Amidst all of this it is no surprise that an investor seeking any type of financial advice is unsure where to turn. It is becoming increasingly difficult to determine who is truly independent, knowledgeable, ethical and professional. I would recommend investors focus on the following: Education, Organizational Independence, Revenue Model and Reputation.
Any professional committed to his or her craft is going to have a strong educational background. In the financial profession, this should include a commitment to formal education (perhaps a graduate degree or at least an undergraduate specialization) as well as professional certification. The two most recognized professional certifications are the CFP® mark and the CFA. Both require significant study and a rigorous examination. The CFP®, or Certified Financial Planner, is a broad-based personal financial planning curriculum which includes investing, insurance, retirement planning, estate planning and tax. The CFA is a technical financial and investment program, requiring candidates to pass three challenging examinations covering security analysis, ethics, financial statements, economics and portfolio management. Both certifications represent an individual’s commitment to acquiring professional expertise.
Unfortunately there is a litany of miscellaneous certifications available in the financial industry. Some, such as the ChFC or CLU, while not attaining to the quality of the CFP® or CFA, are more robust than others. Investors might ask an individual who lacks the CFP® or CFA why they would choose a lesser recognized designation instead. There are literally too many designations to list here, but investors should beware anyone touting lesser designations or a string of alphabet soup following their name on a business card.
Financial professionals have several options when choosing the structure of their career. A choice of a more independent structure represents that professional’s desire to have an ability to present honest and less conflicted advice to his or her clients. The list below is ranked (in my opinion) from the LEAST independent professional structure to the MOST independent.
- Employee of Wall Street/Investment Bank/Wirehouse firm
- This individual is most likely paid on commission by a firm who employs brokers and also manufactures, inventories and otherwise is involved in the production of investment products. Examples of the major wirehouses would include MerrillLynch (now owned by Bank of America), Morgan Stanley, JP Morgan, UBS, etc. This is the most traditional career model, but it is rife with conflict as advisors can feel pressured or be financially incentivized to sell a proprietary product to a client. Advisors answer to a branch manager whose primary concern is how much revenue the advisor is generating for the firm.
- Employee of an Independent (or Quasi-Independent) Broker/Dealer
- The word “independent” is thrown around a lot and its safest interpretation is “non-Wall Street firm.” An independent broker-dealer can still have subsidiaries which manufacture investment products. This professional is again paid either on fees generated or commissions charged to clients by the firm and has less flexibility in providing investment advice than the next category. Examples may include Ameriprise, Edward Jones, Raymond James & Associates, Northwestern Mutual Life, Mass Mutual, etc.
- Independent Contractor of a Broker/Dealer
- This is a growing model, where the advisor is more independent from a broker/dealer in that there is no formal employment agreement. Instead the advisor is an independent contractor, but still under the oversight of the Broker/Dealer and can still be paid on commission. The most common examples are LPL and Raymond James Financial Services along with a number of smaller “regional” broker/dealers.
- Hybrid Broker/Dealer and RIA
- This professional is either an employee or a contractor of a broker/dealer and an Investment Advisor Representative (IAR) of a Registered Investment Advisor (RIA). This role comes in many flavors as the Registered Investment Advisor (firm) may be a subsidiary or affiliate of a broker/dealer. The decision to become an IAR creates a fiduciary relationship between the advisor and the client, forcing the advisor to act in the best interests of the clients. Unfortunately it is easy for this “hybrid” advisor to move in and out of the fiduciary relationship with the client on an ongoing basis in today’s environment.
- “Pure” Registered Investment Advisor
- The fastest growing “sleeve” of the financial advice industry is the Registered Investment Advisor. A “pure” (unaffiliated with a broker/dealer) RIA cannot accept commissions for investment products and instead is paid on a fee-only basis, typically a percentage of the client’s investment assets. These firms (and their advisors) are independent of product producers (mutual funds, ETFs, managed accounts) and should be significantly less conflicted than those still affiliated with a brokerage firm.
The investment industry has undergone a dramatic shift in the past 25 years from primarily generating revenue from trading commissions and mutual-fund loads to fee-based accounts. This is a significant change for the better, as transaction-based charges are rife with conflict, and promote churning, performance chasing and other tax-inefficient failed strategies. The asset-based fee, typically around 1% of the value of a client’s investment portfolio, removes some of these conflicts. Of course, it is not without conflicts of its own.
The asset-based fee encourages the advisor to manage as much of an investor’s money as possible, which can lead to conflicting advice about outside investment opportunities or debt reduction (such as eliminating a home mortgage). It may also encourage risk-taking behavior as an advisor has a long-term incentive to aggressively grow a portfolio when this may not be in line with the client’s goals. Finally, fees grow as the size of a portfolio grows, which may not reflect the value of the services offered and can lead to clients paying dramatically large sums for advice.
Alternatives to the asset-based fee model include flat retainer fees and hourly charges. These fee structures can allow for more flexibility in the type of advice needed, and remove some of the conflict related to asset-based fees.
Of course, trusting someone’s reputation can be a tricky and dangerous thing. Many purveyors of fraudulent schemes have appeared to be upstanding members of their respective communities before being caught. Investors should always perform background checks on financial professionals before entering into a working relationship:
- Check on CFP Certificants at the CFP board;
- Check on Broker/Dealer affiliated representatives at FINRA BrokerCheck;
- Check on Registered Investment Advisors at the SEC.
Any investment advisor should have a working relationship with a custodian for client accounts. This may be the broker/dealer itself (Merrill Lynch, Ameriprise, Raymond James, etc), or an independent third-party custodian for a Registered Investment Advisor. The biggest third-party custodians are Charles Schwab, TD Ameritrade, Fidelity, Pershing, Scottrade, TradePMR and more. These custodians provide third-party custody, recordkeeping, monthly statements and tax reporting. They are also members of the Securities Investor Protection Corporation (SIPC) which provides insurance against brokerage default (not against market losses). It is extremely common for ponzi and other fraudulent schemes to lack this simple independent third-party mechanism.
After verifying a clean background check, investors should consult knowledgeable and trusted relationships (personal and professional) as to the reputation of the individual in question. Even in a larger city such as Denver, professionals such as CPAs, attorneys and financial advisors cross paths, working together in clients relationships and exchanging professional expertise. This provides professionals an opportunity to “vet” one another and have a better understanding of a professional’s knowledge, expertise and professionalism that may be otherwise difficult to detect from a web site or phone call.
It can be scary for many to attempt to navigate the world of financial advice and evaluate the merits of a single financial professional. The manner of a professional’s independence, education and the choice of compensation arrangement say a great deal about that person’s integrity, commitment to learning and desire to provide clear and unbiased advice to clients.