Guest Article: DSC Index Funds

This is a another guest article by Jim Stark. Jim Stark is a pseudonym for a practicing Canadian financial advisor.

Why are there no DSC Index Funds?  On one hand, pretty much any advisor knows that there is no such thing as a DSC index fund and why that is so.  On the other hand, many retail investors probably never thought about it- and likely wouldn’t be able to accurately explain why this little wrinkle exists even if they did.  There’s likely a pretty severe disconnect on this- a topic that could have applications in the fields of practice management, ethics, client suitability and advisor ‘value propositions’ to name a few.

(Note: there actually are DSC Index funds these days, but they are far from ubiquitous – Preet)

In order to be clear, it needs to be underscored that mutual fund companies “manufacture” products, while financial advisors “distribute” them.  Obviously, no one could be expected to distribute a product if no one is manufacturing that product in the first place.  So, to modify my original question in the interest of specificity, “why don’t mutual fund companies manufacture DSC index funds?”

I’ll try to grapple with the question by confessing my concern right off the bat.  To me, this is a case of undue bias.  I would hope that all readers would agree that in an advisory relationship, the interests of the client should always come first.  Still, advisors are absolutely allowed (indeed, expected) to advocate for whatever products and processes they feel are best and are absolutely allowed to choose their own business model, too.

Many advisors insist that they are “independent”.   When asked by someone who understands the industry, however, one quickly finds that many “independent” advisors have an attitude that is similar to Henry Ford’s early take on car colours: “you can have any colour you want, as long as it is black”.  My take on those advisors who use mutual funds is that they effectively tell their clients that they suggest that they can: “have any mutual fund they want, as long as it pays an embedded compensation”.

This isn’t a topic that is confined to index funds, obviously, since there are dozens of credible actively-managed mutual funds available that never make it on to many advisors’ product shelves, either.  I chose to explore index funds because in the case of actively-managed funds, advisors can always find a similar fund that offers an embedded compensation and skirt the ‘advisor value’ conversation that might otherwise ensue.

The problem, as I see it, is when the business model drives the product recommendations to the potential detriment of the client interest.  The implicit premise of much financial advice is that the advisor is more likely than a layperson to reliably identify outperformers in advance.  Indexing drops all pretense of doing that.  As such, it begs the question of what one might reasonably expect from an advisor.  It has been suggested that the three primary functions of good financial advisors are to:

1. Spot problems and identify solutions.

2. Motivate people to act/change their behaviour.

3. Help people to emotionally detach from investment market events.

Notice that picking stocks and picking people who pick stocks (i.e. picking actively managed funds) is not on the list.  When talking about index funds that offer no embedded compensation, there’s no product alternative available today that has a similar mandate, but with advisor compensation built in.  In essence, advisors that use a commission model simply do not offer index products to their clients.

Obviously, the absence of a DSC index option would be a complete non-issue if actively managed products were demonstrably superior.  But what if substantial evidence suggests otherwise?  What if there are a number of clear and compelling reasons for a rational, self-interested investor to prefer an index product?  That brings us to what I believe is one of the fundamental questions in our industry today.  Where does one reasonably draw the line in regard to required disclosures regarding the risks and limitations for competing products and strategies where the relative efficacy of two or more alternatives is not obvious?

When giving presentations to ten or more members of the public, what if the following disclaimer was used:

The views expressed are those of (advisor name) and are not necessarily shared by (firm name).  Debate regarding market efficiency, the usefulness of fundamental and technical analysis, active vs. passive management and the efficiency of payments is ongoing.  To date, neither side has been able to claim unchallenged victory.

I cannot help but notice that people who favour active products and strategies, but fail to compare the two are not required to use the disclaimer.  The question that it begs is: “if neither side has been able to claim unchallenged victory, then how can an independent advisor recommend only one side to clients with a clear conscience”?  The corollary is: “how can it be acceptable to avoid an important disclaimer by simply avoiding a direct comparison”?  At the very least, shouldn’t all advisors be required to disclose that both alternatives exist, irrespective of the approach they favour- especially if there’s a reasonable possibility that the alternatives they favour is inferior to the one being recommended?  The industry hides the ugly truth by tolerating the non-disclosure of material considerations that could alter the decision-making process.

From my vantage point, the issue is not whether or not advisors should be allowed to advocate for one product line or business model or another.  Clearly, they can do whatever they feel is best.  The issue is whether or not they should be allowed to deliberately withhold credible and viable alternatives from their clients and still be considered independent professionals.

Thanks Jimbo. So what do you guys think? I realize this is written more towards advisors (as Jim’s articles usually are), but there is certainly food for thought for everyone.