DOL Rule concerning Proprietary Products

As I mentioned in the previous post, if you offer proprietary products, the new Department of Labor rules are about to rock your world, and not in a good way. As the DOL explains, " Proprietary products are products which the firm or its affiliate manage, issue, or sponsor, and an adviser may face increased conflicts of interest with respect to advice on such products due to the benefit to the firm. Advisers/financial institutions offering a limited set of proprietary products must fully disclose that they are offering only a restricted menu of products, and also disclose the associated conflicts of interest, adopt measures to protect investors from those conflicts, and insulate the adviser from conflicts when making recommendations from the restricted menu. In addition, advisers that recommend a limited set of products must consider what is in the retirement investor's best interest, and, if it is a product that they do not offer, they cannot recommend a product from their limited menu." That means it's going to be very difficult to sell an equity-indexed annuity to a retirement investor. And, if the broker-dealer sells mutual funds that their related investment advisory arm manage, or if they sponsor the funds as wholesalers, they are going to have to rethink that whole business model from top to bottom. This is big stuff here, people. Huge, in fact. Get Help on your Series 7 Exam

What does the new Department of Labor Fiduciary Rule mean to you?

The new Department of Labor Fiduciary Rule is too complex to handle in one blogpost. But, I can still address the basics in a few words. As the Department explains, "When the basic rules governing retirement investment advice were created in 1975, 401(k) plans did not exist and IRAs had just been authorized. These rules have not been meaningfully changed since 1975. The Proposed Regulation is intended to take into account the advent of 401(k) plans and IRAs, the dramatic increase in rollovers, and other developments that have transformed the retirement plan landscape and the associated investment market over the four decades since the existing regulation was issued. In light of the extensive changes in retirement investment practices and relationships, the Proposed Regulation would update existing rules to distinguish more appropriately between the sorts of advice relationships that should be treated as fiduciary in nature and those that should not." What that means is that if any of your customers is investing in a retirement account, you will not be able to treat him as a customer to whom any suitable product can be offered and sold. Rather, you will have to figure out a way to work with the investor as a fiduciary, with a contract stating that you intend to act as a fiduciary. A fiduciary can be sued for breach of contract if he fails to disclose all potential conflicts of interest. In other words, a fiduciary can't act like a salesman. Rather, a fiduciary has to place the needs of the client first. As the DOL states, "In order to protect the interests of the plan participants and beneficiaries, IRA owners, and small plan sponsors, the exemption would require the adviser and financial institution to contractually acknowledge fiduciary status, commit to adhere to basic standards of impartial conduct, warrant that they have adopted policies and procedures reasonably designed to mitigate any harmful impact of conflicts of interest, and disclose basic information on their conflicts of interest and on the cost of their advice." That's a sea change right there in the way registered representatives have dealt with customers up to now. Further, the DOL explains that "The adviser and firm must commit to fundamental obligations of fair dealing and fiduciary conduct—to give advice that is in the customer's best interest; avoid misleading statements; receive no more than reasonable compensation; and comply with applicable federal and state laws governing advice." BTW, for purposes of the rule, anyone who works with a retirement investor is an "adviser" going forward, whether he's licensed as a life & health-plus-securities representative, an RIA or an IAR. If you work with retirement investors you are an "adviser" under the new rules, period. Beyond the best-interest-contract with customers, registered representatives and their firms are going to have one heck of a time selling proprietary products, but this is already running longer than I intended. Need help with Series 7?

High-Risk Low-Reward?

Is it true that high risk = high reward? Maybe not. In a recent full-page ad in Forbes magazine Fidelity shows that between 1985 and 2015 ten different industry groups did not necessarily perform as their risk characteristics would have predicted. What was the riskiest--by far--of the 10 industry groups? Technology, of course. How did technology perform? Only #6.
Ouch. That right there pokes some holes in the notion that high risk = high return. But, we aren't done yet. The highest-returning industry group was health care. Where did it rank in terms of risk? Third from the bottom. Yes, the highest-returning industry group was also one of the least risky. Consumer staples was second from the bottom in terms of risk, yet it ended up second from the top for performance! What if one had invested in the least risky of all groups, utilities--surely, he would have ended up at the bottom for performance, right? Wrong. The least risky of all groups, utilities, still came in #7, just a hair behind technology, for performance. Think about that for a minute! Not only would taking on the highest-risk group not have gotten you high performance, but also, it would have gotten you just barely ahead of the lowest-risk group, utilities.
I'm not sure if technology is the most disappointing of all ten industry groups, or if we should nominate financials for that dubious honor. Financials--banks, insurance, broker-dealers, etc.--surely this was a lower-risk and higher-reward group, right? Actually, it was #4 in terms of risk but only #8 in terms of performance. No, on second thought, materials was the worst industry group. Materials was #2 in terms of risk but ended up second-from-the-bottom for returns. As I scan the excellent illustration in this full-page ad, I note that not one of the 10 industry groups ranked the same in risk as it did in reward. The one that came closest to doing that was consumer discretionary, which was #3 in risk and #4 in return. But, still, healthcare and consumer staples beat out #3, #4, and #5 by around 4 percentage points over 30 years! And, again, both industry groups were at the bottom of the pack in terms of risk.
Basically, no matter how I look at these numbers, all I can conclude is that the high-risk, high-reward myth has been soundly . . . busted. Need help on the Series 7?

Suitability Question - DPPs

Let's look at a practice question concerning suitability and direct participation programs:

If a customer on your book of business is expressing interest in a direct participation program, which of the following would you discuss with him first?

A. his appetite for risk

B. his need for liquidity

C. his experience with lower-quality bond investments  

D. his need for tax shelter

EXPLANATION: this is how the Series 7 maintains its tough reputation--all four answer choices look pretty good at first. Your job is to find fault with three of them. Are all DPP investments risky? Well--they all lack liquidity, which is a type of risk. But, existing properties is not as risky as raw land once you get past the liquidity problem. I'm not sure why this investor needs experience in junk bonds, which would not be illiquid or nearly as high-risk as most DPPs. Tax shelter is important . . . for most DPPs. But raw land programs provide no tax shelter.

Okay, so what would apply to all DPP investments?

A lack of liquidity. So, what should you discuss first with this investor? His need for liquidity.

The answer is . . .

B

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Suitability--the dreaded HOLD recommendation.

As a registered representative, you have suitability obligations whenever you make a recommendation to a customer. A recommendation could involve telling someone to buy a security, to sell a security, or even to hold a security. Therefore, you wouldn't send out a large-group email to 100s of customers telling them to hold securities unless you were sure that was a suitable recommendation for every recipient on the list.

Good news, not telling someone to sell a stock that you once recommended is not the same thing as a "hold" recommendation. A hold recommendation is an explicit recommendation to hang onto a particular securities investment.

Since a "hold" recommendation would not lead to a commission, I can't think of a good reason to send one out. Can you?
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US Treasury also Issues FRNs or Floating-Rate Notes

Even though buying a 2-year US Treasury Note was never a big risk, investors did face the risk of watching interest rates rise right after they buy. Buying new T-Bills every single week at auction is totally impractical for retail investors. Luckily, the Treasury now sells a floating-rate debt security whose interest rate re-sets each week based on the yield established through the weekly T-bill auction. Investors now don't have to worry if interest rates go up each week if they own a Floating-Rate Note, or FRN, since investors will receive whatever rate is established each week for 13-week Treasury Bill yields. The key facts on Floating-Rate Notes or FRNs include:

• Interest payments on FRNs rise and fall, based on discount rates for 13-week bills.
• FRNs are sold in increments of $100. The minimum purchase is $100.
• FRNs are issued in electronic form.
• You can hold an FRN until it matures or sell it before it matures.
• In a single auction, a bidder can buy up to $5 million in FRNs by non-competitive bidding or up to 35% of the initial offering amount by competitive bidding.

Floating-Rate Notes or FRNs provide liquidity and protection against capital risk/default risk, and interest-rate risk.

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SEC Announces securities fraud charges against the state of Kansas!

First, let's see the press release from the Securities and Exchange Commission's website:
Washington D.C., Aug. 11, 2014 — The Securities and Exchange Commission today announced securities fraud charges against the state of Kansas stemming from a nationwide review of bond offering documents to determine whether municipalities were properly disclosing material pension liabilities and other risks to investors. According to the SEC’s cease-and-desist order instituted against Kansas, the state’s offering documents failed to disclose that the state’s pension system was significantly underfunded, and the unfunded pension liability created a repayment risk for investors in those bonds. 
At first, this kind of headline might confuse someone studying for the Series 7. After all, aren't municipal securities exempt under the Securities Act of 1933 and the Securities Exchange Act of 1934? Yes, and yes. However, that just means they don't have to file registration statements with the SEC under the Securities Act of 1933 and don't have to file those annoying 10Q, 10K, and other reports that companies like SBUX and MCD have to under the SEA of 1934. Municipal securities are still securities and all securities are subject to anti-fraud statutes in the securities laws at both the federal and state level. Note that I didn't say every-thing is subject to the securities laws' anti-fraud statutes. I said all securities are. A fixed annuity is not a security, but a municipal bond or a Treasury Bond is still a security that is simply exempt from registration requirements. Big difference. The SEC already busted the chops of the State of IL, who has already implemented changes that involve making their own even worse pension fund situation clear to those buying their bonds. Kansas will likely follow suit, as they need to borrow money as much or more than any other state. Last thing they need is the SEC getting a federal court to prevent the State from issuing any bonds at all until they get their act together.Need help with your Series 7 exam?