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Form Follows Function

October 30th, 2012

Jennifer Cooper

formfollows function

When an investor engages an investment advisory firm, the investor delegates its investment authority.  As part of this relationship, the investor expects the advisory firm to be in service to the client.  In exchange for this professional service, the investor pays fees.

There are many investment advisory firms that are structured in a way to be fully in service to the client.  But there are also many investment advisory firms that fail their clients.  Even when the individual serving the client is well-intentioned, if the advisory firm is not structured properly, the relationship will fail the client.

There are a number of structures that, in our view, have strong potential to conflict with a firm’s ability to serve advisory clients. Three of those types are listed below:

  1. Advisory firms that are also brokers:  In our view, a firm that is selling products for commissions cannot concurrently construct portfolios objectively for its advisory clients.  There are a total of 11,002 investment advisory firms registered with the SEC at September 30, 2012.  Of those firms there are 497 advisors that are also brokers, or 4.52% of the total number of SEC-registered advisors.
  2. Advisory firms that are affiliated with brokers:  Companies that share ownership and/or control are called “affiliates” and tend to work together to achieve corporate objectives.  Investment advisory firms that are affiliated with brokers often cultivate advisory clients to be buyers of their investment products.   There are 2414 investment advisory firms that have broker affiliates, 21.94% of the total number of SEC-registered advisors.
  3. Advisory firms that are affiliated with insurance companies: Like advisory firms affiliated with brokers, investment advisory firms affiliated with insurance companies tend to be highly focused on serving the insurance company’s interests.  Institutional clients can be captive buyers of undesirable assets while retail investors generally find insurance products placed into their managed accounts.  The total number of advisory firms that are affiliated with insurance companies is 1777 or 16.15% of the total number of advisors.

Investors should look closely at their advisors’ business activities and the lines of business of any affiliated companies.  The investor should be aware that affiliates can often influence the way a client’s portfolio is structured and the securities that are placed into it.  When this happens, the investor can be paying commissions as well as management fees.  Worse, when portfolios are constructed by a firm more focused on other corporate interests, the clients are exposed to additional and uncompensated portfolio risks.

Investors should carefully review Item 6 and Item 7 of their investment advisor’s Form ADV as well as the Part 2 Form ADV Brochure to better understand these relationships.   Investors should ask their advisors specific questions and ask for those answers in writing.  In this way, investors can determine whether the structure of their investment advisor is well-suited to meeting all of the client’s expectations for the relationship

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