Who’s In Control?

fightLast week, Susan and I taught a course through the Falmouth adult education department to pre-retired and retired folks. The class is intended to educate students in six areas of life that people need to understand, to have a successful and happy retirement. There is a lot of material to cover and sometimes we do not have time to answer everyone’s questions, so we offer time after the class to give the students the opportunity to ask questions as to how the course material pertains to their personal situations.
Bob, one of our star students, pulled me aside after class and asked for more clarity on the difference between Institutional Money Management (IMM) and Retail Money Management (RMM) and how it applies to him. As I began explaining the difference to Bob, a few others joined the discussion because they also wanted to know. So this week, I thought you and I would spend some time together so you too can understand the differences and how it may apply to you.
In the financial industry, there are two primary parties who are able to offer investment advice to individuals, as well as institutional clients such as pension funds, non-profit organizations and corporations. These parties are investment advisors and investment brokers who work for brokers-dealers. Generally, the retail financial industry predominantly distributes its products and advice to its customers through a broker, where as investment advisors generally offer advice to institutional clients and high net worth individuals.
A broker is a person who introduces a willing buyer to a willing seller of a product. The broker’s job is to close the transaction between his or her “client” and the “market.” For brokering this transaction, the broker generally gets paid a commission based on the amount of the product sold, irrespective of the benefit of that transaction to the client. In many cases, the commission a broker receives depends upon the benefit received by the company that creates the financial product – the more lucrative the product, the higher the commission is to the broker.
A broker works from what is called a “suitability” standard. As long as a broker believes that the advice he or she gives is suitable for a client, the broker has no obligation to put the client’s needs above the needs of the broker, which is often to satisfy quotas defined by the broker-dealer he or she works for. In fact, recent legal challenges have upheld a broker’s ability to simultaneously take positions against both seller and buyer.
Retail products, such as mutual funds, are designed to give the general public easy access to financial markets. Distribution and marketing costs, together with internal trading commissions, are built into the price of these retail products to make them profitable for the large retail brokerage firms to create, operate and distribute them.
IMM strategies, on the other hand, are those used for large institutions, endowments, pension funds and often times, high net worth individuals. IMM actively and directly allocates capital to asset classes across a wide range of sectors and regions without incurring additional fund-related “expense ratios.” Unlike the trading costs that most people don’t understand are associated with many retail investment products, IMM trading costs are fully transparent to investors. Each client’s investments are held in separate accounts that are supervised by third party custodians and managed directly by institutional-level investment managers on behalf of each client. Often times, IMM strategies will focus on absolute rates of return (staying positive), thereby resulting in lower risk, less volatility, and the ability to sidestep market downturns. The securities are registered in the client’s name and traded on the client’s behalf. By using separate accounts, clients can benefit from tax advantages that are not available to RMM investors in retail mutual funds.
Investment advice is usually given to institutional clients by investment advisors, rather than brokers. Investment advisors normally receive a quarterly fee for that advice, which is based on the value of the client’s assets being managed. They can often help their investors bypass the additional costs of the retail brokerage market by trading in very large quantities of stock or mutual funds directly through a custodian without the extra costs associated with retail distribution and marketing.
Many people are called advisors, however not all can say they are “fiduciaries”. A Fiduciary is a person legally appointed and authorized to hold assets in trust for another person. The fiduciary manages the assets for the benefit of the other person rather than for his or her own profit. Most advisors who are registered with an RIA (Registered investment firm) that is regulated by the SEC, are held to a fiduciary standard. Anyone held to a fiduciary standard must act in the best interests of his or her client and must put their clients’ best interests above their own.
True investment advisors take a comprehensive approach to meeting the needs of their clients, including an analysis of risks and costs, together with a forward-looking income plan and expenditure projection. They use a highly consultative approach to constructing integrated financial options.
I explained to Bob that in my opinion, the fiduciary standard, asset allocation and absolute return strategies are essential for successful investment performance. Unfortunately, with RMM, a broker dictates the allocation of assets to various investments and financial products and a conflict can arise when a broker, whose compensation is based on the sale of specific financial products, is the same person who “advises” a client.
IMM, on the other hand, generally does not risk that same conflict because investment advisors are compensated on a fee basis.
I will tell you what I told Bob. In unsettling economic times like these, you must know the questions to ask and seek solutions you deserve. If you do not take control of your financial future, who will?
Be vigilant and stay alert, because you deserve more.
Photo courtesy of Microsoft Office