DOL rule silver lining? It may trigger a shift of $1 trillion to ETFs

Five specific aspects of the DOL's new rule that could send assets flooding into ETFs.

If you hear wailing and the gnashing of teeth, it’s probably the financial services industry reacting to the Labor Department’s proposed fiduciary rule for retirement accounts.

But from time to time, you may also hear giddy laughter, and that’s coming from the ETF industry, which stands to gain about $1 trillion in assets if the rule takes effect.

“If the rules pass in the way they’re written, it’s going to drive people to low-cost passive products,” said Dave Nadig, director of exchange-traded funds for FactSet. “That’s 100% the case.”

At first glance, you wouldn’t think ETFs have much to gain from the DOL’s rule, which is designed to make sure advisers put their clients’ best interests before their own. After all, ETFs aren’t a big part of 401(k) plans, most of which aren’t set up for intraday trading.

COST ADVANTAGE

Nevertheless, nearly one-third of U.S. households owned individual retirement accounts in 2015, according to the Investment Company Institute, the funds’ trade association. Those IRAs had $7.3 trillion in assets at the end of the third quarter. The ICI says 59% of those with rollover IRAs worked with a financial adviser in choosing investments.

What part of the new rule will make ETFs so attractive for advisers who oversee retirement accounts? Primarily, low cost — although that’s not limited to ETFs.

“The issue becomes that every time an adviser is in a position to have to explain higher costs versus lower costs, it will welcome regulatory scrutiny,” said David M. Mrazik, managing director at MarketCounsel, a compliance consulting firm.

Morningstar senior equity analyst Michael Wong lists five aspects of the DOL’s new rule that will produce an estimated $1 trillion shift into ETFs:

Robo-advisers. If the fiduciary rule is finalized, it’s likely to mean that many advisers will not be able to keep smaller accounts, which are tough to justify on a fee-based or hourly billing basis. Most likely, those accounts will migrate to robo-advisers, which typically prefer passively managed index funds and ETFs. “One area we want to solve for is small accounts,” said Colleen Bell, vice president of fiduciary services at Cambridge Investment Research Inc., which is developing low-cost model ETF portfolios for small investors in anticipation of the DOL rule.

Commissions. Some advisers may transfer clients to ETFs from funds with trailing commissions or other incentives, which would reduce potential conflicts of interest under the fiduciary rule. “It becomes the safer, easier call for the adviser,” Mr. Mrazik said.

BICE. The rule may include an exemption for high-quality, low-cost funds known as the best interest contract exemption. The BICE provision reads, in part: “If it could be constructed appropriately, a streamlined exemption for high-quality low-fee investments could be subject to relatively few conditions, because the investments present minimal risk of abuse to plans, participants and beneficiaries, and IRA owners.” If the wording stays in the DOL rule, which is not guaranteed, ETFs and index funds would fit the DOL’s description nicely.

Cost balancing. If advisers are not collecting commissions, they may raise other fees for advice and record keeping. To keep total costs down, they might move clients to lower-cost options, such as ETFs, Mr. Wong said.

Safe harbor. The DOL rule says you can’t simply offer one company’s products on an adviser platform and claim fiduciary best practices by choosing the lowest-cost items on the menu. And that means you’ll probably need a few low-cost options on the platform, such as ETFs.

Under the DOL rule, index funds and ETFs aren’t the only allowable investments. Actively managed funds, even those with high expense ratios, may fall within the fiduciary test if they are the best investments for your clients’ needs. An actively managed REIT fund with a long history of beating its index, for example, could be a good choice for an income investor.

And it could be some time before ETFs make significant inroads to 401(k) plans, Mr. Nadig said. One big hurdle: It’s not always possible to buy fractional ETF shares, which makes dollar-cost-averaging difficult.

“Fractional shares are the secret sauce of dollar-cost-averaging,” Mr. Nadig said. “Buying by whole shares turns out to be a terrible way to do that.”

Nevertheless, low-cost ETFs will be the path of least resistance for many advisers once the fiduciary rule goes into effect. And if you happen to hear a merry trill of laughter during the debate over the fiduciary standard for retirement plans, you’ll know where it’s coming from.