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How Trustworthy Is Your Investment Advisor?

August 1st, 2012

Jennifer Cooper


It’s hard to know who to trust.   Trust in financial institutions is completely breaking down.  At the same time, worldwide structural change is making work and income sources much more uncertain.  We have increasing responsibility for our financial future.  Some individuals are adapting to this new reality by learning financial and trading strategies and managing their own money.  Others choose to delegate their asset management duties to an investment advisor. Both avenues, done well, require a lot of work.

Investment advisors are those firms that provide regular and continuous investment advice over clients assets.  Investment advisors can be firms that provide mutual funds, ETFs, pooled and separate account arrangements, hedge funds and private equity funds.  They can also be investment consultants and financial planners.  In an effort to zero in on those asset management firms that are more likely to be trustworthy, we wanted to get a clearer view of the entire asset management industry in the US.  To do this, our firm downloaded the July 2, 2012 Securities and Exchange Commission “SEC” Form ADV data.

The data consisted of files from 11,622 advisors submitting Form ADV as a registered advisor.  For the most part, investment advisory firms that manage $100 million of assets or greater are required to register with the SEC.  (There are many mid-sized investment advisors registered at the state level, but we don’t yet have access to state aggregate data.)  Each of the 11,622 files had over 150 searchable data fields that included regulatory and legal violations, information about business activities, related parties, and the answers to many questions about potential conflicts of interest.  These can each be indicators of trustworthiness.

To get a better handle on where to focus due diligence efforts and which questions are most important for each firm, we carefully placed firms onto Red, Yellow and Green Lists.  Our August 1, 2012 “Red-Yellow-Green Report” includes the Red List, the Yellow List, and the Green Lists of investment advisors, with a completely transparent description of our methodology.  The report is free on our website.

The Red List contains firms that have a significant adverse regulatory event, which is a red flag, listed on Form ADV.  Red flags indicate that one or more high risk areas exist.  We investigate these areas to find out if a firm has a systemic culture of breaking the law (as many do) or if the firm has operational weakness that allowed a regulatory violation to occur.  Either way, a red flag is an indication there may be a serious problem.

Yellow List firms have yellow flags, which are other risk items to be investigated.   Yellow List advisors could have a financial relationship with a broker or other company that could give rise to potential conflicts of interest.  Some Yellow List firms have another interest in client transactions.  Each firm is different and a bit of investigation is required to determine whether the yellow flag is benign or whether the firm is using client accounts to generate benefits to the firm that the client might not realize.

Green List firms have no red or yellow flags.  Placement on the Green List does not necessarily mean that there are no organizational or due diligence concerns at these firms.  It simply means that the most obvious ADV Review issues did not turn up.

With that background, here are our key findings:

Key Findings:

  • A total of 11,622 investment advisors are registered with the SEC, as of July 2, 2012.  These advisors have total regulatory AUM of $49,446,235,716,391.  In other words, they manage nearly $50 trillion dollars.
  • Red List:  We identified 1,315 advisors (11.31%) that had a red flag in Form ADV. Red List firms manage over $23 trillion dollars, or 46% of all assets managed by SEC-registered investment advisors.
  • Yellow List:   We identified 4,970 advisors (42.76%) that had a “yellow flag” uncovered in the review of their Form ADV.  Yellow List firms manage over $21 trillion dollars, or 44% of all assets managed by SEC-registered investment advisors.
  • Green List: The Green List contains firms that have no significant adverse items on Form ADV.   We identified 5,337 advisors (45.92%) that meet these criteria.  Green List firms manage over $4.7 trillion dollars, or approximately 10% of all assets managed by SEC-registered investment advisors.

Pie Chart of Red Yellow Green Report Fundings August 2012Consider these lists a starting point, not an ending point, in the investor due diligence process.  Some firms on the Red List and Yellow List have multiple red flags or multiple yellow flags.  Some firms have only one red or yellow flag.  Firms are very different from one another.  Each firm has its own story, history and situation to be uncovered by an investor making a hiring decision.  Our lists are a quick way to highlight key due diligence areas, which we believe will help investors to better evaluate the trustworthiness of an advisor.  As our report suggests, a way to do even more research is to look for your advisor’s Form ADV online at the SEC.

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