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3 strikes - Advisor Warning Signs

Brokers, Advisors, and the Fiduciary Standard

Gary Karz, CFA
Host of InvestorHome
Founder, Proficient Investment Management, LLC

     There are a number of reasons why investors may want to be on guard when dealing with their financial advisors and firms. The following are some potential warning signs investors may consider in evaluating their finances and their advisors. There are plenty of good brokers and advisors and some of them may qualify for one or more of these triggers. While any one may be good enough to call into question an advisor or a specific investment product, three or more of the following conditions could be viewed as seriously warranting further investigation and a second opinion.

  1. Discipline, complaints, convictions, or fraud in history
  2. Not a Fiduciary
  3. Firm switches involving up-front compensation packages
  4. Employed by public company
  5. Employed by company with history of financial trouble (saved by government or merger?), losing assets and staff
  6. Charging fees in advance and/or excess fees
  7. Layers of fees, wrap, funds of funds, and portfolios of high cost funds
  8. Excess turnover (results in high visible and less visible costs = slippage)
  9. Lack of relevant education, degrees, and or credentials in investment related fields
  10. Lack of relevant experience (does the advisor have a background in sales or in investments, planning and business)

1. Discipline, complaints, convictions, or fraud in history
For obvious reasons it makes sense to check background information on Brokers and Advisors. Fortunately a great deal of information is available online via Broker background check and Investment Advisor Search. See also Getting Help With Your Investments from InvestorProtection.

2. Not a Fiduciary
A fiduciary must not place their own interests above the client's interests. Traditionally. brokers have not been subject to fiduciary responsibility, but there has been a trend of advisors moving away from commission based business to % of asset based business, which tends to involve a fiduciary relationship. Investors seeking advice from their advisors rather than just execution services might be well served by evaluating whether it makes sense to work with an advisor that is not a fiduciary. If you don't know, ask your advisor if they are a fiduciary. Many brokers do register as an investment advisor. Stockbrokers are required by law to identify themselves with the phrase “Securities offered through (firm name).”

3. Firm switches involving up-front compensation packages
Switching firms isn't by itself generally an obvious reason to second guess a relationship, but if your advisor is shopping your relationship it may also make sense for you to reevaluate that relationship, especially if your advisor is getting paid an upfront bonus based on how much they earn from your account and their other clients' accounts. It is worthwhile to investigate the reasons for the switch, and to evaluate the advisors explanation for why you will be better off with the new firm. When switching advisors call their clients, the argument that the new firm provides better service to the client is often used as a reason for the switch. A potential flaw in the logic of that argument is that in most years advisors are typically likely switching between firms in both directions. You can easily do some research by going to InvestmentNews' Advisors on the move and searching the firm by "firm joining" and "firm leaving". If you find lots of advisors moving from A to B and from B to A, you can imagine that both moving groups are telling their clients that the new firm is better for them. In reality the main reason for the switch may simply be because the new firm offered them more money or better terms.

According to this article (SEC plans to issue new rules on broker pay - 11/8/2010) SEC Chairman Mary Schapiro expressed her concern with some brokerage pay practices, specifically the large upfront bonuses firms pay many brokers and advisers when they leave one firm and join another. Upfront bonuses and compensation that encourages risk-taking “are things that absolutely have to change,” she said. Ms. Schapiro said that the SEC intends to write rules that require “compensation programs that incentivize the right kinds of behavior.” She also suggested "Certain forms of potential compensation may carry with them enhanced risks to customers.” The article notes that some broker-dealers offered top advisers pay packages that could be greater than 300% of one year's fees and commissions. Much of the bonus is linked to the broker's performance after joining the new firm. There has also been a surge in the number of deadbeat brokers walking away from their new firms, creating a separate potential problem for clients of those advisors.

When brokers decide to leave their firms they can move to another firm (either as a broker, or as an RIA), or go independent. Some would consider it a positive when a broker moves from a commission based relationship to asset based fee, and that often involves a change from a suitability standard to a fiduciary standard, but it may be more expensive for clients. Commission based (or hourly based) relationships can be the lowest cost option for buy and hold investors and an investor with a portfolio requiring little or no rebalancing and maintenance is quite likely to be better off staying with a commission based account rather than now having to pay a % of asset based fee. That said it's still a problem for a commission based advisor to justify charging large commissions when most investments can be bought just as easily for little cost at a discount broker.

Recent trends in terms of where brokers have been moving is included in After the Flood (11/18/2010) from AdvisorOne. Advisors have been leaving wirehouses and bank Broker Dealers (each lost 20% of their brokerage force from 2002 through 2009 according to a May 2009 TowerGroup study), while regional Broker dealers lost 31%, and insurance BDs saw their ranks decline 40.6%. The total number of all financial advisors declined 9.5% during this period - some left the business all together, but the vast majority went independent. Independent broker Dealers increased their advisors by some 21.4%, while independent RIAs grew from 25,000 to 41,500—an increase of 66%.

There is a legitimate question for larger brokerage firms of how they add value given the rise of discount brokers. IPOs are far less common than earlier times and even then IPOs have been shown in studies to consistently underperform. Access to new issues like municipal bonds arguably could be another advantage, but in many states (like my home state California), individual investors get first shot at municipal bonds so that argument has little weight as well. From an advisors perspective, what do they gain from the relationship with a large firm for the fees that they must split? Why not start their own firm and likely keep more of their fees assuming overhead is less than they were paying the large firm?

If you get a call from your advisor that he is moving from one firm to another, there is a good chance that you'll find some new information relevant to your decision if you seek an independent opinion. Your advisor and someone from the old firm will almost certainly be calling you to try to retain your account. Why not seek out a third opinion? Incidentally, when key staff at large institutional money managers leave their firms, its very common for institutional clients to freeze or transition their account away from the prior firm (staff stability is a major flag for many of them) and to begin a new search for the account mandate.

4. Employed by public company
There is evidence that investors may be well advised to consider whether the firm they are invested with is a public company, private company, or some version of not for profit entity. Public companies have a duty to their shareholders to maximize their profits, which may give them a conflict of interest with their clients. For further discussions see A New Order of Things – Bringing Mutuality to the “Mutual” Fund by John Bogle (or William J. Bernstein's The Investor's Manifesto). Bogle documents that returns for mutual funds of nonprofit and privately owned mutual fund companies outperform those of publicly owned mutual fund companies. See also Putting Investors First from Jason Zweig (5/1/97).

5. Employed by company with history of financial trouble (saved by government or merger?), losing assets and staff
Firms that were bailed out by the government may have taken on excessive amounts of risk thereby placing your relationship in jeopardy. See The Housing Crash/Financial Crisis Review for a discussion of firms that qualify and have a history of involvement in crisis. Firms (or specific funds) losing significant assets or staff also pose a risk. No one wants to be the last off a sinking ship and once confidence is lost it can be costly to stick to a firm or fund that is being shunned (or targeted by short-sellers). There are plenty of firms that have underperformance that subsequently outperform so it's not an automatic cause for termination, but it is worthy of investigating if a firm has lost significant assets and/or staff.

6. Charging fees in advance and/or excess fees
In the old days commissions were fixed. We now live in a world where most investment products can be found via various channels for minimal costs. There are rarely good reasons to pay large commissions or loads because reasonable, if not superior alternatives can usually be found with little or no cost. The reason most large commissions and loads still exist is because that's the way some advisors get compensated. Some advisors charge fees in advance (for instance quarterly management fees), but regulators tend to interpret that as making the advisor a debtor of the client. For obvious reasons its preferable to work with an advisor that only collects their compensation after providing the service rather than in advance. If an advisor is going to help you make money rather than lose money wouldn't they prefer to earn their fee on the assumed larger (but later) account?

Recent trends regarding load mutual fund sales are included in Growth of Fee-Based Mutual Fund Sales Driving Down Use of Loads Among Traditional “A” Shares (5/10/2010) from Strategic Insight. They found that during 2009, 68% of “A” share sales among fund managers primarily selling through financial advisors were made at NAV, which means they carry no front-end “load” or commission. That proportion is up from 66% of “A” share sales in 2008 and 58% in 2007. At the same time, “A” shares sold at 4% or higher commissions declined to just 13% of total. They point out that mutual fund sales are moving away from high-commission model models as more funds are sold in a structure where advisors receive fees for advice. As this trend continues, fund sales through share classes without a front-end sales load will also continue to expand.” “No Load” shares accounted for 54% of total fee-based advisory sales during 2009, up from 44% in 2008.

There are basically three main avenues for loads and high commissions to continue their path toward zero.

  1. For the regulators to do something to make them less appealing to investors and advisors,
  2. For advisors to stop selling them, and/or
  3. For investors to stop buying them or allowing their advisors to sell load funds to them.

While 1% is a common rule of thumb for asset management fees, lower rates are often easily obtainable especially for larger accounts. Rick Ferri argues in High-Fee Passive Advisor Hypocrisy that "A fair fee for servicing a $1 million client should be no more than $5,000 annually, which is 0.50%." That happens to be exactly what my firm charges for managed accounts of that size. Investors with accounts in the tens of millions and greater may also prefer advisors that charge hourly fees (my firm also offers services on an hourly basis). There are also some advisors that manage accounts for a flat fee or limit the maximum dollar amount, which is obviously advantageous for larger accounts (and one reason firms like mine charge lower % rates as account size increases).

7. Layers of fees, wrap, funds of funds, and portfolios of high cost funds
Investment costs reduce your returns. Each layer of fees decreases your expected return, but increases the amount you pay advisors and subadvisors. Wrap fees effectively mean your advisor makes money and the wrap manager also makes money, likely at your expense. Portfolios of active funds or managers also reduces your odds of success in investing. Active management is a zero-sum game and the more active funds you own (and the longer the time frame) the worse your odds get of beating the market and index funds.

8. Excess turnover (results in high visible and less visible costs = slippage)
There are some cases where high turnover strategies can add value, but they are the exception rather than the rule. More on why that is the case at The Bid/Ask Spread and Market Making. Terrance Odean has published extensive research on the topic. See his collection of research and published paper (for instance, see Why do Investors trade too much?).

9. Lack of relevant education, degrees, and or credentials in investment related fields
Does your advisor have degrees and credentials in the investment business or have they published investment material (preferably peer reviewed)? There have been plenty of outsiders that have done well for themselves and their clients in the investment business, particularly some that have focused on identifying Wall Street's conflicts of interest. But they are relatively rare and it's generally constructive to work with advisers that have some formal education in the business.

10. Lack of relevant experience
Does your advisor have a background in sales or in investments, planning, and business? Unfortunately, many firms in the financial industry don't seek employees with related experience in the investment fields. Rather, many firms target individuals with sales experience.

At my firm advisory firm I provide two services for investors facing these scenarios. is a service for evaluating portfolios and providing an unbiased opinion of whether it is efficiently structured to meet your goals. is a service to evaluate your portfolio or advisors performance and the costs incurred. Feel free to contact me for a no obligation evaluation of your situation and whether one of these services might be helpful for you. In many cases we can determined the likely results at no cost within 15 minutes - I usually only charge for the services requiring in depth analysis and at least an hour of work.

Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value. The investment business is a giant scam. It deletes billions of dollars every year in transaction costs and fees.
Jack Meyer (former Harvard Management CEO) in Husbanding That $27 Billion from BusinessWeek (12/27/2004)

You are engaged in a life-and-death struggle with the financial services industry. Every dollar in fees, expenses, and spreads you pay them comes directly out of your pocket. If you act on the assumption that every broker, insurance salesman, mutual fund salesperson, and financial advisor you encounter is a hardened criminal, you will do just fine.
William J. Bernstein in The Investor's Manifesto

Brokers have never enjoyed the purest of reputations in our popular imagination. From the corruptible Bud Fox of Wall Street to the manipulative bond salesmen of Liar's Poker, the people whose job it is to push investments out the door and into investors' arms have often been depicted as morally elastic. After all, brokers are ultimately salespeople who are generally compensated by commission and whose primary loyalty is to their employers . . . You wouldn't go to a doctor who earns a commission on every prescription he writes. Why treat your finances with any less respect.
Elizabeth Ody in Whose advice can you trust? from Kiplinger's (December 2010)

While we are on the subject of minimizing costs, we need to warn you to beware of stockbrokers. Brokers have one priority: to make a good income for themselves. That's why they do what they do the way they do it. The stockbroker's real job is not to make money for you but to make money from you. Of course, brokers tend to be nice, friendly, and personally enjoyable for one major reason: Being friendly enables them to get more business. So don't get confused. Your broker is your broker-period.
Burton Malkiel and Charles Ellis in The Elements of Investing

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Last update 12/27/2010. Copyright © 2010 Investor Home. All rights reserved. Disclaimer