All posts by Sellwood Consulting

Rise and Shine: Why Bond Investors Still Shouldn’t Fear Rising Rates

Back in 2014, we wrote a piece, Who’s Afraid of the Big Bad Rates?, which argued that long-term investors in fixed income securities should not fear rising rates.

At the time, we argued two things — first, that it is not the question of whether rates would rise, but rather the timing and pattern of their rise, that determines how harmful rising rates are to a bond investor. Second, we suggested that of all the reasons for rates to rise, investors should not fear rates rising because of Federal Reserve actions – because the gradual nature of typical Fed interest rate movements gives rise to bond returns that are essentially unaffected by the rate movement. Rising rates are a double-edged sword, slicing principal value from bonds already owned, while paying higher coupons on those not yet purchased. It is possible, we showed in 2014, that rising rates could actually turn out to be a good thing for bond investors.

While all of that logic remains true, the world for bond investors is a different one than it was four years ago. Unlike in 2014, rates are rising today, because of strong economic growth, a tight labor market, concerns for potential inflation in the future, and an articulated long-term, careful reversal of the Fed’s stimulative monetary policies that have kept rates low for the last nine years.

The world is different today, and rates are (finally) actually rising. Is it different enough that investors should now fear rising rates?

What’s to Fear?

“Aggregate” bonds are those issued by US-based investment-grade issuers, including the US Treasury, agencies, and corporations. They are intermediate-term in nature and have a current duration of 6.1 years. They are a reasonable proxy for the types of bonds typically held by many long-term investors.

For a variety of good reasons, Aggregate bonds currently yield less than their long-term average: as represented by the Bloomberg Barclays Aggregate Bond Index, Aggregate bonds currently (as of February 28, 2018) yield 3.1%, whereas since 1990, their average yield has been 4.8%. Fears of their rates rising in the future are well founded. What happens to bond portfolios if rates continue to rise?

We have modeled several scenarios for future Aggregate bond portfolio returns, given different paths of rising interest rates. In each chart below, the tan bars represent the hypothetical future yield of an Aggregate bond portfolio, and the blue line represents the growth of $100 invested in the portfolio over the next ten years. Yields are plotted on the right axis, and value of the initial $100 is plotted on the left.

It may go without saying, but it bears repeating: the expected return for a bond portfolio is its current yield. If rates do not change over the next 10 years, we expect a portfolio of Aggregate bonds to return 3.1% per year over the decade. This is the base case return, against which we can compare several alternate scenarios.

Scenario #1: Rates Gradually Rise to Their Long-term Average

The following chart depicts the value of $100 invested in an Aggregate bond portfolio over the next 10 years, if the portfolio’s yield moves from its current level, 3.1%, to its long-term average, 4.8%, in even annual increments over the next ten years.

Under this scenario, the annualized return for the decade is 2.8%, which is 0.30% per year lower than the current yield. If rates rise in this fashion, holding all else equal, investors will earn 90% of the return they would have had rates not changed at all. Hardly a disaster.

Scenario #2: Rates Rise Quickly to Their Long-Term Average

What about a scarier scenario – that instead of yields rising monotonically to the long-term average in every year, they spike immediately in the first year, returning to their long-term average, and then never change again?

This scenario is even better for the investor than the first: after a one-time drawdown, of about 7% of initial portfolio value, the bond portfolio recovers, and its total return returns to positive territory in the third year. The reason is that higher rates pay higher income – enough to offset a principal drawdown after less than two years, and in every year thereafter. The total annualized return over the decade is 3.5%, significantly higher than the portfolio’s starting yield. Far from being a scenario to fear, this is the type of rising rate scenario that long-term investors should root for.

Scenario #3: Rates Rise to Their Long-Term Average, 9 Years from Now

At the other end of the thought-experiment spectrum, we can design the opposite scenario: one where rates don’t change at all for nine years, and then spike to their long-term average in the final year:

This scenario combines the worst of both worlds – low coupon income for most of the decade, followed by a principal drawdown at its end due to the sudden rise in rates. Still, this worst case of our three scenarios results in a positive annualized return of 2.0% over the decade – a disappointing outcome relative to expectations, but far from a devastating one.

Holding all other variables constant and focusing solely on interest rate movement, these three scenarios represent bookends for future Aggregate bond returns. Under these assumptions, we cannot engineer a scenario where Aggregate bond returns will be painful over the coming decade. If we accept that interest rates are low and have potential to rise, but only as high as their long-term average, their annualized returns over the next decade will be somewhere between 2.0% and 3.5% — somewhere between 65% and 112% of the return you’d expect if rates didn’t change at all (3.1%, the current yield).

The gravitational pull of current yields is strong and nearly inescapable– it is very likely that future returns will be close to it. Any scenario less dramatic than those depicted above will result in an annualized return for Aggregate bonds, all else equal, closer to their current yield of 3.1%.

What Would It Take To See Negative Returns?

We have seen that it is very difficult to engineer a path of rising interest rates that would generate disappointing returns, as long as we assume that rates will rise no farther than their long-term average.

But what if we relax that latter assumption? It is possible, after all, that a regime change for bond yields lies just over the horizon, and that an extended period of below-average rates will be followed by a period of above-average rates.

How high would rates have to rise to generate zero bond returns for an investor, over a 10-year period? A scenario where rates don’t change for 9 years, and then rise by 4.5% in the final year of the decade, would do it:

So would a scenario where bond yields rise every year by 1.85% — for a total of 18.5 percentage points over a 10-year period (from a yield of 3.1% to a yield of 21.6%):

This is what it would take for Aggregate bonds to deliver a flat return over the next ten years: either rates need to gradually rise to historically unprecedented levels (the highest recorded yield for the Bloomberg Barclays Aggregate Index was 15.4%, in 1981) or yields need to actually not rise at all anytime soon, until they more than double in a single year, nine years from now. How likely are these scenarios?

If these scenarios are unlikely, any predictions for a meaningfully negative Aggregate bond returns over the next ten years are downright outlandish. These “disappointing” returns we have constructed are merely 0% annualized returns over a 10-year period. It would take significantly more heroic assumptions to forecast meaningfully negative returns for Aggregate bonds. As well, any such scenario we could design would build in such high yields at the end of the 10-year period that subsequent bond returns would be phenomenal, benefiting from very high yields (coupon payments) at the end of our ten-year forecast period and the beginning of the next. Under this extremely unlikely scenario, any loss in the coming decade would be quickly recovered shortly thereafter.

Nothing to Fear but Fear Itself

All of our modeling has made a critical assumption that investors are long-term investors, with relevant investment horizons of at least a decade. We are comfortable making this assumption because investors with shorter horizons than a decade probably should not have all of their bond investments in Aggregate bonds anyway. Investors with shorter horizons should own shorter bonds, which are less exposed to interest rate movements. Investment horizon is among the most relevant questions to ask when designing a portfolio.

Over long enough horizons, most risks melt away, and interest rate (duration) risk is no exception. The ability to ignore short-term market forces is one distinct advantage of being a long-term investor. Most of the damage that an intermediate duration bond investor can suffer from a rapid rise in interest rates is a result of either choosing to or being forced to sell shortly after a significant rise in interest rates. If an investor can hold onto the bonds for the longer term, higher coupons will recover the early losses over time – but only if the investor doesn’t sell them first.

We caution any investor against the temptation to modify a long-term portfolio away from its optimal allocation, which should ideally be designed specifically for that investor and its unique circumstances, in response to predictions for short-term market forces. This includes any predictions for the direction of interest rates. All forecasts, including those for interest rate direction, are unreliable. Even the US government hasn’t demonstrated any ability to forecast US government bond interest rates.

Equally, we maintain ourselves, and counsel our clients to maintain, humility in the investment process. While it’s always possible that this time is different, and interest rates could go from 3% to 21% over the next decade, it is very unlikely. It would take an unprecedented circumstance for a bond investor to experience a truly disappointing return. While every risk is worth hedging, very unlikely risks are worth hedging only at the margin, not by dramatically changing either the size or composition of a bond allocation within a diversified portfolio.

Finally, we encourage all investors to do the math. The above modeling is available to anyone with a finance textbook and a calculator. We did not invent it. Every scenario we have modeled acknowledges a possibility for higher rates – in fact, every scenario assumes rising rates. But assuming rising rates is not enough – the path and magnitude of the rising rates are much more consequential than a prediction of whether they will rise. The above analysis shows that some reasonably likely scenarios for rising rates actually benefit the investor.

Ultimately, when we look at bonds, it is difficult for us to see a scenario where long-term investors will be disappointed relative to reasonable expectations – you have to torture the data pretty thoroughly to get it to confess to prospects for disappointing return. Very few portfolios are made up entirely of bonds. They typically exist in a portfolio to offset other risks – mainly, those delivered by equities. This important portfolio role for bonds is far from nullified in the face of prospects for rising rates.

2018 Capital Market Assumptions

 Download our 2018 Capital Market Assumptions White Paper.

Sellwood Consulting’s 2018 Capital Market Assumptions are available. These 10-year, forward-looking assumptions of asset class return, risk, and correlation are the key input variables for our asset allocation work on behalf of clients.

We update our assumptions annually. Over the course of 2017, investors’ shifting preferences away from bonds and toward risk-seeking assets caused valuations for risky assets to expand, fixed income spreads to tighten, and yields for shorter-term Treasury bonds to rise. Updating our assumptions for 2018, we forecast lower returns for every equity category, and higher returns for most fixed income categories, than we did last year.

As a result of these updates, our forecasted “capital markets line,” depicting opportunities for investment return at varying levels of risk, has flattened: we believe that over the next ten years, investors will not be as compensated for taking risk as they have been in the past. In the case of fixed income, higher real yields bring greater opportunity for return with lower risk. For risky assets, like global equities, the market experience of 2017 brought higher valuations, which pull return from the future into the past.

Within equities, it is no coincidence that the markets that experienced the largest gains in 2017 saw the largest declines in forward-looking assumed return under our valuation-based methodology. Even after these changes, our modeling suggests that investors will be well served to diversify their equity exposure outside the United States. Emerging Markets equity remains the asset class with our highest expected return, albeit with our highest forecasted risk amongst equity categories.

Within fixed income, our analysis presumes that interest rates will rise. Consequently, we forecast that duration risk will not be compensated. We expect that nominal bonds between low and long duration will experience roughly similar returns over the next decade.

This year, we made two changes to our methodology. First, we added a short-term TIPS assumption, to go alongside the TIPS assumption that has been included in our assumption set as long as it has existed. Our methodology for this assumption is consistent with our methodology for all other fixed income assumptions. Second, we improved the methodology that we use to forecast US small-cap returns. Details can be found in our white paper. All other changes to our assumptions simply reflect new information that the market provided us in 2017.

Postmortem of a Correction

Loathe as we are to give any thought to short-term returns, the recent market correction has been interesting.

The S&P 500 index peaked on January 26, before dropping approximately 2% over the next few trading sessions, and then dropping more precipitously during the week of February 5. On February 8, the market had declined by 10%, officially a “correction” (it has since recovered a portion of these losses).

How bad was it?

While never comfortable, market corrections are common, and the recent 10% market decline was not historically unusual.

Since 1949, there have been 34 double-digit drawdowns in the US stock market – about one every other year, on average. Over the same period, the average magnitude of a market correction has been 15%. Over a longer history, since 1900, the Dow Jones Industrial Average has declined by 10% or more about once per year, on average.

Even in the current post-2008 market cycle, the US stock market has declined by double digits five times. US stocks fell 16% in 2010 over fears of a double-dip recession, and they declined by nearly 20% in 2011 during the European debt crisis. 2015 and 2016 saw corrections of 12% and 14% after a global growth scare and fears of a hard landing of the Chinese economy.

What caused this correction?

Nobody knows for sure, but that hasn’t stopped everyone from having an opinion. One interesting thing about markets is that the return experience drives the narrative. Several narratives have emerged, each of which is plausible:

  1. Rising rates: Real interest rates on government bonds have been rising since early September. Higher interest rates make future cash flows worth less today, sending stock and bond prices lower.
  2. Inflation concerns: On February 2, the government’s non-farm payroll report showed signs of wage growth, which suggests higher inflation in the future. Higher expected inflation implies that the Federal Reserve, especially with a new Chair, will raise interest rates more quickly than had previously been anticipated.
  3. Mean reversion: The S&P 500 index rose by nearly 6% in the month of January. Because broad stock market averages don’t rise by 70% a year, something had to change.
  4. Human emotion: Market participants, being human, wanted an excuse to sell and take profits. A market drop of uncommon (in recent memory) magnitude provided the reason.
  5. Robots: High-frequency trading, algorithms, and risk parity strategies have been blamed by some observers, although there is not consensus on whether these strategies represent enough of the market to have caused the correction.
  6. Valuations: In January, the two-year Treasury bond yielded more than the S&P 500 did.
  7. Fiscal (over)stimulus: In the face of historically low unemployment and stable economic growth, the recent adopted corporate tax cuts and proposed federal infrastructure spending initially poured high octane fuel into the economic engine. Subsequent realization that burgeoning deficits and rising inflation could disrupt the economic engine sparked a sell-off.
  8. Optimism: It is said that “markets climb a wall of worry.” The tremendous market gains since March of 2009 came during a period when most of the news about, and public analysis of, the market was negative and discouraging. With the benefit of hindsight, we can look back and see that economic fundamentals were steadily improving over these past nine years, but in the moment, that steady growth was obscured by dramatic negative events and headlines. By the end of 2017, all the headlines had turned positive – a survey of small business optimism was the highest it had been since 1980, consumer confidence readings were their highest since the mid-1990s, US unemployment was lower than at any time since 1999, and even wage growth was finally appearing. By January 2018, the wall of worry had crumbled, and the stock market, having reached its summit, responded to the law of gravity.
  9. Random chance: The 10-day market return was well within a normal distribution of short-term returns, and a reminder that returns are compensation for bearing risk.

Or some combination of the above. In the end, nobody knows, and it doesn’t really matter. Markets experience corrections of similar magnitude in most years. Explanatory narratives always emerge after the fact, but they don’t change the fact that markets don’t necessarily need a reason to correct. Just as trees do not grow perfectly vertically, markets never rise without interruption. Corrections are a normal feature of markets.

Nowhere to hide

What is more interesting to us is how diversified portfolios held up in the market correction – which is to say, not very well.

From peak to trough (January 29 – February 8), markets saw the following returns:

Return-seeking assets

  • US large-cap stocks (S&P 500): -10.1%
  • International stocks (MSCI ACWI ex US IMI): -7.8%
  • US REITs (Wilshire US REIT): -9.1%
  • Commodities (Bloomberg Commodity): -4.1%

Risk-hedging assets

  • Intermediate-term high-quality bonds (Bloomberg Barclays Aggregate): -1.0%
  • Long-term high-quality bonds (Bloomberg Barclays US Gov’t/Credit Long): -3.2%
  • Trend following strategies (Credit Suisse Managed Futures): -8.9%
  • US Treasury Inflation-Protected Securities (Bloomberg Barclays US TIPS): -1.1%
  • US short-term TIPS (Bloomberg Barclays US TIPS 0-5 Years): -0.3%
  • US Cash (US T-Bill): 0.10%

This correction was unique in that diversification did not appear to help. Assets that traditionally have offset market declines, like long-term bonds and trend following strategies, suffered negative returns along with equities. Although correlations between assets typically rise in times of market stress, risk-hedging assets have often been exempt from this phenomenon. In this recent correction, they declined as well, because the scare that affected equities – concerns for higher inflation and real interest rates – is bad for both bonds and stocks. Even assets designed to protect against changes in inflation expectations – TIPS – declined, because one component of their return is that of a Treasury bond.

Onward, With Caution

In a sense, market corrections are a gift: they provide risk, without which there would be no return.

The correction is a reminder that the only market history worth paying attention to is its long-term history. Prior to this most recent correction, the S&P 500 had experienced 404 consecutive trading days without a 5% drawdown, the longest such streak since 1959. An evaluation of the market only since January of 2016 would suggest an environment of return without risk, against a backdrop of global economic stability and a very low volatility. Complacency is a risk to investment decision-making in this sort of environment.

Moreover, we believe that a long-term perspective is equally valuable when assessing the merits of diversification. While all data points are valuable, diversification cannot be judged by how it performs in any ten-day period.

Finally, as much as the world is driven by computers and machines, markets are still moved by human beings. Humans overreact to new information, become overly exuberant when prices rise, and unreasonably panic when prices decline. The rational response to this scenario is to maintain calm and discipline – to be more robotic. Disciplined portfolios, including periodic rebalancing strategies, take advantage of market corrections by buying at lower prices.

There is no return without risk. Until three weeks ago, this notion may have seemed passé. The recent market correction suggests that the laws of finance have not in fact been repealed. A proper long-term perspective suggests that market corrections like the one we just experienced are normal features of risky markets.

Steep declines are much more likely in shorter periods than longer periods. A 10% drawdown inside a calendar year is relatively common, but a 10% drawdown over several years is very unlikely. Whether a 10% market correction is consequential to an investor depends entirely on the investor’s investment horizon. For any true long-term investor, over time, market corrections fade into irrelevance as signal overwhelms noise and distributions of return narrow. For investors with shorter horizons, the correction is a reminder that stocks are less suitable components of a portfolio and should be approached with appropriate caution and portfolio sizing.

Further Reading

December 2017 Market Snapshot

Download (PDF, 146KB)

Fourth Quarter 2017: Bitcoin Steals the Show, but Doesn’t Ruin the Plot

The final quarter of 2017 was a microcosm of the year as a whole; every major asset class was up around the globe, and nearly all sectors and regions were as well. For the first time in history, the S&P 500 rose in every single month of the calendar year, accompanied by historically low volatility. In US markets, investors continued to prefer growth-oriented and larger-capitalization companies. Global markets continued to expand as emerging markets posted the strongest gains; in contrast to the US, smaller companies outgained larger names. Almost 1,700 companies made initial public offerings in 2017, the most since the financial crisis, with a resurgent US and emergent China leading the way.

US GDP expanded modestly for the year, echoing the world economy, which also continued to grow. All 45 countries tracked by the Organization for Economic Cooperation and Development grew in 2017, with the majority seeing accelerating growth. In the US, job growth remained strong and the unemployment rate continued to tick down below Federal Reserve projections. Export growth, helped by a weakening dollar, grew by more than 5% in the third quarter after 6% and 7% growth in the first two quarters, respectively.

Divergent monetary policy paths between the US and the rest of the world are evident in sovereign bond markets. The Federal Reserve judged the US economy robust enough to raise rates for the 5th time since the financial crisis and reiterated a path of “policy normalization” (gradual reduction) of its balance sheet. Stimulative monetary policies from Japan and the European Central Bank, on the other hand, have put downward pressure on global interest rates. This policy has helped keep a lid on long-term Treasury rates, which ended the year approximately where they were five years ago. The combination of rising short-term rates and stubbornly low long-term rates created a significantly flatter yield curve.


Happy Holidays From Sellwood Consulting

In the spirit of the holiday season, every year Sellwood Consulting donates to a local charity on behalf of our clients. This year, we elected to support Habitat for Humanity. Every day, families of all sizes struggle to find affordable places to live. Rapidly rising rents force people to live in unsafe, unhealthy, and crowded conditions. Habitat for Humanity is a global nonprofit dedicated to eliminating substandard housing by building simple, decent, affordable homes in partnership with families in need.

This December, Sellwood’s employees joined Willamette West Habitat for Humanity for a “Team Build Day.” We are honored that both our physical labor and monetary donation will help provide affordable housing to some of our community’s neediest families.

“Fiduciary” Isn’t Enough

“Political language is designed to make lies sound truthful and murder respectable, and to give an appearance of solidity to pure wind. One cannot change this all in a moment, but one can at least change one’s own habits.”

— George Orwell, Politics and the English Language

The recently implemented Department of Labor standard, under which all providers of investment advice to ERISA retirement plans are designated as fiduciaries, has increased awareness amongst the public and plan sponsor universe that not all providers of investment “advice” have a client’s best interests at heart.

The word “fiduciary” has leapt from legal esoterica into the common parlance, but in the transition it has become misunderstood. While it would be tempting to take the presence or absence of a single descriptive word to determine whether an investment advisor places client interests first, a single word is not sufficient. While we believe that no client should take advice from any party that is not a fiduciary for that advice, “fiduciary” isn’t enough.

To understand why, we must first delve into some competing definitions of the word “fiduciary.”

The Common Definition:

“A person who has the power and obligation to act for another under circumstances which require total trust, good faith and honesty.”

Source: (emphasis added)

This definition is simple and straightforward. “Total trust, good faith, and honesty” leaves no room for interpretation. Under this common definition, serving as a fiduciary for someone else means behaving absolutely in the other person’s best interest. Period.

This is, broadly, the standard that institutional clients – trustees of nonprofit organizations, members of committees overseeing retirement plans, etc. – are held to in oversight of those portfolios.

If the client sponsors an ERISA pension or benefit plan, the standard is even more explicit. The Employee Retirement Income Security Act (ERISA) defines the word “fiduciary” more comprehensively:

The ERISA Definition:

“A fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and –
(A) for the exclusive purpose of:
(i) providing benefits to participants and their beneficiaries; and
(ii) defraying reasonable expenses of administering the plan;

(B) with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims;

(C) by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so; and

(D) in accordance with the documents and instruments governing the plan insofar as such documents and instruments are consistent with the provisions of this subchapter and subchapter III of this chapter.”

Source: The Employee Retirement Income Security Act (ERISA)

This is a strong standard. It requires that fiduciaries to an ERISA-governed plan place the interests of the plan’s participants and beneficiaries first and foremost, pay only reasonable expenses in the management of the plan, and act with high degree of competence when overseeing it. It leaves no wiggle room around these requirements.

Both of these definitions of the word “fiduciary” are considerably stronger than the one to which the Securities and Exchange Commission holds Registered Investment Advisers.

The Securities & Exchange Commission’s Definition:

“As an investment adviser, you are a ‘fiduciary’ to your advisory clients. This means that you have a fundamental obligation to act in the best interests of your clients and to provide investment advice in your clients’ best interests. You owe your clients a duty of undivided loyalty and utmost good faith. You should not engage in any activity in conflict with the interest of any client. … You must eliminate, or at least disclose, all conflicts of interest that might incline you — consciously or unconsciously — to render advice that is not disinterested. … If you do not avoid a conflict of interest that could impact the impartiality of your advice, you must make full and frank disclosure of the conflict.”

Source: The SEC (emphasis added)

This is the definition of “fiduciary” that applies to investment advisors who provide investment advice (as distinct from sales of investment products), and register with the SEC as Investment Advisers under the Investment Advisers Act of 1940.

Note the SEC’s emphasis on disclosure. The SEC does want investment advisors to put client interests first, but according to its definition, that aim is accomplished if the advisor adequately discloses all the ways that it doesn’t.

This odd definition creates the problem. While the people and organizations overseeing institutional portfolios – Board members, staff members, companies sponsoring retirement plans, etc. – are fiduciaries to the portfolios and institutions they oversee under the first or second definitions of the word, the investment advisors they hire are typically fiduciaries under the third definition. (We are leaving aside the very important question of whether the “advisor” chooses to be a Registered Investment Advisor and uphold even the SEC’s definition of “fiduciary.”)

This wouldn’t be a problem if the word “fiduciary” had common meaning. But the SEC’s definition of the word “fiduciary” (the one applied to investment advisors) is considerably weaker than the common-law definition of the word (which applies to the clients themselves).

Clients are fiduciaries in the strong sense of the word; advisors (if they are Registered Investment Advisors) are fiduciaries in the weak sense of the word. Clients can’t simply disclose away a conflict of interest that renders them less than totally impartial in fulfilling their duties. They shouldn’t hire an advisor to help them discharge this responsibility, if the advisor they are hiring isn’t held to the same standard.

Sellwood’s Definition of “Fiduciary”:

Sellwood Consulting is a Registered Investment Advisor, registered with the SEC. While we believe that the only advice worth taking is that which comes from a fiduciary, we also believe that the SEC’s definition of the word is inadequate to ensure that advice to clients is unbiased and undertaken with their interests first and foremost. So, we define “fiduciary” a fourth way:

  1. Eliminate, rather than disclose, all conflicts of interest.
  2. Operate culturally as fiduciaries, in writing, for all services & for all clients.
  3. Offer only one line of business: institutional investment advice.
  4. Treat client assets as if they were our own.
  5. Make every recommendation or portfolio decision in the client’s best interest.
  6. Pursue highly rigorous professional education & certification.
  7. Implement the highest-quality investment programs possible.
  8. Implement investment programs at the lowest possible cost.

Sellwood’s definition is much closer to the first and second definitions of the word, above. It is therefore closer to the standard that our clients are held to in fulfillment of their important duties. When we help clients discharge their fiduciary responsibilities, we are behaving fully as fiduciaries in the same sense that they are.

There is no word for this type of fiduciary. We may have to settle for “Fiduciary, for Real,” or “Old School Fiduciary.” It doesn’t roll off the tongue.

Client Implications: Count the Disclosures

As important as it is to consider the definition of the word “fiduciary,” it’s equally important to examine the word that typically comes next. It’s not a fiduciary rule; it’s a fiduciary standard. Being a fiduciary shouldn’t mean adhering to a set of externally imposed limitations or constraints on behavior. It shouldn’t be something that can be turned on or off, depending on the client or service performed. It should mean, instead, upholding a standard for professionalism and ethics that places client interests before the advisor’s, at all times and for all clients. Culturally and permanently, not optionally or just when the regulators require it.

It is unfortunate that the word “fiduciary” means so many different things. If we had a shared definition of the word, it would serve as a useful shorthand for evaluating whether an investment advisor operates in a culture of placing client interests first. Without that shared definition, we propose a different rule of thumb: count the disclosures.

The SEC’s definition of “fiduciary” requires that the advisory firm “eliminate, or at least disclose, all conflicts of interest that might incline [the firm] to render advice that is not disinterested.” It stands to reason, therefore, that the number of disclosures in a firm’s ADV filing, marketing materials, and Advisory Agreement is a rough proxy for how many conflicts of interest the advisor would have in serving a client, even as “fiduciaries” as defined by the SEC. Count these words, which are typically in eight-point font and written by lawyers. They are all there because they have to be, not because the advisor wants them to be.


The word “fiduciary” means too many things, leaving open the possibility that clients are held to stricter standards than their advisors are, in oversight of their portfolios. These differences are meaningful: the Department of Labor estimates that conflicts of interest between investment advice providers and their clients cost investors $17 billion every year – and this is only counting retirement savers.

Nobody should take investment advice from any party that is not a fiduciary for that advice, in writing. But it remains the case that an investment advisor can call itself a fiduciary while operating with meaningful conflicts of interest that impair the advice it delivers to clients, as long as those conflicts are disclosed. Clients don’t have an option to disclose away conflicts, so they should insist on a higher standard of their advisors.

Disclosure is no substitute for elimination of conflicts of interest. “Fiduciary” isn’t enough.