In the Wizard of Oz, Dorothy and friends make a long and dangerous journey to see the great Wizard of Oz, who they have heard can grant any wish. If only there were such a wondrous being in the investment world! Like the Wizard, many in the financial services industry would have you believe that all solutions are within their realm. As with the Wizard, what you see is sometimes much different than what you get. Dorothy’s initial visit to the Wizard is somewhat confusing, as it is not clear whether the Wizard is a man or some other powerful being. Access to the wizard, she soon learns, comes at a considerable cost. Similarly, financial service providers present a confusing array of duties and costs. How does one differentiate between the many and varied players?
Short of hiring in-house management (realistically requiring a minimum portfolio of approximately $150MM), there are basically 3 different types of players offering services to investors.
Brokers, who are also referred to as registered reps, financial advisors or wealth managers, can engage in transactional relationships or fee based relationships. The transactional relationship fits most people’s traditional image of a broker. The broker sells you products and earns a commission in the process, either a fully transparent stock commission, non-disclosed bond “mark-up” or either a front end or back end load commission on mutual funds. This type of relationship, however, is quickly going the way of the buggy whip. Most brokers can now work with clients on a fee basis as well as a transactional basis.
Brokers, not unlike the Wizard, can project an image of majesty and power, suggesting that the vast resources of their employer are at your beck and call. At the end of the day, however, the vast majority of brokers are small businessmen working under a big umbrella. Day-to-day decision making does not emanate from the Mighty Wizard; it comes from the small business that keeps its securities license with the Wizard in exchange for a cut of the business. Fees tend to be higher, and product selection is rife with conflicts of interest, as brokers are incentivized to sell certain products over others. Brokers have begun to recognize the shortcomings of their business model as many brokers are now moving their “books” of business to independent registered investment advisors.
The distinction between a broker and a registered investment advisor is very important to understand. The regulatory regime each is governed by perhaps tells it best.
Contrast the regulatory regime For Brokers:
Fiduciary Duty, FINRA Regulated
Brokers or financial consultants etc. are regulated by FINRA and are required to “know” their customer, a requirement most often fulfilled by a suitability questionnaire which is part of the account opening paperwork. Once the broker or advisor is familiar with a client’s circumstances, the recommendations they make must be “suitable” given the client information submitted in the account opening form. Importantly, the advisor is not required to act only in the best interest of the client, as entities regulated by the SEC must.
With that of Registered Investment Advisors:
Fiduciary Duty, SEC Regulated
Investment advisors are regulated by the SEC and have a higher fiduciary standard than FINRA regulated (broker-dealer) financial advisors. Investment advisors have a fiduciary duty to put their clients’ interests first and must always act in the best interests of their clients. This is a much higher standard than the financial advisor’s duty to recommend suitable investments while not necessarily placing the client’s interests first.
Registered Investment Advisors, unlike brokers, are not transactionally oriented. They charge an investment management fee, most often based as a percentage of assets managed. Investment managers manage portfolios of stocks, bonds, ETFs and mutual funds and have full discretion to manage client assets.
As in many walks of life, investment managers tend to specialize in market segments, such as fixed income, large cap growth stocks, small cap value stocks, international stocks etc. While some managers offer a full suite of investment products, most of the times a few of their products are better than others.
While investment managers play an important role in investment policy implementation, they are often not able to build the framework for the investment process with the same independence and objectivity of the consulting approach. They are not in the business of hiring other investment managers, for example. Their fee structures often do not account for the difference between discretionary day-to-day portfolio management (Buy IBM, sell Dell for e.g.) and consulting arrangements, resulting in higher fees over all.
Investment Management Consultants
Investment management consultants are the next best thing to in-house portfolio management used by large institutions.
Regulated by the SEC, the fiduciary duty is the same as for investment advisors; they must always act in the best interest of clients. Unlike investment managers, they should have no conflicts of interest in development of Investment Policy, Asset Allocation, Manager Search and Selection and Portfolio Monitoring. Importantly, they offer independence and objectivity in Performance Reporting and evaluation of results. The consultant’s purpose in life is to help fiduciaries manage the investment process. This allows fiduciaries to focus on high level decisions.
Investment management consultants help organizations assemble teams of investment managers for the purpose of implementing an investment strategy that has been developed without conflicts of interest and is transparent with regard to fees. The process becomes more efficient, using managers who have been thoroughly vetted for performance and fees. Speaking of fees, consultant fees are generally a fraction of investment management fees and because the consultant is charged with finding efficiencies in developing the process, total fees can actually decrease when using a good consultant.