In today’s rapidly evolving investment universe investors are often confused by the different types of advisers and their roles and responsibilities.  Largely this confusion is a product of marketing efforts by investment firms trying to either maintain or capture various investment markets.

For the most part, investment firms can be divided into three categories: the first is brokerage, which encompasses the vast majority of advisers; the remaining two are professional investment services with uniquely different roles and responsibilities to that of brokerage—these are fee-only fiduciary advisers and hedge funds. Even among the professional advisers, fee-only advisers and hedge funds are quite dissimilar in their style and substance.

Let’s take a closer look.

What is a stockbroker?

A stockbroker is loosely defined as a person licensed through the National Association of Securities Dealers (NASD) to buy or sell securities on behalf of third parties for a commission. A stockbroker is legally not an adviser, instead stockbrokers are legally recognized as only “order-takers” for their clients. (For further exploration, see “Merrill Lynch Rule”—which permits stockbrokers to call themselves advisers despite the fact that they are limited on the advice that they can give investors.) Precisely because they do not advise their clients and supposedly only take orders from their clients, they are not registered with the Securities and Exchange Commission and do not have a fiduciary duty to their clients. Indeed, stockbrokers have no legal duty to their clients except the mere suitability standards (not a high threshold). A stockbroker operates in a similar fashion to that of any salesperson; namely, caveat emptor (let the buyer beware).

My adviser calls herself a retirement planner (or college planner, financial planner); does that mean that she is not a stockbroker?

The vast majority of these variously referred to advisers or planners are stockbrokers. Unfortunately, once a person is licensed as a stockbroker he or she is permitted, with limited exceptions, to hold oneself out as, and otherwise market as, a specialist in many financial areas. Whatever these planners refer to themselves as, they still are stockbrokers, not in itself a problem, as many are fine individuals. The problem lies in the fact that stockbrokers have no legal duty to their clients beyond mere suitability.  Indeed, their legal duty is to their firm: to optimize their commissions or fees off their clients. Unfortunately, and because of this, most of their training is, in reality, sales training.

My adviser (stockbroker) markets himself as independent and objective.  Is that correct?

Unfortunately, in most cases calling oneself independent and objective is mere marketing. A stockbroker is permitted to sell various investment vehicles, with various commission schedules and/or fee schedules. These commissions or fees bear no relationship to the needs of the clients. An environment is created where a client may need one type of investment but another product is offered or recommended to the client due in large part to the enhanced commissions or fees of that product. Regrettably, this conflict of interest is not only perfectly legal (remember they have no duty beyond suitability), but also it happens regularly.

The highest paying commissions often come from insurance-based products such as annuities, life insurance and long-term care insurance. Many stockbrokers are also licensed insurance brokers (or vice versa). Insurance makes for good insurance, not investments. The other high load/commission (and high internal fees) products are actively managed mutual funds (these usually can be spotted by the letters A, B, C shares, and so on). A relatively new approach which is usually very costly, and not very productive, is the so-called, “Manager of Managers” (which adds multiple layers of costs to the investor).

My advisory firm calls itself fee-based; is that the same thing as fee-only?

Absolutely not. Fee based is just that, “based on a true story.” It is often part fee, part commission (or commission offset). Most fee-based planners are licensed to accept a commission but have shifted their business models to fees as a marketing effort to maintain their client base against the fee-only advisory firms.

What is a fee-only adviser?

A fee-only adviser only accepts a fee and not a commission. If your portfolio does well, the adviser does well. If it fails to perform, your advisory fee reflects this lack of performance. You win or lose in alignment. A fee-only adviser is regulated by the Securities and Exchange Commission (SEC).  A fee-only adviser has a fiduciary duty to his clients. A fiduciary duty is the highest duty recognized in the law. As a fiduciary, a fee-only adviser is not permitted to have any conflicts of interest with his clients. Indeed, a fee-only adviser is not even licensed to accept commissions, which cause most of the conflicts of interest.

As a fee-only adviser does well when his clients do well, there is an incentive to use the lowest cost investment vehicles, preferably institutional investment vehicles as opposed to retail investments.

Recently, I have heard a lot about hedge funds.  What is a hedge fund?

A hedge fund is an investment vehicle for accredited investors (high net worth individuals) willing to take the risk of investing in a largely unregulated investment vehicle. To avoid regulatory review in the United States, the majority of hedge funds are created offshore in various island nations.  With hedge funds, the investors are usually not permitted to know the identity or nature of the investments. In addition to this lack of transparency, like private equity investments, many hedge funds require investors to hold their investment for a period of several years before it can be withdrawn. The typical hedge fund fee is “2 and 20”; that is, 2 percent of assets under management and 20 percent of the gains beyond a threshold return on investment. Often these fees can be greater than 4 percent and higher than 30 percent of a threshold gain.

The sad reality for hedge funds: Since 2000, they have earned an approximate average of less than 8 percent despite their supposed promise of riches, lack of regulation and transparency, and draconian restrictions.   Indeed, due in large part to poor performance, many hedge funds have stopped publicly reporting their performance altogether thus making average estimates difficult.

		Stephen L. Hicks, JD, MS and Roger L. Millbrook, JD, CPA/PFS, are Fee-Only Fiduciary Investment Advisors and principals of Siena Capital Management, LLC and Siena Accounting Services, Inc..  Both are accountants and hold law degrees as well as other advanced degrees and designations in the area of financial services.