Registered Investment Advisors versus “Traditional” Brokerage Firms
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It has become evident that most investors do not understand the basic difference between a firm that is a Registered Investment Advisor and one that operates as a “brokerage” firm. The purpose of this article is to explore the most important differences that exist between the two, the relationship to the client and compensation.
Investment professionals generally earn their income from commissions on products they sell or on fees charged for services. Some may earn income on a combination of both. Commissioned brokers are licensed with the National Association of Security Dealers (NASD). Individual sales representatives have to obtain the Series 7 license to be able to offer investment products to the public. Representatives are required to follow the rules of the NASD when offering products to clients. The NASD requires that the sales representative have reasonable knowledge that the investment is suitable for the client.
On the other hand, Registered Investment Advisors (RIA’s) who manage more than $25 million are required to register with the Securities and Exchange Commission under the Investment Advisors Act of 1940. By law, they have a fiduciary responsibility to act in the client’s best interest and to make full and fair disclosure of all material facts, especially if there is the appearance of a conflict of interest.
RIA’s that advertise “fee-only”, such as Crescent Sterling LTD., derive their income from fees charged to manage a client’s assets or from hourly consultations. Management fees are usually stated as a percentage of assets (e.g. 1% of assets under management); hence the objective of the firm is the same as that of the client, to maximize the value of the account.
Brokers will derive their income from commissions on transactions. When a mutual fund or other security is purchased, a commission is usually generated. The type of products offered has become increasingly complex in recent years due to competition from discount brokers and RIA’s. But rest assured, most of these products carry some type of “transaction” based feature that will generate a commission for the sales representative. Some firms offer fee based alternatives commonly referred to as “wrap” accounts in which the annual management expense charged will be 2-3% of the invested value. Investment Managers are used to manage the assets while the broker maintains the relationship with the client. This product is similar to the fee structure of a RIA; however, with the introduction of a third party investment manager, the fee has to be increased to provide adequate compensation for the broker, the brokerage firm, and the investment manager. The addition of a third layer to the compensation structure will increase the cost to the investor well above the cost of using a RIA in most circumstances.
Over the past 20 years, the fee-only structure of RIA’s has become an increasingly popular alternative to traditional brokerage firms. Since investment advisors are compensated for managing and growing a clients portfolio, the interest of the advisor is the same as the client’s creating a win-win for the client and the advisor.