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Independent Advisors Can Still Have Conflicts of Interest. How to Protect Your Finances.


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777彩票地址When Gavin Riley quit working at age 55, he expected his savings to carry him through retirement. A mechanic and supervisor at a nuclear plant in upstate New York, Riley amassed $1.4 million over a 35-year career—more than enough, he figured, to live comfortably.

But eight years into retirement, Riley’s portfolio isn’t performing as he expected. A financial advisor at a small, independent firm recommended that he plow almost everything into variable annuities and nontraded real estate investment trusts. The investments were meant to generate growth and income, he says, but they were high fee and didn’t keep up with the market’s gains. And he had a hard time selling the REITs when he needed extra cash since they weren’t publicly traded, forcing him to sell at a loss. The drawbacks of the investments were never fully explained, he says. “Saying I was misled would be putting it mildly,” says Riley, now 63, who has taken his former advisor to arbitration over the losses. His advisor has denied wrongdoing.

777彩票地址“Independent” has become something of a buzzword in the advice business, and more and more investors are turning to independent advisors who work for small firms. But independent doesn’t mean conflict-free. An advisor at an independent broker-dealer may be just as conflicted as one who works for a large Wall Street “wirehouse”—that is, perhaps overly incentivized to put clients into products that earn them commissions, such as privately traded REITs and other nonpublic securities. These investments often skirt the boundaries of suitability, says Jason Kane, a lawyer representing Riley. “Are the drawbacks disclosed in a prospectus buried on page 200? Perhaps. But are they actively discussed in a way that normal investors can understand? In 99% of the cases I see, no.”

The independent advisory world is booming, creating greater potential for conflicts. Many advisors have left Wall Street, aiming to make more money on their own. And small advisory firms are merging or being snapped up by larger players—creating incentives for advisors to ramp up revenue and profit, potentially at the expense of clients.

777彩票地址“The word ‘independent’ is used a lot to create the impression that investors are getting less-biased advice, but just because a firm is independent doesn’t mean it’s free from the biases that other firms have,” says Micah Hauptman, financial services counsel for the Consumer Federation of America, a consumer-advocacy group. Advisors at independent firms usually have more flexibility to recommend private investments such as nontraded REITs and private-equity funds, which tend to come with big commissions and high fees, he adds. “The risk is that the independent firms take advantage of that flexibility, to investors’ detriment.”

If you’re confused 777彩票地址 about whether your advisor is acting in your best interest, you’re not alone. The term “best interest” is itself a loaded phase—it’s at the heart of a new set of regulations for advisors and brokers, going into effect in June. The financial industry uses a hodgepodge of titles and terms with different standards for advisors, depending on the role they play, how they’re compensated, and how they’re registered.

In a nutshell, if you work with a registered investment advisor, or RIA, he or she must abide by a “fiduciary” standard of advice. That means your advisor isn’t allowed to put his or her financial interests ahead of yours. Things get confusing, however, because many individuals in the industry are dual-registered as brokers and investment advisors. And firms have dual registrations as broker-dealers and advisory firms, too. Individuals who are dual registered can then wear two hats: They can recommend products for which they can earn commissions, such as annuities and nontraded REITs, and they can act as fiduciaries in other capacities, such as providing ongoing advice or account monitoring.

Fact Box:

Independent Broker Dealers

777彩票地址*Merrill Lynch, Morgan Stanley, Wells Fargo, UBS

777彩票地址Source: Cerulli Associates

777彩票地址Dual registrations for brokerage firms and individuals make a lot of sense, since the licenses allow advisors to be as full-service as possible, offering every possible flavor of service and product. An advisor who isn’t dual registered can’t sell products like variable annuities with transaction-based commissions, for instance. And many advisors want the flexibility to sell such products, including nontraded REITs and other private investments (not all of which are bad). Moreover, advisors often manage multiple accounts for a client, some that are fee-only and others that are commission-based.

Of the 629,000 broker-dealer representatives, 335,000 are solely registered as brokers and 295,000 are dual registered as brokers and investment advisors. Investment advisors only—who are generally fee-only and can’t accept commissions on securities like mutual funds or stocks—account for 61,500 individuals, according to the Financial Industry Regulatory Association, or Finra, the industry’s self-governing organization.

If you haven’t heard of independent broker-dealers, that’s because they tend to operate in the background of the big players. Only a handful are publicly traded, including LPL Financial Holdings (ticker: LPLA), Raymond James Financial (RJF), and Ameriprise Financial (AMP), a spinoff of American Express 777彩票地址 (AXP). The prime distinction between an independent and traditional brokerage is that the indies tend to be roll-ups of small advisory firms: They provide trading, marketing, and compliance services, along with research and investment platforms for products such as mutual funds, alternative assets, and insurance.

Plenty of good advisors work for independent firms—just like there are plenty of good advisors at the traditional brokerage firms—and it would be a mistake to think they’re trying to line their pockets at your expense. Independent firms are like big tents covering a wide variety of advisors, some of whom may not earn a penny from commissions. Funds and other products on brokerage platforms have to pass due-diligence requirements, and some independent brokerages offer more choices than the wirehouses; LPL, for instance, the largest independent broker, has 4,800 mutual funds on its platform, many more than the wirehouses, including Merrill Lynch, Morgan Stanley, and UBS.

Nonetheless, several industry trends may be fueling conflicts in the independent broker world. For one, the independent model is appealing to advisors who want to run their business with more autonomy—and profit potential—than they would get at a wirehouse. Advisors pocket 85% to 92% of management fees and commissions at independent brokerages, versus 50% at a wirehouse, says Chetan Patil, former senior counsel for Cetera Financial Group, a large independent brokerage. Independent advisors have to cover their own expenses, including office space, technology, and staff, and therefore need a higher cut of revenue and commissions to make a profit. Still, says Patil, “it’s an eat-what-you-kill system. There’s a natural incentive to maximize your revenue and use products with the greatest payouts.”

As of year-end 2018, independent brokerages had grown assets at a five-year annualized rate of 4.9%, reaching nearly $2.8 trillion in assets under management, according to Cerulli Associates. The industry accounts for about 14% of advisory-held assets.

The industry isn’t just growing due to asset gains. It’s also a hotbed of mergers. LPL and others have been adding to their advisory ranks by making deals with smaller brokerages and advisory firms. Capital has flooded in from private-equity firms such as Lightyear Capital, Bessemer Venture Capital, and Stone Point Capital. Large brokerages and banks are doing buyouts, too: 777彩票地址man Sachs Group777彩票地址 (GS) bought advisory firm United Capital Financial Partners last May.

Recruiting at independent brokerages is highly competitive, as they vie for assets and advisors, especially those who have carved out a regional business or niche, such as working with associations of doctors or engineers. A standard buyout multiple is two times revenue on a current book of business: If a firm manages $1 billion and earns $10 million in fees, for example, the business would be worth $20 million in a buyout. Multiples are also based on earnings before interest, taxes, depreciation, and amortization, and they can exceed three times Ebitda for an attractive client base.

777彩票地址Buyout deals usually include incentives for the advisor to retain clients and boost assets and fees after an acquisition. “If you’re moving with your book of business, they want you to grow it; they don’t want you to take the payout and kick back on the golf course,” says Nicholas Rotello, founder of Seven Two Partners, an investment consulting firm in Denver. The new owners don’t want to see a client exodus after a buyout, he adds, giving the advisor incentives to stay on board and increase revenue.

777彩票地址Advisors who affiliate with an independent brokerage also tend to be independent contractors, covering much of their own expenses. Brokerage firms lure advisors with deals to help cover some of those costs: offering bonuses for client retention, asset growth, sales of high-fee products, and “forgivable loans” made on favorable terms. All of that can put the advisor’s interests in conflict with clients.

Moreover, the primary customer of an independent broker-dealer isn’t the investor; it’s the advisor. “We call the advisors our clients,” says Richard Steinmeier, the managing director and head of business development at LPL. It and other independent brokerages get a cut of revenues generated by advisors who use their platform and services; that creates incentives for both the firm and advisor to sell high-fee products that generate the most revenue for both.

How are investors affected by all this? One way is that advisors have incentives to put clients in high-fee share classes of mutual funds. Many brokerages have paid fines and restitution in recent years for doing so when lower-fee classes were available. The Securities and Exchange Commission secured agreements in 2018 from 79 advisory firms that agreed to repay clients $125 million for such practices, under a voluntary self-reporting initiative. Last August, the SEC brought civil charges against Commonwealth Financial Network, one of the largest independent brokers, alleging that the firm failed to disclose revenue-sharing payments that resulted in clients owning high-fee share classes of mutual funds. A spokesman for Commonwealth said the firm “vehemently denies the allegations and believes they are categorically without merit.”

Wirehouses participated in the SEC’s self-reporting initiative, too, paying restitution for excessive fund fees. And the wirehouses have been fined for failing to disclose conflicts of interest; Bank of America’s (BAC) Merrill Lynch business paid $8.9 million in 2018, for instance, for depriving clients of “unbiased financial advice,” according to the SEC. (Merrill consented to the SEC’s order without admitting or denying wrongdoing).

777彩票地址Yet, while everyone in the industry has to follow the same rules, compliance procedures and regulatory oversight isn’t uniform: Advisors at large firms tend to be audited internally and are supervised by branch and regional managers. Independent advisors have more autonomy to build and run their own portfolios, and they may not face as much oversight from a home office.

Indeed, oversight in the independent brokerage world isn’t clear-cut. Steinmeier says that most advisors affiliated with LPL operate under its corporate RIA umbrella, meaning that LPL takes on oversight and compliance risk. But advisors may retain their own licensing registration. That “hybrid” model can result in compliance gaps since an advisor may be partly self-supervised. The firewalls of the wirehouses—layers of compliance procedures, due diligence, internal monitoring, and auditing—may not extend as far with advisors affiliated with an independent brokerages.

According to the SEC, violations remain widespread, regardless of the type of the firm. The SEC recently completed an investigation of 50 advisory firms, collectively managing $50 billion in assets for 220,000 clients. Nearly all of the examined firms (which remained anonymous) had employed an advisor who had been disciplined, and each firm received “deficiency letters,” the SEC says, mostly relating to compliance issues and problems with disclosures, including undisclosed conflicts of interest that could impact the “impartiality” of investment advice.

Disclosures by independent brokerages are crammed with conflicts of interest. Among them are revenue-sharing deals with fund companies; payments by fund sponsors for advisor education and training; “concessions” from investment sponsors and mutual fund “finder’s fees.” These practices may influence product selection, according to many firm disclosures, and customers can wind up in high-fee funds that generate the most compensation for advisors and the firm.

Granted, the same conflicts arise at the wirehouses, as Barron’s previously reported. And the wirehouses may be more conflicted, since they do their own asset management, sponsor proprietary funds, and engage in stock offerings and syndication deals (agreeing, say, to find investors for a private-equity fund that generates commissions for the firm).

“We’re not making money on asset management; we’re not running a syndication desk, and we’re not underwriting deals that we distribute through a broker-dealer,” says Steinmeier of LPL. He adds that “we’re completely open-architecture. Our goal is to provide the broadest set of products to our clients.”

777彩票地址Nonetheless, many clients don’t wade through disclosures. Even if they did, it’s unclear how an advisor is compensated or affected by the firm’s conflicts of interests. “It’s often really difficult to get the full picture of an advisor’s compensation and conflicts,” says Christine Lazaro, a law professor who runs an investor legal clinic at St. John’s University. “It’s a black box.”

Regardless of their affiliation or regulatory registration, advisors say they would lose business if clients weren’t satisfied. Does it matter if an advisor makes a bundle in commissions if your portfolio performs well? Some argue that’s for investors to decide, not regulators (or the media). Advisors are for-profit entities, just like nearly everyone in financial services. As long as they follow the rules, disclosing conflicts of interest where necessary, they are entitled to maximize economic gains for their services.

Yet, investors may be confused about whose side their advisor is really on. The industry’s titles—wealth manager, financial advisor, broker, registered representative—each have different connotations, regulatory requirements, and disclosure rules. RIAs and broker/dealers operate under different rules. And regulators don’t appear eager to clear up the confusion.

The SEC recently imposed new rules for brokers, for instance. Starting in June, brokers will be held to a “best interest” standard when making an investment recommendation, up from a “suitability” standard under current rules. That is a higher standard for financial advice, implying that brokers must act in the best interest of their clients, rather than simply recommending suitable investments. But it leaves the door open for conflicts, such as selling high-fee share classes of funds, as long as it’s disclosed and firms make an effort to mitigate the impact.

If conflicts are disclosed and mitigated, firms can continue to sell high-fee products rather than similar products with much lower fees. And they can continue to receive payments from fund companies to market and distribute their products—incentivizing an advisor to recommend a fund or portfolio manager who compensates the firm.

777彩票地址RIAs, meanwhile, are still being held to a higher “fiduciary” standard. They’re required to put their clients’ financial interests above their own, and they have an ongoing duty to monitor portfolios, whereas a broker’s responsibility for investment advice can end with the transaction, says Jim Lundy, a partner with law firm Drinker Biddle & Reath.

Some RIAs say fee transparency helps them win business. “When an advisor is dual registered, you never know when he’s changing hats,” says Joseph Janiczek, a fee-only RIA in Denver. “He could be talking as a fiduciary one moment and representing the broker-dealer in the other. We think that’s a complexity that investors shouldn’t have to sort through.”

777彩票地址Doug Regan, co-chairman of Cresset Capital Management, a fee-only RIA with $5 billion in assets, says his firm has won business, in part by being transparent about his compensation practices and fees.

“What resonates with clients is when an advisor can open up the fee schedule and show precisely how he or she is compensated,” he says. “I’m amazed at how powerful the narrative is with prospects and clients.”

Write to Daren Fonda at daren.fonda@barrons.com


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