What Kind of Advisor Do You Have?

SECURITIES EXCHANGE ACT

The Securities Exchange Act of 1933 regulates brokers and others who make their money through selling investment products. It presumes that everybody understands that a salesperson will be biased in favor of products that pay commissions. It also presumes that the client knows what he or she needs. A broker can recommend a specific stock, bond or mutual fund. But is the advice unbiased? This is up to the client to determine. Is there a conflict of interest? This is also up to the client to determine. Unfortunately, it’s not always easy to know where the broker’s pay really comes from. In a culture where this quarter’s sales goals have much greater priority than clients’ long-term financial goals, it’s easy to imagine that brokers have incentives to sell high-commission products instead of others that pay less.

The broker-dealer operates under a “know your customer” rule. He or she must know enough about you, based on your income, your net worth, your tax bracket, your investment experience and so forth, in order to determine what high-risk investments he may not sell you. He is free to sell you anything else, and as you can see from Figure 1, that covers a lot of territory. If the broker can choose between two products that are not inappropriate for you (that’s the standard imposed by the law), and if one of those products pays a higher commission, this law presumes that you will understand the broker has a financial incentive to sell the higher-commission product. This is a conflict of interest. Your needs may be best served with a tax-efficient, low-cost, no-load index fund. The broker’s needs may be best served by selling you a variable annuity that pays a high commission but saddles you with unnecessarily high expenses and taxes. As far as the law is concerned, that’s too bad. The broker is required to give you extensive disclosure materials written by lawyers; the law presumes that you have made a buying decision after understanding what’s in those materials.

Because of this legal presumption, you – not the broker – are responsible for choosing the products that will be best for you. This is similar in some ways to purchasing a new car. If you go to a Ford dealership, you know what the bias will be. There’s no presumption that the salesperson’s job is to find the best transportation solution for you (which might be to take the bus!). You know this person’s being paid to do just one thing: sell you a Ford product.

You know how the Ford salesperson chooses what car to recommend. A broker is under no obligation to disclose how he or she chooses a stock or fund to recommend. The broker doesn’t have to avoid conflicts of interest or disclose them. Disclosure tends to be scattered over sales receipts and various forms. If you buy a fund, you’ll get a copy of the prospectus; but if you read it carefully, you’ll be in a small minority of fund investors.

In plain language, this law seems to say to the investor: Conflict of interest? Tough! You figure it out.

INVESTMENT ADVISER’S ACT

When Congress passed the Investment Adviser’s Act, the basic purpose was to protect investors from potential conflicts of interest. The SEC used the words “competent” and “unbiased” to describe the sort of advice investors needed from professionals.

The SEC and the courts regard fiduciary responsibility as the duty to put the client’s interests ahead of the advisor’s interests. In other words, if there is a conflict of interest, a fiduciary must always resolve the conflict in favor of the client. Congress tried to implement that by creating an environment of openness and transparency designed to empower investors to know who they were dealing with. Before establishing any new customer relationship, a registered investment advisor is required to do a number of things: tell the customer the advisor’s process for giving advice; disclose all (note that important word) actual and potential conflicts of interest; explain how the advisor is compensated; disclose any past disciplinary problems with regulators. In addition, the advisor must offer to disclose these things again once a year for as long as the relationship continues.

Registered investment advisors are required to report all this information on Form ADV, a form they have to file with federal and state securities regulators. They must give a copy of part of this form to each new client. Once a year, continuing clients must be offered a copy, without charge, of the most recent version of that document.

In plain language, this law seems to say to investors: Conflict of interest? Don’t worry, we’ve got you covered.

That’s the overview.

Brokers, of course, aren’t simply free to do whatever they want. They may have a limited fiduciary duty to give their customers the best execution price on buy and sell orders. They are accountable for cash that you own that’s in their possession or control. However, brokers are primarily salespeople, not advisors. Here’s one way this difference can play out. Suppose your life circumstances change in a big way, whether it’s losing a job, getting married or divorced, retiring or inheriting a bundle of money from your Uncle Fred. If you become a widow or lose your job just as a risky investment starts to nosedive, the broker isn’t obligated to suggest that you sell and protect what you still have. The culture of a registered investment advisory firm should be dominated by fiduciary responsibility, that is, doing the best thing for the client. That includes making new recommendations when the client’s circumstances call for a different approach.

In my opinion the same should be true of the brokerage industry. But in reality, generating revenue is often the overriding priority, and achieving sales goals and quotas gets most of the attention. Customers – and the products they can be persuaded to buy – are sometimes regarded as only tools for meeting these short-term goals. Brokers’ training is mostly focused on understanding financial products. The main emphasis is not on helping clients determine their needs and risk tolerance and creating carefully diversified portfolios to produce favorable long-term results.

Many brokerages have proprietary funds that typically charge more in loads and ongoing expenses than comparable funds that might do the same job for the client with less cost and more tax efficiency . The broker is under no obligation to recommend – or even inform the customer about – those cheaper alternatives. The law presumes that the investor knows about all these choices and freely chooses to buy inferior products that are less suitable.

It’s perfectly legal for a brokerage firm to receive rewards of various kinds (without ever disclosing this to you) from mutual fund companies in return for sending your business to them. It’s perfectly legal for a broker to carefully structure (again without ever disclosing this to you) your load fund investments so that you never get the benefit of “break points” that reduce loads for large investors.

DETAILS

When you’re in the midst of a raging bear market, the details of your investments may not seem to matter much. But when returns are mediocre and you’re struggling to meet your needs, the combination of an extra fee here, an added expense there and a tax bite around the bend can add up to the difference between success and failure.

A fiduciary is bound to help you with those details. A broker doesn’t have to care.

The world of brokers is driven by optimism. Hope sells. Fear paralyzes. A sales-dominated culture has little use for the latter. When the market fails to dish up the gains that you and your broker hoped for, the pervasive optimism creates a reluctance to sell. Imagine that your broker comes to you and says: “We made a mistake. Let’s sell.” That might be the best possible analysis and advice. But what will you think? Will you trust that broker again after having your hopes dashed? Will you wonder if that broker really knows as much as you thought?

I guarantee that your broker has thought about this. And he or she will be reluctant to admit a big mistake for fear of losing your confidence and your future business. The predictable result: With a broker, unless you take the initiative, you’ll probably stay in failed investments longer than you should. Your broker has no obligation to prevent you from doing that, so long as the investment was “not inappropriate” for you when you bought it.

A fiduciary, by contrast, is obligated to take a longer-term view of your needs and your investments. Such an advisor is required to give you “only suitable investment advice,” based on your own circumstances, to “exercise a high degree of care” to make sure you have accurate and thorough information. And because the law requires this, the advisor has to be prepared to prove that he or she took the necessary steps.

My guess is that you’d want this level of care from a physician. You should want it from a financial advisor, too. You can get it by dealing with an advisor who is a fiduciary.

THE QUESTION YOU SHOULD MEMORIZE

How can you tell what type of advisor you’re dealing with? There is one key question, and I suggest you memorize it: “Are you a fiduciary?” If you ask somebody if he or she is “acting as” a fiduciary, that’s not what matters. The real question is whether your advisor is legally a fiduciary. Unless the answer is yes, you are dealing with somebody whose financial interests aren’t necessarily aligned with yours.

 

 

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