This is a guest post by Kenneth G. Winans, a veteran investment manager based in Novato, Calif.
Despite what you might read elsewhere about managing your own finances, it is often a good idea to get some help. It’s for roughly the same reason you hire an attorney. You don’t have the skills to handle a divorce or a property dispute.
First, though, you need to understand a little bit about the mind-bending terminology Wall Street uses to describe those who want to help you enlarge your nest egg. This basically comes down to two words: advisor and broker.
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An advisor is a professional you hire to pick stocks, bonds, real estate investment trusts and other investments for you. Advisors are “fiduciaries,” which means they’re legally obliged to act in your best interest. They usually charge a flat salary or fee or receive a cut (1 percent is typical) of the assets under management. Because of the compensation structure, advisors are seen as having fewer conflicts of interest than brokers.
Broker is short for stockbroker—someone working for an investment firm whose job it is to persuade a client to buy or sell stocks, bonds, mutual funds, ETFs and other financial products. Brokers are salesmen, and they’re paid on commission: no transaction, no pay. So there’s considerable incentive for them to gin up business. And they’re not fiduciaries. The broker’s standard is “suitability.” That means the investment should be appropriate for a client, but doesn’t have to be the best or even conflict-free.
“In their ads, the brokerages sell themselves again and again as providing comprehensive financial planning,” says Scott Ilgenfritz, a Florida securities lawyer and past president of the Public Investors Arbitration Bar Association, an advocacy group that helps public investors in securities arbitrations. “They send the message: You’ll be safe with us—right up until you have the audacity to complain. Suddenly, it’s: `We’re not advisors, we’re just order takers.’”
The distinction between advisor and broker used to be reasonably clear. But traditional brokerage revenues turned out to be vulnerable to competitive pressure from discount investment firms, no-load mutual funds and exchange-traded funds, and the advent of the Internet. And in the 1990s, the major brokerages stopped calling their salespeople “brokers” and started calling them—surprise!—“advisors.”
This triggered a decade-and-a-half-long fight, brought by traditional investment advisors who argued these renamed brokers were deceiving the public into thinking they were money-managing fiduciaries. The brokerages responded that they were better policed, by the Financial Industry Regulatory Agency (FINRA), than traditional advisors, who, depending on size, were regulated by either the U.S. Securities and Exchange Commission or state securities departments.
At first, the SEC passed “rule 202,” which sided with brokerages, allowing brokers earning commissions to also call themselves financial advisors and charge advisor-type fees in exchange for guidance without registering with the SEC as investment advisors or living up to tougher fiduciary standards. But advisors sued and, in 2007, won. The rule had “created an unlevel playing field,” says Duane Thompson, a senior policy analyst with Fi360, a fiduciary-standards advocacy and education firm based in Bridgeville, Pa.
Alas, the SEC still offered brokerages exemptions that allowed them to call their brokers “advisors” and charge fees based on the size of a client’s brokerage accounts, as long as they met some more stringent disclosure standards.
The Obama administration has called for changes to SEC rules that would force anyone called an advisor to adhere to the tougher fiduciary standard. But with the Dodd-Frank Act in 2010, Congress left the decision up to the SEC. The SEC has studied the issue and asked for public comment, but hasn’t ruled on the matter since the comment period ended in early June. And last month, when President Obama pressed regulators to tighten financial-industry rules to avoid a repeat of the 2008 economic crisis, he didn’t deal specifically with the advisor-broker controversy.
Until the SEC makes its next move, who is stuck in the middle of all this? You, especially if you don’t want to overpay for good investment guidance.
I happen to be a long-time financial advisor who started his career working for big brokerages. Here’s my take on this:
If you take full responsibility for your investments and really just need somebody to carry out your orders and handle basic administrative tasks, then a salesman—a broker or broker-type advisor—is probably all you need. FINRA provides some good tools to help you pick one. To check out the background of any broker, including complaints and disciplinary matters, go here.
If that’s not you, you need a real investment advisor. To be sure, not every genuine investment advisor is an angel. In 2006, the SEC ordered Bernie Madoff to register as a fiduciary, but that didn’t help his investors when his Ponzi scheme collapsed in late 2008. I’ve also seen registered investment advisors who charmed their clients, opened brokerage accounts, then stuffed them full of mutual funds and ETFs using canned asset-allocation programs requiring little effort on the part of the advisor. The client ended up paying not only the advisor’s quarterly fee but also a second level of fees charged by the mutual funds. There was very little ongoing advising and lots of portfolio neglect.
So I say ignore the word advisor altogether—along with other terms like financial planner, wealth manager, investment counselor and portfolio manager. And don’t be overly trusting of the alphabet soup of credentials that follows them, either: CFA, CMT, CFP, CFC, WMI just to name a few.
Instead, find out what this person actually does.
The Department of Labor publishes a pretty good list of questions to start with. And Forbes has published numerous stories on how to pick an investment advisor. To add to these resources, I’ve developed a list of six questions that I think provide the most revealing answers. Have it in front of you when you grill a prospective advisor:
1. Who is actually managing my investments? A genuine advisor keeps your funds in a discretionary account and can conduct transactions involving individual stocks, bonds, ETFs, mutual funds and so on without your trade-by-trade approval. Beware the investment pro who claims to be a “money manager” and touts his “assets under management” but is really just a middleman between you and another investment advisor doing the investment research and management.
2. What is your track record? Ask for a copy of the Form ADV, which discloses possible conflicts arising from securities trades and answers a lot of other questions. Also request a risk-adjusted performance record going back at least five years, in writing. Get a list of client references—and call them.
3. What is your background? Many registered investment advisors have advanced degrees in business and finance and years of experience as investment analysts or traders at major financial firms. Be wary of an advisor with little or no previous experience outside of his or her years in brokerage and/or insurance sales.
4. Who pays you? Virtually all the compensation an investment advisor receives should come directly from his clients. Any other sources of income should be insignificant and fully disclosed. Brokers, on the other hand, can earn commissions on trades, trailer fees for mutual funds and annuities, and bonuses tied to their firm’s proprietary investment products or trading. These other sources of income create lots of conflicts.
5. Can I pay you by the hour? The going rate for a genuine financial advisor has historically hovered around 1 percent of assets under management. But one benefit of the Internet has been a dramatic reduction in transaction costs. If you and your advisor agree that most or all of your money should be put in a mix of index funds, mutual funds and exchange-traded funds that’s practically on autopilot, ask him to charge less. Get him to subtract the cost of the fund expenses from her percentage. Or better yet, ask if you can pay by the hour, as Forbes’ William Baldwin suggests here.
6. Are you always legally bound to act in my best interest? The answer has to be yes, all of the time. If it is, get it in writing. This is fiduciary duty. It’s a well-established legal principle, backed by decades of precedent. An advisor who acts as your fiduciary knows you can haul her into court or, if you agree, arbitration.
Finally, beware of any “advisor” who swears you’ll always be the boss. From a legal standpoint, brokers are free to carry out your orders, even ones they think are unwise. But mindful of his fiduciary duty, a true advisor will say he’d decline to make an investment he believes could threaten your financial health. At the very least, he should try hard to talk you out of it. If he can’t, he should give you your money back and let you go it alone.
Kenneth G. Winans is a veteran investment manager based in Novato, Calif.