Our goal in developing these questions is to provide you with important questions to consider when establishing a new financial advising relationship. Regardless of whether you work with Vector or not, we want to help you minimize any of the real or construed conflicts of interest that can exist in a financial relationship. In using the phrase “conflicts of interest,” we are not implying that any individual or firm is not representing the best interests of their clients; rather, we are saying that there is a way of engaging an investment advisor that limits the conflicts that can be present. Currently, in Washington, D.C., there is an effort to try to strengthen the protections of advisors by changing either the disclosure of responsibilities or the very nature of those responsibilities that advisors should undertake with their clients.
The following background and questions may be helpful to you in uncovering some of these potential conflicts of interests as you interview firms to work with.
What is a Registered Investment Advisor?
A Registered Investment Advisor is a person or firm who has registered with the U.S. Securities and Exchange Commission or state regulatory agency in connection with the management of others’ investments. A pure RIA does not receive income on a transaction for any investment product. They are generally paid a fee as a proportion of the assets under management. The RIA is, by definition, a fiduciary, which is required to act at all times for the sole benefit and interest of another, with loyalty to those interests (as defined in Wikipedia). It is not a suggestion, it is a requirement. It is among the highest standards available and is what you should expect in a relationship with an RIA. The use of a fiduciary in managing your assets is not going to guarantee the results of your portfolio but does align the advisor’s interests with your own.
The quality of RIAs varies and still should be subject to your normal vetting process and due diligence. Here are some questions that would be reasonable to ask a prospective advisor:
Is your firm a nationally registered investment and advisory firm?
The answer to this question will allow you to better understand the advisor’s compensation model. As mentioned above, Registered Investment Advisors are generally paid a percentage of the assets under management, which is reduced as the size of the portfolio managed increases. The use of just a pure RIA will assure the client that there will be no compensation received when any product is purchased or sold for that client's portfolio. This allows the client to feel more comfortable that any transactions taking place are motivated by the client’s best interests rather than by the advisor’s external motive.
If your firm is a Registered Investment Advisor, do you also act as a registered representative?
There are many firms that act both as a Registered Investment Advisor and as a registered representative. The registered representative portion of the business holds itself to the suitability standard rather than the fiduciary standard. The suitability test is one in which it is the registered representative's responsibility to ascertain that the product or service that they are offering is reasonably suitable for the client. Once this standard is met, the product decision and results become the client's responsibility and not the advisor's. As mentioned above, a fiduciary is required to act at all times for the sole benefit and interest of another with loyalty to those interests. Note the distinction that exists between the two standards - the suitability test allows for a lower standard of responsibility and liability. In addition, the registered representative also has the potential for compensation as a result of transactions in a client’s portfolio.
In essence, a firm that operates as an RIA and as a registered representative, is forced to switch hats, sometimes acting as the fiduciary and at other times as a quasi-sales organization. Although these models do not imply that one is not representing the interest of the client, it simply introduces a level of perceived conflict in interest that is not necessary in a financial relationship.
Do you sell or offer any products that pay a commission?
If a potential advisor is a registered representative, you should be aware that if you decide to enter into this relationship that there may be times when commission is generated on the transaction. This is in contrast to an RIA relationship in which a fee is generated over a longer period of time through assets under management. It is important to understand this distinction so that if you enter into an RIA and registered representative relationship then sometimes you may pay a fee and at other times pay a commission.
Do you sell or offer any products developed by the firm that you work for?
Within the financial services industry, many firms not only develop products that have profit margin inside of them but also sell those products through a captured sales force or group of registered representatives. This does not imply that these are bad products. However, it is important to know and understand that a firm offering these products may have more motivation to use these products over products that the firm has not developed because of the incremental financial benefit.
How else are you compensated?
You may want to ask if the prospective advisor has any soft dollar arrangements. These arrangements exist when the firm receives additional compensation from others for a variety of reasons. For example, sometimes a firm gets reimbursed expenses based on the volume of a companies’ products that are sold by the firm. In some cases, especially with bundled products, such as variable annuities, there may be incentive trips that are offered for certain levels of product sales.
You may also want to inquire about other indirect compensation that may flow back to the firm in any fashion. Compensation, in and of itself, is not a bad thing. As a matter of fact, it's critical to providing services in a way that is beneficial to both the client and to the advisor. There should not be any reason why all of the levels of compensation, be it direct or indirect, received by the firm are not fully disclosed to you.
Additional Thoughts
Entering into a financial relationship is different than buying a car. The objective of any financial product that is purchased, be it mutual funds, stocks, bonds, or ETFs, is to provide some future value based on the underlying investments inside of that product. It is the future value of that product that you are dependent on in most cases, rather than its present value. Therefore, the alignment of interests between the advisor and the client, in which fees are earned instead of commissions, seems to be logical. As stated previously, this is not to imply that anyone who receives compensation for a specific product does not have the best interest of the client at heart; it is just a potentially construed conflict of interest that in many cases does not necessarily need to be present.
