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Fiduciary and Best Interest Rules

Between the existing DOL fiduciary rule and the new SEC best interest proposals, who is impacted by which regulations, and how?

The DOL fiduciary rule was originally proposed in 2010. It finally came into effect in June 2017 after some revisions, but has been officially not enforced by the DOL. In March, the Fifth Circuit Court overturned the rule. This ruling is being appealed not by the DOL, but by a group of state Attorneys General and by the AARP. The impact of this rule was only to qualified plans and retirement accounts, although in a big change for many money managers, it applied to everyone who selected or recommended investments in those plans or accounts.

Consumers are in favor of the DOL rule. In 2013, AARP surveyed more than 1,400 people.   93% favored requiring retirement advice to be in their best interest, and fewer than four in 10 indicated that they would trust advice from an advisor who is not required by law to provide that advice in the best interest of the investor.1

In the wake of the fiduciary rule debate, several states have passed laws or regulations that address the issue. New Jersey, New York, Connecticut, and Nevada are all in the process of implementing rules that address investment adviser conflicts of interest and fiduciary duty. These rules vary by state, with Nevada being the most stringent, requiring the fiduciary standard for all those giving investment advice, in all types of accounts.

In April, the SEC weighed in with their own new set of standards for investment advice. Coming in at over 1000 pages in total, the SEC sets out 3 proposed rules: Regulation Best Interest2, Relationship Summary3, and Restrictions on the Use of Certain Names or Titles3. Additionally, there is a regulation interpreting the fiduciary duty of Registered Investment Advisers4.

Although these new rules seem to be intended to add consumer protections, there are concerns that not only do the rules not go far enough, but that they may even dilute the existing RIA fiduciary duty. A major criticism of the new rule is that “best interest” remains undefined, which led SEC Commissioner Kara Stein to nickname the rule “Regulation Status Quo.” Ms. Stein, in her comments published on the SEC website5, states, “this proposal allows a broker-dealer to meet its “best interest” obligation by doing three things: providing some “reasonable” disclosure about its relationship with the customer, fulfilling what are essentially the existing standards for broker-dealer conduct (i.e., suitability), and having reasonably designed policies and procedures to eliminate, or mitigate and disclose the broker-dealer’s competing interests. By doing these three things, the proposed regulation protects the broker-dealer from liability or penalty, or what lawyers call a “safe harbor.” It protects the broker-dealer, not the customer.”

Commissioner Hester Pierce voted in favor of the new rules, but also agreed that this is not adding a fiduciary standard for broker-dealers or other agents or sales reps, stating, “It would be better to say we’re proposing a suitability-plus standard.”6

To an RIA, the disclosure mock-up in the new rules is particularly objectionable, characterizing the RIA as the more expensive option and emphasizing the relationship with a broker-dealer as “best interest” and “fair,” while not defining the fiduciary relationship at all.7 The comparable broker-dealer document contains similar language, while distinguishing the fiduciary relationship from the “best interest” relationship as being different merely in scope.8

While minimizing the difference between business models in the new required disclosures, the SEC seems to try to distinguish between them in their restrictions on the use of certain names and titles. The new rules restrict the use of the words “adviser” and “advisor,” not allowing broker-dealers or their employees to use those titles. RIAs, and, oddly, representatives of banks, insurance companies, and CTAs are still specifically allowed to use these titles. It has been suggested that this new rule might mainly result in more broker-dealers cross-registering as RIAs.

If the SEC wants to continue to allow the broker-dealers and others to provide investment recommendations without fiduciary duty, it’s important that consumers understand that these are, in fact, very different business models, with very different levels of care and loyalty to the consumer. There is certainly a need for the broker-dealer for those who wish to direct their investments, but the least informed consumer, most in need of fiduciary care, is the one who will be least helped by this new best interest rule and disclosure documents, and most likely to be misled by a person titled “adviser” or “advisor” who is in fact acting mainly as a sales representative.

 

1https://press.aarp.org/2018-4-26-AARP-Seeks-Rehearing-Court-Decision-Fight-Protect-Retirement-Savings

2https://www.sec.gov/rules/proposed/2018/34-83062.pdf

3https://www.sec.gov/rules/proposed/2018/34-83063.pdf

4https://www.sec.gov/rules/proposed/2018/ia-4889.pdf

5https://www.sec.gov/news/public-statement/stein-statement-open-meeting-041818

6https://www.financial-planning.com/news/sec-fiduciary-rule-faq-your-questions-answered

7https://www.sec.gov/rules/proposed/2018/34-83063-appendix-e.pdf

8 https://www.sec.gov/rules/proposed/2018/34-83063-appendix-d.pdf

 

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Problems with scientific research

Great article.

http://www.etf.com/sections/features-and-news/smart-betas-foundation-problem?nopaging=1

 

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Sinking of the Lexington – Battle of the Coral Sea

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Solar jobs

This is reported by CNBC, with data provided by The Solar Foundation.  So obviously an interested party making this claim.  However, it’s great news:

Solar jobs in America increased at an “historic” pace in 2016 on “unprecedented” consumer demand as the cost of solar panels declined, according to The Solar Foundation’s National Solar Jobs Census 2016.

The report – now in its seventh edition – found that the solar industry accounted for two percent of all jobs created in the U.S. over the past year, with solar jobs increasing in 44 of the 50 states.

As of November 2016, 260,077 solar workers were employed by the industry, “representing a growth rate of 24.5 percent since November 2015.” Over the 12 month period, the solar industry was responsible for more than one in every 50 new jobs created in the U.S.

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Investing in China

Any emerging markets or global markets investment strategy must, by definition, include an allocation to China.  Investing in China is not simple or straightforward. Here are some facts to help you determine how much exposure is appropriate, what kind of investments are available in indexed products, and other ways to find the investments you want.

Difficulties begin in understanding the availability of Chinese equity.  Here’s a snapshot of share classes available, where they trade, and in what currency:

Share Type Where traded Currency Notes Market Cap (USD, 12/31/17)
A-shares Mainland China (Shanghai and Shenzhen) Renminbi (Chinese Yuan) Ownership by foreigners still somewhat limited 5,089,631.28 (Shanghai)

3,621,635.94 (Schenzhen)

B-shares Mainland China (Shanghai and Shenzhen) US Dollars or HK Dollars   Included in data for A-shares
H-shares Hong Kong Exchange HK Dollars Often correspond directly to A Shares 865,144.86***
Red Chips Hong Kong Exchange HK Dollars State owned companies 732,986.54***
P-chips Hong Kong Exchange HK Dollars Non-state owned companies Included with H-shares and Red chips
S-chips Singapore Singapore Dollars   *
N-shares USA US Dollars    
ADRs USA US Dollars ADRs of H-shares and red chips are often called N-shares **
  Taiwan Taiwan Dollars   10,717.81

*Total Singapore exchange market cap was 787,255 as of 12/31/17 per WFE. 153 of 707 listings on the Singapore Exchange are Chinese companies, S-chips. http://www.shareinvestor.com/prices/stock_prices.html?market=sgx#/?filter=CC03&type=categories&page=1&layout=static_trading_data, http://www.sgx.com/wps/portal/sgxweb/home/marketinfo/indices/indices

**There are currently 93 Chinese ADRs trading on US exchanges and 202 Chinese ADRs trading OTC in the US, according to topforeignstocks.com.

***According to the Hong Kong Stock Exchange, approximately 30% of the total market cap in the exchange is comprised of Chinese companies via H-shares, red chips, and P-chips: http://www.hkex.com.hk/Market-Data/Statistics/Consolidated-Reports/China-Dimension?sc_lang=en&select={3A4BB661-6EB1-469E-AFBA-1E5664DDCE8D}

A, B, and H Shares consist of companies that are primarily Chinese and are incorporated in China. The other share types are incorporated in foreign countries, although the businesses exist within mainland China. Another complication is that many companies are traded using more than one of the share classes listed above. Additionally, Taiwan is in some respects considered a part of China, but economically, it is a separate state, and is a developed market.

What kind of indexed products are available? A variety of funds and ETFs follow indices tracking China. They are very different from one another based on the share types they hold. Here are a few examples, using some of the largest ETFs:

Symbol Benchmark Share types held Top Sector
FXI FTSE China 50 Index H-shares, Red Chips, P-chips Financial Services
MCHI MSCI China H-shares and B-shares Technology
GXC S&P China BMI All shares except A-shares and B-shares Technology

FTSE provides a guide on their website showing exactly what share types each index includes. MSCI also includes some of this information on their website regarding share types. S&P Dow Jones Indices details the geography and markets included rather than share types. All of the index providers have a variety of indices holding a variety of combinations of the above share types.

Active mutual funds are also an option. An advantage of active funds in this space is their ability to select the best available share type(s) for each company, instead of investing in each share type by market cap.

How do you know how much Chinese equity exposure you really have? The major indexing companies all assign a stock to a domicile based on factors other than the home exchange it is traded in. From S&P Indices:

A large number of companies based in China are incorporated and/or listed and traded in other places such as Hong Kong, Singapore, Bermuda (incorporation) or the U.S. (listings) because the Chinese equity markets are not completely open to global investors. These companies have been, and will continue to be, considered Chinese.

http://us.spindices.com/documents/methodologies/methodology-sp-equity-indices-policies-practices.pdf?force_download=true

FTSE reclassified N-shares and S-chips to China as of September 2017.

Morningstar reports also correctly classify these companies as being Chinese and EM, not the country where traded and/or DM. This means that whether your equity is an ADR purchased in the US or an A-share purchased in China or a Red Chip purchased in Hong Kong, your Morningstar report will correctly show you that it is a Chinese equity.

How much Chinese equity should you own? The table above shows us that A-shares traded inside China were valued at roughly $8.7T at the end of 2017, with over $2T more traded in other markets. Compare that to total global market cap of $85.3T, and you might assume that a weighting of approximately 13% for a global cap weighted portfolio might be appropriate. If you include GDP or PPP weightings as a factor, you would end up with an even larger share allocated to China.

However, global indices do not reflect this allocation. MSCI ACWI All Cap Index includes over 14,000 individual constituents. It shows a 6% allocation to Asia Emerging via Morningstar, which includes not only China but also other Asian emerging markets. S&P Dow Jones publishes their Global BMI Index, which includes over 11,000 stocks and allocates 3.7% to China. The FTSE Global All-Cap Index, with 7,400 stocks, includes just over 3% exposure to China.

Part of the reason for this lower-than-justified allocation is difficulties investing inside China. A-shares have gradually become more available to investors who are not Chinese. S&P Indices reviews possible inclusion of A-shares in their indices annually. Thus far, they have declined to add them at full market cap. In June 2018, MSCI will begin to include a portion of A-shares in its indices.

Related to the MSCI change, another reason for the low allocation to China in EM and all-world indices is that making changes to indices is problematic for everyone who uses them, even though changes are certainly required at times.

Investors and investment professionals who use an index as a benchmark will see any sudden changes in constituents of the index reflected in sudden changes to risk and return. MSCI estimated last year that if they included A-shares proportionally in their Emerging Markets index, the country weight for China would go from 28% to 40%. Their current plan only moves the needle a little – from 28% to 29.3%.

Changes to an index will result in market impacts, as funds that replicate the index buy and sell to match the changes. As an example, go look up what happened when Pakistan, UAE, and Qatar were moved from Frontier Market classification to Emerging Market by MSCI over the last few years. Their markets immediately jumped to new, higher levels, and stayed there, due to the additional buying by EM funds.

In addition, there’s a lot of debate about whether A-shares are a “good investment.” The arguments against investing in A-shares include the fact that many of the newly available equities are state owned enterprises and the apparent mis-pricing of stocks sold in more than one exchange. Maybe you aren’t ready to make this change.

What’s the bottom line?

  • To match actual China market cap, additional exposure to Chinese equity is likely required in any index-based portfolio. Many available indices simply do not reflect current markets.
  • Because the index providers are slowly playing catch-up, it’s vital to monitor and adjust exposure periodically.
  • Look beyond the Morningstar report – understand the share classes represented in any indices and funds chosen and verify that they match your intent.

 

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China tidbits

From the New York Times.

This article is discussing goings-on at Davos, January 2018.

 

At one end of town, President Michel Temer of Brazil welcomed an unexpected offer from Beijing for Latin American nations to work closely with a Chinese initiative, known as the Belt and Road, intended to spread its economic and diplomatic influence abroad.

At the other end of town, a senior Chinese diplomat helped introduce the prime minister of Pakistan at a breakfast meeting. Prime Minister Shahid Khaqan Abbasi used his talk to praise the rapidly expanding Chinese investments in his country, including to build power stations and a large port.

“The China One Belt, One Road is going to be the new W.T.O. — like it or not,” said Joe Kaeser, chief executive of Siemens, the German industrial giant, referring to the World Trade Organization.

On Friday, the Chinese government used a policy document issued in Beijing to call for a “Polar Silk Road” that would link China to Europe and the Atlantic via a shipping route past the melting Arctic ice cap.

These are very important developments internationally.

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Global Financial Assets

IIF reported on 1/4/18 that global debt (total financial FI assets) reached $230T.  Of that, according to The Economist, about $58T is government debt.

According to World Federation of Exchanges, global equity market cap for the end of December was $80T.

According to Yardeni Research, major central bank balance sheets are around $20T.

We know that the central banks own government debt, other debt, and equities.  This means that central banks now own approximately 6.5% of outstanding financial assets.

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