In his book The Truth About Money, Ric Edelman presents a user’s guide to picking the right kind of financial advisor for your particular situation. The financial services industry does not make it easy for investors to shop for advice. How do you know whether the person you’re talking with is qualified to advise you? How do you know whether his fees are reasonable? And how do you know whether the advice he gives you is honest, unbiased, and appropriate for your circumstances? These are big questions, but to get started it will help to understand how the advice-for-hire industry is organized.
The Four Kinds of Practitioners You Can Hire
Should you hire a Financial Advisor? How about a Financial Planner? Or maybe a Financial Consultant, an Account Executive, or a Vice President, Investments? The industry has conjured up a variety of titles. All are designed to impress, some to obfuscate. But no matter what a person might call him- or herself, there are really just four kinds of advisors.
Practitioner #1: Registered Representatives
You know who this is, even if you don’t realize it. Registered Representatives are more commonly known as stockbrokers. They are sometimes called Account Executives, Financial Consultants, or Vice President, Investments. Whatever they call themselves, they’re always salespeople first and dispensers of advice second.
The Financial Industry Regulatory Authority, which operates under the auspices of the Securities and Exchange Commission, is called a self-regulatory organization, and is responsible for licensing and supervising the business activities of all brokerage firms and stockbrokers. No company may engage in the business of underwriting securities or executing securities transactions (meaning, it can’t buy or sell investments for consumers) unless it is a FINRA member. To become licensed, your application must be sponsored by a brokerage firm, and you must pass a FINRA-administered examination.
FINRA calls a person who holds these licenses a registered representative because he or she is registered with FINRA and is a representative of the brokerage firm with which he’s affiliated.
Pay particular attention to that last phrase. Stockbrokers legally represent their brokerage firms. Brokers are considered by FINRA and the SEC to be product salespeople whose job is to represent the best interests of their firms. According to the regulators, brokers sell investment products in order to earn commissions; they are not paid to give advice, and any advice they do give is considered “incidental” to the sale of their products.
Don’t believe me? Then read this disclosure, which the SEC requires on the monthly statements that are issued by brokerage firms:
“Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours … Make sure you understand … the extent of our obligations to disclose conflicts of interest and to act in your best interests … Our salespersons’ compensation may vary by product and over time.”
Indeed, registered representatives generate commissions for themselves and their firms through the sale of investment products. The more products they sell, the more money they make.
Do Brokers Suffer from a Conflict of Interest?
You can see the potential problem here: Do commission-based brokers suffer from a conflict of interest? After all, they make money only when you buy products from them. Those products often pay high commissions, some higher than others. So when a broker recommends a certain product to you, is that recommendation for your benefit or for the benefit of himself and his firm?
This same question arises when dealing with the next kind of practitioner.
Practitioner #2: Licensed Insurance Agents
Insurance is regulated by each of the 50 states and the District of Columbia; there is no federal regulation or oversight.
The reason: Unlike securities, which are identical (all the shares of IBM stock, for example, are the same no matter who buys them or how many you buy), an insurance policy is custom-designed for each purchaser. Consequently, you’re not buying a security when you purchase life insurance. Instead, you are entering into a legal agreement with an insurance company. The agreement is executed by a contract — and all contracts are governed by state law, not federal law.
That’s why insurance is regulated by the states and not by the federal government. Every insurance agent must hold a state insurance license. An agent must hold a license based not on his state of residency, but based on the residency of his clients. Thus, if a New Jersey agent has clients who live in Delaware, he must hold a Delaware license.
Like stockbrokers, insurance agents’ licenses are held with one or more insurance companies. And, like stockbrokers, agents legally represent the insurers, not their customers. And, like stockbrokers, agents earn commissions from the sale of products; they do not give or earn fees for rendering advice.
The most common “investment” product that insurance agents sell is annuities. Annuity commissions range from 1% to 15% of the amount you invest. Sometimes, the agent will earn more in commissions than you’ll earn in interest!
You may not realize this, though, because the product’s commission structure is similar to that of Class B mutual funds.
Consequently, the conflict of interest that can afflict stockbrokers can also afflict insurance agents. As a result, consumers in ever-greater numbers are turning to the next type of practitioner.
Practitioner #3: Investment Advisor Representatives
As we’ve seen, stockbrokers and insurance agents legally serve the best interests of their firms. And they earn commissions when selling products. An Investment Advisor Representative is affiliated (often as an employee) with a Registered Investment Advisor — an advisory firm that is registered with the Securities and Exchange Commission or a state regulatory agency.
Registered Investment Advisors and their Investment Advisor Representatives are legally obligated to serve your best interests. That obligation is referred to as a fiduciary duty, and it stands in sharp contrast to stockbrokers and insurance agents.
Here’s the tricky part: Many Investment Advisor Representatives also hold brokerage licenses and insurance licenses! If you find all this confusing, you’re not alone.
Even though they are technically serving in an advisory capacity, the vast majority of Investment Advisor Representatives help their clients implement their recommendations. To facilitate the purchase of investments and insurance, the advisor must hold the appropriate FINRA and insurance licenses.
For these reasons, many practitioners are dually registered. They hold brokerage licenses with a brokerage firm, insurance licenses with one or more insurance companies, and their advisory registrations with a Registered Investment Advisor.
Unlike brokers and agents who earn commissions for selling products, an Investment Advisor Representative is paid a fee to give advice. The fee is typically based on time or account value, or a combination of the two. A fee based on time might be set at an hourly rate or a flat rate based on an annual retainer. A fee based on account value is called an asset management fee; the rate is typically based on the size of the account (usually, the larger the account, the smaller the rate).
Understanding the Difference Between What They Charge and What You Pay
When interviewing prospective advisors you should always ask how they are compensated. Unfortunately, if that’s all you ask, you might not be told the whole story. That’s because there’s often a big difference between what they earn and what you pay. Therefore, instead of asking, “What is your compensation?” you should ask, “What are the total costs I will incur by working with you?”
You see, when your financial advisor provides you with a portfolio of funds, you’ll incur not one cost, but three. So it’s vital that you receive full disclosure — otherwise, you might end up paying far more than you should, and far more than you realize.
First, of course, is the advisor’s fee. Known as an asset-management fee, it is generally expressed as a percentage of assets. At some firms, the asset management fee is as high as 3% per year.
But the asset-management fee is not the only cost you’ll incur. In addition to paying for your advisor, you must also pay for the funds your advisor has recommended, and this is where you’ll find two other costs: fixed expenses and variable expenses.
Fixed expenses are included in something called the Annual Expense Ratio. Every mutual fund and exchange-traded fund charges this fee — even so-called “no-load” funds. (“No-load” means there are no commissions when you buy or sell shares; it does not mean “no fee.”) The expense ratio pays for the fund’s recurring operating costs, from the manager’s salary to the toll-free phone number investors call to talk to customer service representatives. As of December 31, 2009, according to Morningstar, the average expense ratio for all mutual funds is 1.19% per year, although many are more than 2%. The highest in the industry, according to Morningstar as of December 31, 2009, is a staggering 18.4%! Although the expense ratio is expressed as an annual figure, it’s actually debited on a daily basis. But the charge does not appear on monthly statements, making it hard for investors to notice it. To find it, you must look in the fund’s prospectus, where the expense ratio is expressed as a percentage.
Many investors — and, astonishingly, even many investment advisors — think the annual expense ratio covers all fund expenses. But it doesn’t. The expense ratio covers only perennial fixed costs — salaries, marketing, overhead, and the like. But there are many variable costs to operating a fund, and these are in addition to the expense ratio.
The biggest variable costs are brokerage commissions and trading expenses. Trading expenses are difficult to determine, but in 2007, an analysis by researchers at Virginia Tech, the University of Virginia, and Boston College found the average fund, based on a sample of 1,706 U.S. equity funds from 1995 to 2005, incurred annual trading expenses of 1.44% per year during that period. This is in addition to the 1.19% that is the average Annual Expense Ratio according to Morningstar as of December 31, 2009, based on all the mutual funds it tracks.
These two figures put the total cost of the average mutual fund at 2.63% per year. (This calculation is based on historical data; current figures could vary.)
By adding this to a 0.90% advisor’s fee, you can see how ordinary investors can incur a total annual cost of more than 3% per year.
So be careful when asking an advisor what he charges. If the answer is, “My fee is one percent,” he might be omitting the Annual Expense Ratio and trading expenses that you’ll also incur. When you are interviewing potential advisors, make sure they tell you the total costs you’ll pay to work with them.
Practitioner #4: Money Managers
I don’t manage money. Rather than managing money, I manage clients.
The key to helping people achieve financial success lies not in helping them pick the right investments for their portfolio, but in getting them to invest in that portfolio after we’ve designed it for them. People often have the best intentions, but distractions, emotions — or downright procrastination can interfere with our (and their) genuine desire to do what they need to do at the time they need to do it.
This is why my colleagues and I (and pretty much every real advisor in the country) create custom-designed plans and investment programs for each client, and then we focus all our energies on helping the client implement them.
A money manager, by contrast, has no such relationship with clients. His only relationship is with the client’s money.
The most common example is found in mutual funds. Each fund is controlled by a money manager, whose job is to invest the money in accordance with the fund’s objectives. Every person who invests money will be treated identically. If a manager decides to sell a stock, he or she will sell that stock out of every client’s portfolio, and if he or she buys a stock, every client will own it — and they will all own that stock in the same proportionate amounts. Thus, every client’s holdings in a mutual fund is identical and their results will be identical. The only differences in results between two investors would be caused by the fact that one might invest or withdraw money on different dates than the other.
Consequently, it is not only possible but quite common for stockbrokers, insurance agents, and Investment Advisor Representatives to recommend that their clients invest with money managers — often via mutual funds, exchange-traded funds, annuities, or wrap accounts.
Put simply, the money manager manages the fund while the investment advisor manages the client’s personal finances.
When looking at these online programs, a person should ask himself what kinds of computer programs the coach teaches students to use in addition to the principles of portfolio design, what kinds of financial advice he might get, and what kind of ongoing support he can expect. This should include the possibilities of doing internships while in school.