Imagine that you are traveling in a foreign country. You’re feeling lousy, so you go to a health clinic. A man at the front desk says you must choose between two types of physicians.

The first type of physician will interview you and give you a thorough physical exam before prescribing whatever treatment or medicine is most likely to give you a successful outcome.

The second type will take less of your time and probably will cost you less money. This person will listen to your symptoms and might check your blood pressure if that seems to be an issue; but you can’t expect her (let’s presume for the sake of convenience that all doctors in this country are female) to do a full checkup. You are told she will likely recommend a treatment or medicine in which she has some financial interest, but isn’t obligated to let you know whether or not that is the case.

This is puzzling to you. The man at the front desk takes out a sheet of paper and draws a circle. Then he draws a small semicircle inside the right side of that bigger circle, and another semicircle on the left side. “This circle represents all the possible treatments and medicines that are available,” he says. He labels the right semicircle “Things that could hurt you.” He labels the left semicircle “Things that will be best for you.”  Then he explains: “We have two different laws that govern our physicians here. The doctor who will give   you a full checkup is required to know enough about you to determine what you need. She must recommend whatever will be best for you, something from the left semicircle. If she might make extra money as a result of what she recommends, she has to tell you that.

 “The only requirement of the other type of physician is that she must avoid recommending something in the right semicircle, something that will hurt you,” he continues.

 This seems mighty strange to you, but after a few more questions, you get the picture. One doctor’s job is to do the right thing for you. The other’s is to avoid doing something that will hurt you.

 If you were that traveler, which type of physician would you choose?

 Although this is an imperfect analogy, investors in the United States are essentially in the same position as this traveler. It’s too bad most of those investors have no idea that is the case.  In order to walk you through the example of the traveler, I made up a helpful front-desk attendant who explained the rules of the game. But in real life, there’s no such helpful attendant waiting to give that kind of objective guidance to investors.

TWO TYPES OF INVESTMENT ADVISORS

A good guide would start by pointing out that in this country, there are two separate laws that govern investment professionals. These laws effectively separate these professionals into two camps. Every savvy investor should know this distinction, though it’s a fuzzy one.

In the first camp are individuals whose primary job is selling products. They are brokers or broker/dealers, though they use various titles such as “registered representatives,” “investment representatives,” “financial advisors” or “financial consultants.” These titles, also used by some professionals in the second ‘camp’, are not a reliable guide. Brokers work in a sales-oriented culture in which the function of giving advice and making recommendations is restricted by law to an incidental role. They are required only to avoid selling “inappropriate” investment products. (See the circle in Figure 1.) This is loosely equivalent to doctors who are required only to avoid doing things that are obviously bad for patients. Brokers are free to operate with financial interests that conflict with the interests of their customers, and they don’t have to disclose those conflicts.

 

The investment industry’s second camp is made up of individuals whose primary job is giving advice. Legally, they are known as registered investment advisors. They often use titles such as financial advisor or consultant. Some are brokers. Whatever they call themselves, these people are held to a higher standard. They are required to disclose any potential conflicts of interest. They also must know their clients’ circumstances enough to recommend only investment products that serve the best interests of those clients.

Picture yourself as the imaginary traveler trying to choose between two types of physicians. If you are pretty sure you know what’s wrong and you just want merely a quick fix, you’ll probably go to the less expensive doctor. But if you don’t know what’s going on and you think you may need some serious attention, you’ll probably want a doctor who does a thorough examination before rushing to recommend a product or treatment.  When you’re choosing somebody from whom to get financial advice, wouldn’t it be nice to know that the advisors in one camp are behind one door, all the others behind a second door? In reality, it’s not that simple. But if you know how to decode a few signals, you can be your own front-desk guide.

Formal designations don’t necessarily point you to a fiduciary. A CFP certificant or Certified Financial Planner has undergone a rigorous training program for personal financial planning. But a CFP can be either a broker or a registered investment advisor.  It gets even more confusing, because some brokers are also registered investment advisors – putting them in both camps. Their legal responsibility to clients is diluted by their employers, the broker/dealers, who allow them to sell only certain products.

I think this, along with a compensation structure that rewards brokers for selling some funds instead of others, violates the principle that registered investment advisors must not have conflicts of interest with their clients.

THE KEY: FIDUCIARY RESPONSIBILITY

You are much better off with an advisor who has assumed fiduciary responsibility.

Recall for a second that mythical physician who must take the time to know you well enough so you’ll be given only recommendations of “things that will be best for you.” That doctor is on the hook legally, and this gives you two advantages. First, that responsibility will guide that physician to take your needs very seriously. Second, if something does go wrong, you have legal recourse that you would not have with a doctor whose only obligation was to avoid harming you. To understand the difference between those two physicians, you’d need to know something about the laws that dictate how they operate. The same is true of brokers vs. fiduciaries.

 You should at least be aware of two quite different laws: the Securities Exchange Act of 1933 and the Investment Advisers Act of 1940. It’s easiest to understand them one at a time.

SECURITIES EXCHANGE ACT

The Securities Exchange Act of 1933 regulates brokers and others who make their money through selling investment products. It presumes that everybody understands that a salesperson will be biased in favor of products that pay commissions. It also presumes that the client knows what he or she needs. A broker can recommend a specific stock, bond or mutual fund. But is the advice unbiased? This is up to the client to determine. Is there a conflict of interest? This is also up to the client to determine. Unfortunately, it’s not always easy to know where the broker’s pay really comes from.  In a culture where this quarter’s sales goals have much greater priority than clients’ long-term financial goals, it’s easy to imagine that brokers have incentives to sell high-commission products instead of others that pay less.

The broker-dealer operates under a “know your customer” rule. He or she must know enough about you, based on your income, your net worth, your tax bracket, your investment experience and so forth, in order to determine what high-risk investments he may not sell you. He is free to sell you anything else, and as you can see from Figure 1, that covers a lot of territory. If the broker can choose between two products that are not inappropriate for you (that’s the standard imposed by the law), and if one of those products pays a higher commission, this law presumes that you will understand the broker has a financial incentive to sell the higher-commission product. This is a conflict of interest. Your needs may be best served with a tax-efficient, low-cost, no-load index fund. The broker’s needs may be best served by selling you a variable annuity that pays a high commission but saddles you with unnecessarily high expenses and taxes. As far as the law is concerned, that’s too bad. The broker is required to give you extensive disclosure materials written by lawyers; the law presumes that you have made a buying decision after understanding what’s in those materials.

Because of this legal presumption, you – not the broker – are responsible for choosing the products that will be best for you. This is similar in some ways to purchasing a new car. If you go to a Ford dealership, you know what the bias will be. There’s no presumption that the salesperson’s job is to find the best transportation solution for you (which might be to take the bus!). You know this person’s being paid to do just one thing: sell you a Ford product.

You know how the Ford salesperson chooses what car to recommend. A broker is under no obligation to disclose how he or she chooses a stock or fund to recommend. The broker doesn’t have to avoid conflicts of interest or disclose them. Disclosure tends to be scattered over sales receipts and various forms. If you buy a fund, you’ll get a copy of the prospectus; but if you read it carefully, you’ll be in a small minority of fund investors.

In plain language, this law seems to say to the investor: Conflict of interest? Tough! You figure it out.

INVESTMENT ADVISER’S ACT

 When Congress passed the Investment Adviser’s Act, the basic purpose was to protect investors from potential conflicts of interest. The SEC used the words “competent” and “unbiased” to describe the sort of advice investors needed from professionals.

The SEC and the courts regard fiduciary responsibility as the duty to put the client’s interests ahead of the advisor’s interests. In other words, if there is a conflict of interest, a fiduciary must always resolve the conflict in favor of the client. Congress tried to implement that by creating an environment of openness and transparency designed to empower investors to know who they were dealing with. Before establishing any new customer relationship, a registered investment advisor is required to do a number of things: tell the customer the advisor’s process for giving advice; disclose all (note that important word) actual and potential conflicts of interest; explain how the advisor is compensated; disclose any past disciplinary problems with regulators. In addition, the advisor must offer to disclose these things again once a year for as long as the relationship continues.

 Registered investment advisors are required to report all this information on Form ADV, a form they have to file with federal and state securities regulators. They must give a copy of part of this form to each new client. Once a year, continuing clients must be offered a copy, without charge, of the most recent version of that document.

In plain language, this law seems to say to investors: Conflict of interest? Don’t worry, we’ve got you covered.

That’s the overview.

Brokers, of course, aren’t simply free to do whatever they want. They may have a limited fiduciary duty to give their customers the best execution price on buy and sell orders. They are accountable for cash that you own that’s in their possession or control.  However, brokers are primarily salespeople, not advisors. Here’s one way this difference can play out. Suppose your life circumstances change in a big way, whether it’s losing a job, getting married or divorced, retiring or inheriting a bundle of money from your Uncle Fred. If you become a widow or lose your job just as a risky investment starts to nosedive, the broker isn’t obligated to suggest that you sell and protect what you still have. The culture of a registered investment advisory firm should be dominated by fiduciary responsibility, that is, doing the best thing for the client. That includes making new recommendations when the client’s circumstances call for a different approach. 

In my opinion the same should be true of the brokerage industry. But in reality, generating revenue is often the overriding priority, and achieving sales goals and quotas gets most of the attention. Customers – and the products they can be persuaded to buy – are sometimes regarded as only tools for meeting these short-term goals.  Brokers’ training is mostly focused on understanding financial products. The main emphasis is not on helping clients determine their needs and risk tolerance and creating carefully diversified portfolios to produce favorable long-term results. 

Many brokerages have proprietary funds that typically charge more in loads and ongoing expenses than comparable funds that might do the same job for the client with less cost and more tax efficiency . The broker is under no obligation to recommend – or even inform the customer about – those cheaper alternatives. The law presumes that the investor knows about all these choices and freely chooses to buy inferior products that are less suitable.

It’s perfectly legal for a brokerage firm to receive rewards of various kinds (without ever disclosing this to you) from mutual fund companies in return for sending your business to them. It’s perfectly legal for a broker to carefully structure (again without ever disclosing this to you) your load fund investments so that you never get the benefit of “break points” that reduce loads for large investors.

DETAILS

When you’re in the midst of a raging bear market, the details of your investments may not seem to matter much. But when returns are mediocre and you’re struggling to meet your needs, the combination of an extra fee here, an added expense there and a tax bite around the bend can add up to the difference between success and failure.

A fiduciary is bound to help you with those details. A broker doesn’t have to care.

The world of brokers is driven by optimism. Hope sells. Fear paralyzes. A sales-dominated culture has little use for the latter. When the market fails to dish up the gains that you and your broker hoped for, the pervasive optimism creates a reluctance to sell. Imagine that your broker comes to you and says: “We made a mistake. Let’s sell.” That might be the best possible analysis and advice. But what will you think? Will you trust that broker again after having your hopes dashed?  Will you wonder if that broker really knows as much as you thought?

I guarantee that your broker has thought about this. And he or she will be reluctant to admit a big mistake for fear of losing your confidence and your future business. The predictable result: With a broker, unless you take the initiative, you’ll probably stay in failed investments longer than you should. Your broker has no obligation to prevent you from doing that, so long as the investment was “not inappropriate” for you when you bought it.

A fiduciary, by contrast, is obligated to take a longer-term view of your needs and your investments. Such an advisor is required to give you “only suitable investment advice,” based on your own circumstances, to “exercise a high degree of care” to make sure you have accurate and thorough information. And because the law requires this, the advisor has to be prepared to prove that he or she took the necessary steps.

My guess is that you’d want this level of care from a physician. You should want it from a financial advisor, too. You can get it by dealing with an advisor who is a fiduciary.

THE QUESTION YOU SHOULD MEMORIZE

How can you tell what type of advisor you’re dealing with? There is one key question, and I suggest you memorize it: “Are you a fiduciary?”  If you ask somebody if he or she is “acting as” a fiduciary, that’s not what matters. The real question is whether your advisor is legally a fiduciary. Unless the answer is yes, you are dealing with somebody whose financial interests aren’t necessarily aligned with yours.

 

 

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