How to Check Out your Financial Advisor
The executive summary of this article first appeared in the Texas
Association of Small Business newsletter in February. Below is the
original article in its entirety.
Bernie Madoff had it all. Besides stellar returns in his managed fund, posh lifestyle in New York City, and famed reputation, above all, his clients trusted him. Trust is something that is difficult to market and usually comes as a result of performing smaller services well or from respected individuals in the community who enjoyed a good experience and speak highly of that individual or company. The recent betrayal of trust by Madoff to his clients calls into question the trust others may have in their own financial advisor. Unlike Bernie Madoff and high-priced athletes on steroids, legitimate advisors want to be checked out and there are ways of learning detailed information about their background and operations without making them feel un-trusted or suspected.
Types of advisors
There are two types of advisors: Registered Investment Advisors (RIAs) and Registered Broker/Dealer Representatives (RRs). The primary difference between an RIA and a RR is the law that governs each. An RIA is governed by the Securities Exchange Commission (SEC) and are fiduciaries, while RRs are regulated by the Financial Industry Regulatory Authority (FINRA) and held to a standard of suitability.
By definition, a fiduciary is the
highest standard of care under the law. A fiduciary is expected to be
extremely loyal to the person to whom he or she serves; fiduciary
advisors must not put their own personal interests before their
clients. Suitability means that a broker must have a reasonable basis
for believing that an investment meets their client's needs and
objectives. However, suitability is not always clear cut and client
risk tolerances deserve a thorough vetting by the broker.
One of the main missions of the SEC is to protect investors and maintain fair, orderly markets. As such, they provide a resource to investors to search for their advisor's ADV (a document which discloses how RIAs run their business). While this is a good start, regulatory agencies failed to detect Madoff's scheme. http://www.adviserinfo.sec.gov/IAPD/Content/IapdMain/iapd_SiteMap.aspx
RIAs that manage assets below $25 million typically register at the state level and can be found at www.nasaa.org.
The Financial Industry Regulatory Authority (FINRA) provides unbiased information on the industry, broker dealers, and allows one to verify the background of a broker who represents a broker dealer.
The Certified Financial Planner Board of Standards (CFP®) is the recognized standard of excellence for personal financial planning. CFPs® must first pass a comprehensive exam in which the pass rate is about 50%, attest to a code of ethics, and required to complete 30 hours of continuing education every two years. One may also visit the CFP® website to check on certificate holders and if any disciplinary actions exist.
Custody of Assets
A key variable that facilitated Madoff's ponzi scheme was the fact that he owned the custodian which held client assets. There was no independent third party processing trades directed by Madoff for the benefit of his clients; it was Madoff cooking the books and using smoke and mirrors to make it look like assets existed in client accounts. Best practice advisory firms place your money with non-related brand name custodians such as TD AMERITRADE, Schwab, or Fidelity. This separates the investment advisor from client funds. Under this ideal situation, when a client wants to deposit a check to their investment account, they make the check payable to the custodian and never to the financial advisor.
As a result of your advisor placing your money with a brand name custodian, clients receive monthly or quarterly statements in their own name showing transactions, securities owned, account values, and a full account number.
The two prevalent compensation methods for advisors are: fees generated based on assets under management and commissions earned for investment recommendations and/or annuity and insurance sales. There is potential for a conflict of interest under the commission route as some advisors may be lured by high commission rates to recommend certain investment products; however, most professional advisors are more than willing to openly discuss their compensation methods with their clients.
Understanding how and when your advisor is paid for service is an important step for the client to ultimately make the best decision for their own wealth management program. As a result, best practice is for all parties to understand one another's vision, have an awareness of what is in it for each and then frame solutions around what is best for the client. Financial advisors commonly accomplish this, regardless of how they are compensated, when they provide a well written wealth management plan that encompasses the total client profile. Professional advisors advise and product sales people facilitate. Investment decisions should be made from the context of a well thought out financial plan.
Other factors to consider in an evaluation of a financial advisor include;
• Years of experience,
• Interview not only current clients, but also former clients,
• Beware of investments that are kept "secret",
• Surviorship basis, in other words, eliminating a poor track record and starting over with a new one in better market times.
• Know who you will work with (individual, someone else, or a team approach).
Consider our firm, Grunden Financial Advisory, Inc. as an example RIA, this is what we look like:
• Registered Investment Advisor and a fiduciary.
• Governed by the SEC and our ADV can be found here: http://www.adviserinfo.sec.gov/IAPD/Content/IapdMain/iapd_SiteMap.aspx
• Advisors all hold the CFP ® designation (http://www.cfp.net/search/ then search on "Grunden" and "Ragan" in Texas).
• Monthly fee based on assets under management; no commissions earned from investment recommendations (see ADV II for complete disclosure).
• Client assets are custodied at major institutional custodians.
On the other hand, should your professional advisor be a brokerdealer registered representative, follow these steps:
• Use the FINRA database to obtain additional information: http://brokercheck.finra.org/Support/TermsAndConditions.aspx
• Conduct a search to verity they hold the CFP ® designation: http://www.cfp.net/search/
• Understand compensation method.
Most advisors run legitimate business and welcome the opportunity to build trust with their clients. Investigating the background of your advisor will solidify the relationship so they can focus on what they do best, solving problems for clients. Bernie Madoff was too big, too credentialed, and too aloof to be questioned...and in the end, too good to be true. Perform the necessary due diligence on your advisor and ask questions if you are not fully satisfied. In the end, you will have the comfort of confirming the solid relationship you now have with your advisor is indeed, solid.