investment industry covered the ambiguities around the word “advisor.”  Now let’s turn to another confusing description, this time in regard to an investment strategy.

What is “passive investing”?

Investopedia, the most popular online source of definitions for investment terms, summarizes it in this way:

Passive investing is an investment strategy to maximize returns by minimizing buying and selling.  Index investing is one common passive investing strategy whereby investors purchase a representative benchmark, such as the S&P 500 index, and hold it over a long time horizon.

An entry in Campbell Harvey’s glossary reads, “Buying a well diversified portfolio to represent a broad-based market index without attempting to search out mispriced securities.”  But there are other definitions, including one that links directly to “indexing,” which is defined as:

A passive instrument strategy calling for construction of a portfolio of stocks designed to track the total return performance of an index of stocks.

The most recent fact book from the Investment Company Institute echoes that, describing passively managed portfolios as those “in which the adviser seeks to track the performance of a selected benchmark or index.”

In these and other definitions, “passive” and “indexed” are used interchangeably, an approach that is the norm for many media outlets and investment organizations.

A little history

Early on in “the index revolution,” the idea of “tracking an index” meant “tracking the market,” with the market being the S&P 500, viewed as the best gauge of the performance of U.S. stocks, even though it included a relatively small percentage of them.

In 1991, William Sharpe argued, in “The Arithmetic of Active Management,” that the indexes used should be broader than the S&P, while putting a stake in the ground regarding those definitions:

A passive investor always holds every security from the market, with each represented in the same manner as in the market.

An active investor is one who is not passive.

Subsequent developments would take things in the opposite direction, toward narrower and narrower indexes — and a much different application of the terminology.

The Investopedia entry referenced above mentions minimizing transactions and long-term holding periods as a tenet of passive investing.  The original concept behind the name was all about owning the market and not trying to buy or sell in an attempt to outperform.  Also implicit in the approach was the market-capitalization weighting framework referenced by Sharpe.

Over time, that total package (which in turn resulted in much lower costs for an investor) became the passive side of the active-versus-passive debate that has been raging ever since.

Today, the “passive” mantra has been co-opted and applied to strategies very far afield from the original intent.  While just a few indexes were in existence fifty years ago, now there are thousands of them, with more created every day.  Very few could be described as broad-based, and as index providers have sliced and diced the investable markets into ever-finer pieces, the trading of those pieces has increased dramatically.

The ETF pivot point

For the first twenty years or so of their existence, index funds (retail and institutional) mostly followed the original principles.  The pivot point came in 1993, with the debut of what is now called the SPDR S&P 500 ETF Trust.  It replicated the same popular index, but it could be traded intraday on an exchange.  (There went the no-transaction part of the idea.)

As interest in the ETF structure built over time, sector ETFs came on the scene, as well as ETFs based upon other indexes that had become widely used for the analysis of active manager performance.  Eventually, indexes were created just to be able to create ETFs.  Index-based investment vehicles had morphed from a way to play long-term market potential to an engine for generating revenues for brokers and asset management firms.

Despite all of the changes, we’re still using the old words to describe vehicles that look nothing like the old vehicles.  For example, if you see statistics from Morningstar about active and passive strategies, it considers “passive” to be anything that is based on an underlying index.  Thus, the latest fund fee study from the firm has an equal-weighted passive average fee well above where you might expect if you were using the lens of the traditional passive approach:

An excellent paper, “Competition for Attention in the ETF Space,” lays out today’s environment:

The interplay between investors’ demand and providers’ incentives has shaped the evolution of exchange-traded funds (ETFs).  While early ETFs offered diversification at low cost, later ETFs track niche portfolios and charge high fees.  Strikingly, over their first five years, specialized ETFs lose about 30% in risk-adjusted terms.  This underperformance cannot be explained by high fees or hedging demand.  Rather, it is driven by the overvaluation of the underlying stocks.  Overall, providers appear to cater to investors’ extrapolative beliefs by issuing specialized ETFs that track attention-grabbing themes.

An earlier version of the paper said that “financial innovation in the ETF space follows two paths:  broad-based products that cater to cost-conscious investors and expensive specialized ETFs that compete for the attention of unsophisticated investors.”

That’s where we are.  Many people and institutions implement the original form of passive investment — and many call what they do by the same name, even though it is unlike it in every respect but one.  The only thing the two approaches have in common is the tracking of an “index,” which isn’t even a meaningful distinction any more, now that indexes create little worlds of their own rather than capturing the overall characteristics of a market.

So what?

A central tenet of The Investment Ecosystem is that we operate in a complex adaptive system that is always evolving.  But categories often don’t keep up with the developments, and a term that used to mean one thing can now mean another.  That’s not a huge problem if everyone is on the same page, but we’re not.

Obviously, it’s unrealistic to expect that the industry will shift to some more nuanced approach any time soon.  But that doesn’t prevent your organization from doing so.

The purpose is not to come up with some sort of degrees-of-purity scale based upon the original concept of passive investing (unless that fits with your investment beliefs), but to have a framework for understanding.

The process of evaluation may lead you to make changes on the investment front, but the main goal is to examine how you communicate what you do — and how you use the words “passive” and “active.”

You might find them in your newsletters or on your website.  They may even be ingrained into your client portfolio reports.  What do they mean in those contexts — to you and to your clients?

Look around.  Some firms promote “passive” approaches — taking advantage of the salience of that term — when the strategies they offer involve layers of active choices.  Others try to hew to an ideal like Sharpe’s — and a few off them tie themselves in knots over some of the sticky implementation questions that arise when trying to reach that goal.

The education of clients is a core responsibility.  Markets are uncertain enough on their own; don’t make them more so by using inexact descriptions just because everyone else does.  Simple explanations that enlighten should be part of the mission.