There is a big difference between doing what is right and doing what is legal!
What’s the difference and why is it important to me and my money?
Most investors are not aware of the different standards of service / care as it relates to their money. With all the controversy surrounding financial reform and the SEC’s pending lawsuit against Goldman Sachs, now may be a good time to explain the differences. I will touch base on each one’s role and its potential impact to you as an investor.
Registered Investment Advisor (RIA) = Fiduciary responsibility
RIA’s are registered with and overseen by the U.S. Securities and Exchange Commission. For example, IIA is a fee-only RIA firm. Under this arrangement, the work that we perform for our clients requires that we put their best interests first.
Does it mean that our recommendations are 100% perfect and never decline in value? No, not at all. What it means is we must in every way possible perform investment advisory and consulting services in a manner that puts the clients’ best interest first. Bottom line, IIA and its associates must not take actions or make recommendations that we believe puts our interests ahead of or in conflict with our clients.
The fee-only premise is simple. In the management of our clients’ funds, IIA and its associates cannot receive commissions or sales charges, but is only compensated via a small percentage (i.e., 1% or less of the average assets under management). This eliminates any economic incentive to recommend a particular investment or portfolio of investments to our clients or to churn the account (i.e., excess trading of a client’s account to increase commission income). It keeps our recommendations and advisory work completely objective and puts our clients’ best interests at the forefront. Thus, a long-term successful investment strategy is mutually beneficial for all involved. The more successful the portfolio is, then the larger it grows. The clients directly benefit, and IIA has the privilege of managing more assets on their behalf.
Registered representative or stockbroker = recommendations must be suitable
Registered representative and stockbrokers are regulated under the Financial Industry Regulatory Authority, Inc. (FINRA). Under this arrangement, the investment professional has a far different standard that requires them to ensure that products that they are recommending / selling are suitable for their clients.
Traditionally, stockbrokers were compensated on making investment recommendations (i.e., buy or sell certain securities). As such, they were paid a commission on each transaction. Thus, the more transactions placed in their clients’ accounts, then the more income to the stockbroker. Unfortunately, this can lead to churning. Churning is defined in the Dictionary of Finance and Investment Terms as “excess trading of a client’s account. Churning increases the broker’s commission, but usually leaves the client worse off or no better off than before. Churning is illegal under SEC and exchange rules, but it is difficult to prove.”
Stockbrokers and registered representatives are allowed to offer portfolio management services in lieu of the more traditional transaction / commission based model. Under this arrangement, they are allowed to charge management fees and also receive commissions (i.e., 12B-1 fees) from mutual funds they recommend. 12B-1 fees are a form of additional compensation embedded within a mutual fund’s expenses. The predominant use of 12B-1 fees is in funds sold through brokers, insurance agents and financial planners. It should be noted that the majority of mutual funds offer several different share classes of the same fund. Thus, most often you can find the same fund in a share class with no 12B-1 fees, which results in lower fees and higher returns to the clients.
For example, an IIA client transferred their retirement accounts from a large Wall Street brokerage firm. In doing so, they gave me a copy of the other firm’s portfolio management agreement. This firm’s management fee was 1.13% of the assets under management. They can also receive 12B-1 fees from the funds that have them. In this case, the 12B-1 fees were 0.25%. Depending on the funds recommended, the firm’s combined fees could have totaled 1.38% of the client’s assets under management (AUM). At IIA our fees begin at 1% and decline from there.
In addition, this agreement specifically had a section labeled – Conflicts of Interest. This section informed the client that the investment firm can take actions or make recommendations that put it in conflict with what is in the client’s best interest. Thus, the client may be invested in funds that their advisor considers suitable for them. However, they may not be some of the more highly rated, better performing or lower expense ratio mutual funds, which would definitely be in the client’s best interest.
Market maker = provides liquidity by bringing buyers and sellers together
The Dictionary of Finance and Investment Terms defines a market maker as “a dealer firm that maintains a firm bid and offer price in a given security by standing ready to buy or sell at publicly quoted prices.”
In the recent Senate hearings regarding the alleged fraud committed by Goldman Sachs, the firm’s top brass defined itself as a market maker. As such, the firm’s primary objective is to maintain liquidity for investments by bringing buyers and sellers together. In this particular case, the investment was collateralized debt obligations (i.e., mortgages). Thus, as we clearly saw in the testimony, the firm can definitely take positions that are in conflict with its clients’ best interest for the purpose of hedging its position.
This is not meant to be a defamatory statement, but just a fact. As long as all parties involved are fully informed and know the lay of the land, then there are no problems with this arrangement. However, reality shows that this may not be the case.
One interesting and ironic fact is that stockbrokers and registered representatives are allowed to provide client testimonials regarding their services. However, RIAs are not. Thus, the currently 634,000 registered brokers *, who can work on commission-oriented / suitable recommendations platform, are allowed to have their clients give written accolades and positive comments regarding their advisor, but the current 23,000 registered RIAs * who work under a fiduciary obligation are not. Also, in all this talk about financial reform, a provision that would require stockbrokers and registered representatives to work under the same fiduciary obligation as RIAs has been dropped. Do you see any irony in this?
* As noted in the April 26, 2010 InvestmentNews paper edition.
If you would like to see more on this subject, please click on the following links:
http://www.maximizemyriabusiness.com/files/1746_TD_WhtPpr_M12_FINAL.pdf
http://www.investmentnews.com/article/20100425/REG/304259959
In conclusion, you can talk all day about asset allocation and model portfolios. However, under the stockbroker / registered representative and market maker arrangements, clients need to take a caveat emptor (i.e., buyer beware) or should I say fully informed posture. Because when compensation is directly tied to or a motivating factor for recommendations, then more questions and research are required by clients so problems can be avoided.
Quotes
“The whole damn industry lost its moral moorings.”
Charlie Munger, Berkshire Hathaway co-leader opinion of Wall Street’s behavior
over the last several years
“Repeat business or behavior can be bribed. Loyalty has to be earned.”
Janet Robinson, business executive
“Fame is vapor, popularity an accident, riches take wings. Only one thing endures, and this is character.”
Abraham Lincoln, 16th U.S. President
Tony Moeller, President
Integrity Investment Advisors
12721 Metcalf, #202
Overland Park, KS 66213
tmoeller@iia-kc.com
913-897-2074
The information listed in this commentary is a compilation of various publicly available sources and is for informational purposes only. It is not a recommendation or solicitation of any particular investment or strategy. A risk of loss is involved with investments in the stock and bond markets.
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