Pickups and Put Downs: Remarks at the Financial Planning Association 2018 Major Firms Symposium

Thank you, [Skip], for that kind introduction.  I appreciate the invitation to be here in Chicago with you this morning. Before I continue, I need to provide the standard disclaimer that the views I express today are my own and do not necessarily reflect those of the Commission or my fellow Commissioners. Maybe after I tell you the following story, that disclaimer will be self-evident as I am confident that all of my colleagues obey the traffic rules.

Fifteen or so years ago, I was driving through Chicago on the way back to Washington, D.C. in the little Chevy S-10 pickup truck I had bought from my brother, who lived in Colorado.  I was flagged down by a friendly fellow driver, who told me that I was not allowed to drive a pickup on Lakeshore Drive.  The friends I stayed with in Chicago that evening confirmed that he was right.  The anti-truck rule, which puzzles many others too, appears to be a 19^th century relic.[1]  People once enjoyed drives in their horse-drawn carriages on Lakeshore Drive and did not want to be disturbed by vehicles designed to haul freight.[2] Today, that translates into my not being able to drive my little pickup truck on a major road through Chicago.

Once I got back to DC, I rented a parking spot at a nearby hotel, where I sometimes had to wedge my truck between surplus furniture.  One day, as I drove away from the hotel, I heard the sound of breaking glass coming from the back of my truck.  Odd, since I generally kept nothing back there. When I got the chance to stop, I found a set of ice cream sundae glasses in the truck bed, about half of which were broken.  I lodged a complaint with the hotel staff, who apologized with the rather unsatisfying explanation that they had used my truck as an overflow storage space for hotel crystal. Using a pickup truck to store glass might have seemed like a good plan at the time it was concocted, but a little foresight could have prevented predictable trouble.

My pickup truck saga is, indirectly at least, relevant to your lives as financial planners.  First, you work within a very regulated space, and some rules are the anachronistic remnants of an earlier era. Second, your job is all about helping people plan ahead for the future so they can be spared the stress of predictable problems. You work hard every day to help your clients avoid encountering the retirement equivalent of ice cream sundae glasses shattering in the back of my pickup.

Today, I will talk about several ways in which we at the SEC can help you serve investors better by ensuring that our regulatory approach suits today’s markets and technology. I will suggest some ways in which we can make it easier for investors, whether on their own or with the help of financial professionals like you, to plan for their futures and avoid predictable investment pitfalls that too many Americans encounter.  Specifically, I would like to lay out my thoughts on ways the SEC can facilitate fund adaptation of technological and other innovations to better serve investors and provide them with a wider selection of investment choices.  I also will touch briefly on the SEC’s recent proposals addressing the standards of conduct expected of broker-dealers and investment advisers. 

Conservatism is built into a regulator’s DNA.  This resistance to change is evident in the area of new product approvals. This fear of change manifests itself, for example, when it comes to approving applications for exemptive relief to allow the offering of new funds or exchange-traded products (ETPs). The regulatory process can be a formidable roadblock to the development of new products that could provide investors with more diversity and protection in their investment portfolios.  We of course need to be diligent in our review of exemptive applications, but as the clock ticks, the competitive landscape also changes for the people trying to bring a product to market. 

 Take for example the SEC’s consideration of exemptive applications for the operation of actively managed nonfully transparent ETFs (exchange-traded funds).  An exemptive application for relief to allow the first actively managed nonfully transparent ETF was publicly filed in September 2011.[3]  Seven years sounds like a long time, but, as you may know, discussions regarding an exemptive application can begin years prior to the filing of the initial public notice of the application.   As of today, the application for relief still has not been granted or resolved. Admittedly, the issues presented by a nonfully transparent ETF are more difficult than those in previous ETF applications, but the passage of so much time suggests there may be opportunities to streamline our review process.

As we look for ways to make our process more efficient, we should be conscious of the effect that our decisions have on who gets to the market first.  The product that gets approved first may have a competitive advantage over other, later arriving products.  A slow approval process can inadvertently discourage new product development, since the originator of an idea will lose the advantage of its head start in getting its product to the market. Competitors benefit from the delay in considering the first mover’s exemptive application, which they are able to see and copy.

Another recent, much discussed example of the SEC’s conservatism with regard to new products is the recent set of decisions to deny applications by exchanges to list ETPs that would invest directly in bitcoin or in futures contracts for bitcoin.[4]  As I stated in my dissent to the Commission’s order disapproving a proposed rule change to list and trade shares of the Winklevoss Bitcoin Trust, “the disapproval order demonstrates a skeptical view of innovation, which may have an adverse effect on investor protection, efficiency, competition, and capital formation well beyond this [Bitcoin ETF] particular product.”[5]  The Commission, instead of assessing the ability of the listing exchange to surveil trading and deter manipulation of the ETP shares listed and traded on the exchange, focused on the characteristics of bitcoin and the spot markets in which it trades.  To the extent it was considering underlying markets, the Commission should have considered how an ETP could have improved price arbitrage and increased participation by institutional investors in the bitcoin market, which in turn could have led to bolstered defenses against theft, greater investment in custody solutions, and lower likelihood of market manipulation. 

Whether bitcoin should be part of any investor’s portfolio is not my decision to make. As financial planners and financial advisers, you are far better suited to thinking through whether and how digital assets can contribute to your clients’ long-term financial well-being. The SEC can help by allowing crypto-based products that comply with our rules to trade and ensuring that you have access to accurate information about those products so you can provide informed investment advice to your clients. 

Allowing investors access to the products they want to include in their investment portfolios may require us to change not just how we approve individual products, but how we treat certain practices.  As an example, one issue that the Commission should examine is how advisers to actively managed mutual funds are able to be compensated.  The Investment Advisers Act generally prevents advisers to registered investment companies from receiving straightforward performance fees of the sort that are common outside the registered fund context.[6]  Advisers to registered investment companies are permitted to charge a specific type of performance fee, known as a fulcrum fee. 

Allowing funds to experiment with performance fees may be one way to facilitate the continued availability of actively managed funds. Today, in part due to fees and expenses, index funds are scooping up assets at the expense of actively managed funds.[7]  Because index funds track indices, advisers to such funds typically limit themselves to ensuring that the funds are correctly tracking the applicable index.  Advisers to index funds accordingly charge lower management fees than advisers to actively managed funds who have to spend time researching and selecting investments for the funds they manage.  Passively managed funds also hold investments for longer periods of time than actively managed funds.  As a result most index funds have lower management and transaction costs than actively managed funds.  The higher fees often are not offset by better performance.  Morningstar, for example, found that over the twelve months through June 2018 only 36% of active managers outperformed comparable passive funds.[8]  Morningstar also found that, in general, actively managed funds have failed to beat their benchmarks, especially over longer time horizons.[9]  Some actively managed funds, however, do outperform their benchmarks.[10] 

The limitations on the ability of actively managed funds to pay their advisers performance fees may make it more difficult for well-performing funds to signal their quality and attract and retain assets. Under the standard level-fee approach, the adviser collects the same percentage fee whether or not the fund performs well.  Allowing actively managed funds to have more flexibility in how they choose to pay their advisers might be one way to help keep actively managed funds available as an option for investors.  Actively managed funds have started to look for ways—using fulcrum fees permitted by the statute—to vary their fees with performance.[11]  The funds incur a management fee comparable to the low management fees paid by index funds if the funds do not beat their respective indices.  Higher management fees are only charged if the funds beat their respective indices by a preset amount.  Allowing actively managed funds more flexibility in designing performance fees potentially could further enable active managers to compete on price with index funds.  More generally, we should be open to other creative ideas for increasing the variety of options available to investors and those of you who help them plan their financial futures. Indeed, technological change is forcing all of us to think creatively.

I see that this afternoon you will have a panel discussion on blockchain and how it will disrupt the financial services industry.  Disruption of this sort, although difficult to foresee with any specificity, is fascinating to contemplate.  Blockchain is not the only technological innovation that will have or could have a big impact on the financial services industry.  Here too, the SEC should keep an open mind so that the Commission and the industry can use technological innovations to better serve investors. 

The Commission, for its part, should embrace and incorporate new technology to improve the effectiveness of disclosure for retail investors.  It is no secret that many investors are not reading the disclosure the Commission requires funds, other issuers, and registered market participants to provide to investors.  I have been told many times by broker-dealers, investment advisers, and funds that investors often call complaining about the amount of paper disclosure they receive and requesting that they stop sending the disclosure materials to them.  I am sure that you have heard similar complaints from your clients.

This problem is not new.  It has been discussed by Commissioners since at least 1974 when then Commissioner Al Sommer noted that the “expansion of disclosure has gone forward unremittingly.”[12]  In discussing whether there should be “differential disclosure” for different types of investors, Commissioner Sommer stated that “the problem is much more complex than simply quantity…. There is at a minimum a correlative necessity to process and prepare the information for use by the ‘average’ investor (to use a wholly inadequate term) in a manner that will make it useable and useful; it is a matter of presentation, as well as quantity.”[13]  He also noted that if the information provided to an average investor is complex, “then it may well have the effect of causing the unsophisticated investor to back off in fear and confusion.”[14]  Since that time many Commissioners have spoken about the need to make disclosures more accessible for the average investor.[15]     

Changes in fund disclosure requirements in the last decade are a mixed bag.  Fund disclosures were significantly overhauled through the adoption of new Forms N-MFP, N-PORT, and N-CEN.  Form N-MFP requires significant information about a money market fund’s portfolio holdings.[16]  Forms N-PORT and N-CEN will require disclosure of additional key information about fund portfolio holdings then currently required.[17]  We also adopted amendments to Regulation S-X so that a fund’s financial statements in its shareholder reports contain certain derivatives disclosures.[18] These changes significantly increased the information to be reported by funds and contain information that might not be understandable to most investors. 

Conversely, in 2009 the Commission adopted the mutual fund summary prospectus, which provides investors with a shorter document that contains only key information about a mutual fund in plain English and in a clear and concise format.[19]  An investor who wishes to do so could obtain the full statutory prospectus through an internet website or by requesting it from the fund.  Commission staff is working on a recommendation to the Commission to allow a similar variable annuity summary prospectus.  Summary prospectuses provide investors with a less daunting document that provides the most important information about a fund.  Funds have embraced the summary prospectus option, and it has served investors well.

As Commissioner Sommer noted, in addition to content, the presentation of the information also determines whether the information is useful and useable for investors.  Staying true to the traditions of Commissioner Sommer’s generation and many generations before his, fund disclosures are still predominantly paper-based.  The amount of paper material that investors receive is voluminous and could result in investors being overwhelmed.  Electronic or digital delivery should be the default for fund disclosures. The Commission has recently made some headway in this area by adopting rule 30e-3 under the Investment Company Act.[20]  Rule 30e-3 allows website transmission of fund shareholder reports as the default method of transmission.  In addition to the cost savings to funds and fund investors, electronic delivery of shareholder reports as the default should make the reports more user friendly.  For example, in an electronic format the reports should be easily searchable for specific information of interest to each particular investor.  By eliminating the huge stack of paper and making it easier for investors to read only the information in which they are interested, rule 30e-3 should result in the disclosed information being used by more investors to make investment decisions.                                              

On balance, despite some important positive steps, the amount and complexity of the information provided to fund investors has increased and the Commission has not yet taken full advantage of the technological change that has happened since Commissioner Sommer called for a better approach to disclosure forty-some years ago. This technology stands ready to improve the content of the fund information disclosed to investors.  For example, technology could be used to layer and customize investor disclosure, particularly the fees and expenses information that is so important to investors.  Again, I do not want to substitute my judgment for that of those of you who work with investors every day.  We need to allow flexibility so that issuers and financial professionals can compete on, among other things, how well they communicate with investors.

This past June, the Commission took the unusual step of asking investors themselves to weigh in on what they want in disclosure.  We issued a Request for Comment on Fund Retail Investor Experience and Disclosure (“Request for Comment”).[21]  The Request for Comment focuses on the Commission’s entire fund disclosure regime, the volume and complexity of the content of the information disclosed, and how the information is delivered to investors.

Retail investors have a way with words that is often more direct than the shrouded critiques of the typical industry commenter.  Helen and Bob Hague, for example, recommend “that the SEC should speak softly and carry a big stick.  That is, give folks flexibility, but crack the skulls of wrongdoers.”[22]  Another commenter similarly suggested that the SEC “[k]eep information simple!” and “[g]ive funds more flexibility to show what might be helpful.”[23]  Similarly, Carla Rojas writes “Give funds the flexibility to use technology and prescribe general principles to keep them honest.”[24]  She further advises “Stop showing us how smart fund people are, and write for your audience.”[25]  Yet another commenter echoed the need for flexibility: “Allow pilot programs, and provide a principles based approach to disclosure so that the industry can innovate.”[26] I hope and look forward to receiving additional comments from—most importantly—retail investors, as well as funds, advisers, broker-dealers, other financial intermediaries, and academics.  I am especially interested in comments regarding whether investors favor the use of mobile apps for fund disclosures and whether the use of video would be more likely to result in investors digesting and using the disclosed information. 

Admittedly, if retail investors are not reading fund disclosures, they may not be perusing our requests for comment.  It is therefore extremely important that the Commission use its authority to engage in investor testing to devise creative approaches for getting investors the information they want in a format they want to use.[27]  My only caveat is that the Commission need not test everything itself.  As a number of the retail investors who responded to our request for comment noted, we simply need to allow the industry the flexibility to do its own investor testing.  A lot of this work is already being done, but we need to give firms the comfort that they can implement, consistent with the law, the changes that their investor testing inspires. As disclosure is the cornerstone of our regulatory regime, it is important that investors have access to meaningful information presented in such a manner that it can be used by investors to make informed investment decisions. I will next turn to one instance in which investor-friendly disclosure is of the essence.                      

Recently, the Commission had an opportunity to design a proposed new form that would provide information to investors concerning the financial professionals from whom they seek investment advice.  As part of the Commission’s package proposing standards of conduct for broker‑dealers and investment advisers that provide advice to retail investors, the Commission included new Form CRS.[28]  Before discussing this proposed form, I want to take a minute to address concerns that some people, including perhaps some in this room, have about the proposed standard of conduct for broker-dealers, Regulation Best Interest.

I appreciate the healthy debate that our proposal has fostered, but some of the put-downs seem to ignore the text of the proposed rule and the limits of the fiduciary regime.  Many of the critiques are based on the assertion that because broker‑dealers would not be subject to the same fiduciary duty to which advisers are subject, broker-dealers’ conflicts of interest with clients would continue to exist to the detriment of their clients.  They have said that, under the Commission’s Regulation Best Interest, broker-dealers would “only” have to mitigate and disclose the conflicts of interest but could continue to give advice colored by the conflicts.[29]  The requirements addressing conflicts of interest included in proposed Regulation Best Interest are stronger than those required by an investment adviser’s fiduciary duty to its client.  As has been correctly noted, proposed Regulation Best Interest would require disclosure and at least mitigation of any material financial conflict of interest a broker-dealer may have with its client.  An adviser is required only to disclose such a conflict. In addition, Regulation Best Interest, if adopted, will make it substantially easier for us to bring enforcement actions against brokers who have subordinated their clients’ interests to their own.  Loud calls to cast all of Regulation Best Interest aside in favor of an approach that forces everyone into a fiduciary model have drawn a lot of attention away from ideas about how we should refine and clarify the proposed standard and the rest of the rulemaking package.

Proposed Form CRS, for example, suffers from the paper-centric, regulator-centric status quo.  The four‑page (at most) document is to be delivered in addition to—not in place of—any of the disclosure documents that broker-dealers and advisers currently provide.[30] It is replete with legal terminology. We would be better off drafting up a short form entitled, “How could I cheat thee? Let me count the ways.” At least a form like that might inspire investors to ask probing questions and keep an eye out for potential red flags.  We may not get that radical, but we should draw on the many comments we have received to inform changes to Form CRS to make it more useful for retail investors in both content and delivery.   This form would be a great place to start advancing a digital-based disclosure system.  It would be a wonderful opportunity for us to encourage firms to experiment with videos, mobile apps, interactive web-based disclosure, and whatever else they can think up with the benefit of their millennial technology savants.  Form CRS also would be a perfect place to allow firms to talk to investors in language that is not riddled with legalese and technical terms.                                            

Just as financial planners are embracing technological innovations to better serve their clients, the SEC should allow investors to benefit from innovations.  To do so, the Commission should allow firms the flexibility to experiment with new technology, new products, new fee structures, and new approaches to disclosure. In so doing, the Commission will help investors make better decisions about whether and how to invest.                      

I wish you the best for the rest of your conference. If you do make it to Lakeshore Drive during your stay in Chicago, make sure it is not in a pickup truck. Thank you for the opportunity to share my thoughts, and I am happy to take some questions.