Financial advisors can be very creative about the fees they charge to clients in the distribution of investment instruments. Do you know what you are paying for? Are your advisor's interests aligned with yours?
Independent family offices and independent advisors generally provide the simplest and most aligned fee arrangements, given that the they charge a flat fee, typically on a quarterly basis.
But when investment advisors are also product providers or distributors that attempt to combine delivery of products with delivery of advice, fee structures start to get a little bit more complicated. In these arrangements, the purported advisors are typically receiving income, related to their client activity, which stems from a source other than their clients. In this case, it is legitimate to ask whose interests they place first.
"Investors should make sure their investment professional is a fiduciary at all times," said Knut Rostad, president of the Institute for the Fiduciary Standard. "The difference between 'advisers' and 'sellers' in finance is clear. Clients pay fiduciaries - or advisers - to get objective advice. Manufacturers pay product sellers - whether they're selling mutual funds or insurance policies -- to get sales. To mix up the two is like confusing the car dealer with the consumer report on the car dealer."
For starters, most retail share classes of mutual funds charge their clients, in addition to asset management and administration fees, 12b-1 fees (the industry term for marketing fees). These are usually subtracted from the value of your fund on a daily basis and periodically remitted to the agent who sold the fund to you. Are these agents recommending the funds that best meet your needs, or those that extract and remit the highest marketing fees? This is something clients need to know.
If your portfolio includes single bonds, many brokers act as principal rather than agent in offering these bonds to you. This means that, rather than shopping the bond markets for the lowest price on your behalf, they will shop on their own behalf, buy the single bonds into their inventory, and sell them at an undisclosed spread to you. It can take a substantial research effort to find out whether the spread they earned can be considered fair based on current market conditions.
In a "soft-dollar" arrangement, a third- party broker that executes stock and bond trades on behalf of an asset manager or advisory firm will offer research services, data subscriptions, or even expensive Bloomberg terminals to its clients, with the understanding that a certain volume of trades will continue to flow in its direction.
At a minimum, this creates the perception of conflict, with an actual conflict developing if the client firm winds up directing trades to a "friendly" trading firm when those same trades could be executed on better conditions with a different third party.
"Hypothecation" of securities, meanwhile, may be practiced in certain types of brokerage accounts. During the account opening process a client, usually unwittingly, will sign a package of documents that includes a "hypothecation agreement." This means that the broker can, with no additional notification, periodically borrow securities from the client's account and return them at a later date.
These securities will be loaned to the "prime brokerage" side of the broker's business, which will, in turn, lend them to hedge funds, that can then sell them into the market as part of a legitimate "short selling" strategy. The conflict in this scenario is that the broker is earning additional fees while taking risk with securities that belong to the client.
All of these little fees add up and are best avoided by turning to investment advisers, who are looking out for client interests first.
"Clients are willing to pay reasonable fees for caring professional advice; but if the fees are hidden, how can they evaluate if they are fair?" said Michael Warszawski from Manchester Capital Management, a private family office. "A reference which some of our clients find helpful is the list of 'Best Practices for Objective Financial Advice' published by the Institute for the Fiduciary Standard."
True advisors strive to align their interests with their clients in every aspect of their business practices, including their sources of income, compensation practices, and financial transparency. Financial product providers and distributors play an essential role in our industry. But it is unwise to think of them as impartial advisors, given the complexity and potential conflicts in their sources of income.