A Fiduciary Approach to Money Management

When your adviser is required by law to act in your best interests

Two models of money management — the registered investment adviser and the broker/dealer — vie for the privilege of managing the assets of wealthy individuals. Often lumped together in a way that suggests they are interchangeable, the two models are different in several important ways. These differences strongly influence both the nature of the client-adviser relationship and how assets will be invested.

The registered investment adviser (RIA) model imposes an exacting "fiduciary standard" on the adviser, a legal requirement that the firm act in the best interest of the client. In the broker/dealer model, the adviser is held to a less strict, less specific "suitability standard," that the recommended investments be suitable for the client.

Is suitable good enough?
The "best interests" of a client and "suitability" are not the same thing. Suitability generally means little more than that the client has sufficient assets to tolerate the risk of a given investment. A quick review of the client's balance sheet establishes the basis for suitability. Best interests are much more complex and client-specific. Best interests can only be gleaned through detailed discussions regarding the client's specific circumstances and goals.

Furthermore, a fiduciary is charged with considering the source and mechanics of potential investments and recommending those that best match the needs of the clients. For instance, an RIA choosing between two asset managers that are essentially identical, except that one has a considerable management fee, would have a fiduciary responsibility to select the less costly alternative or disclose why the more costly manager was selected. A broker/dealer has no such obligation; the chosen manager must only be suitable for the client.

Function follows form
Why the different standards? The standards relate to the structure and business purpose of the firms themselves. Broker/dealers are in many businesses, including the development, marketing and distribution of products, such as research, investment funds, derivatives and private investments. Like sellers of any other goods in competitive markets, broker/dealers promote their wares based on their merits, and have no obligation to identify the products of other suppliers that may be better suited to the purchaser. A broker/dealer is free to recommend its own proprietary products — or others with favorable commissions — over all competitors. Holding broker/dealers to a fiduciary standard creates obvious conflicts between serving client needs and advocating their own products.

RIAs do not create or sell products. They sell advice and manage client accounts. RIAs are consumers of research and investment products, purchased on behalf of clients. By buying these products in arms length transactions, from broker/dealers and other providers, RIAs choose from all available products. With no opportunity to profit through strategic selection of products, RIAs can maintain complete objectivity.

Not a suggestion, but a requirement
The fiduciary standard for RIAs is not an industry guideline or ethical goal. It is a legal responsibility. RIAs are legally required to act in their client's interest, an active, anticipatory approach that encourages communication between adviser and client. An adviser cannot be ignorant of the client's needs, and must differentiate between and balance the many types of client interests and needs. Case law uses words like "duty" and "obligation" in reference to this responsibility. The Supreme Court left no doubt as to the advisor's obligation in a 1963 ruling, stating that investment advisers are fiduciaries with "an affirmative duty of 'utmost good faith and full and fair disclosure of all material facts,' as well as an affirmative obligation 'to employ reasonable care to avoid misleading' clients."

An RIA must completely avoid conflicts of interest, such as selecting investments that enrich the RIA or its affiliates, or fully disclose these conflicts to clients. Broker/dealers have no such fiduciary standard — it is simply a case of buyer beware.

What is the goal?
Another important difference between the RIA model and the broker/dealer model is how success is measured. RIAs are typically privately held businesses that charge clients a fee calculated as a percentage of account balance. Growing the business means increasing assets under management by fostering positive investment returns, and by attracting new business, often by referral. As such, meeting the expectations of clients is the fundamental basis for the RIA business model.

Broker/dealers tend to be sales-driven, product manufacturing businesses where success is defined by product profitability, share price (most investment banks are public) and shareholder profitability. In this model, there are obvious incentives to recommend products based on the commissions and other revenue they generate for the business rather than purely on risk, return and cost characteristics.

The RIA model is employed by many independent, private investment advisers, as well as by private banks and trust companies, only some of which are public. Most RIAs remain private firms for private clients.

Making an informed choice There is more than enough room in the investment world for both models of money management. But investors must fully understand the standard of care under which a prospective money manager operates. Expecting a broker/dealer to act in a fiduciary role is neither fair nor realistic. The selection of an adviser should be based on the type of advice sought and the kind of relationship desired.

John Osbon
September 2006