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The Flip Side Of The Registered Investment Adviser Explosion: What Investors Need To Know

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Sometimes there can be too much of a good thing, even in the investment world.

The current explosion of Registered Investment Advisor (RIA) firms has given average investors an alternative to the regular brokerage houses for investment advice. This alternative comes with a higher standard of care by the advisors, in that registered investment advisors are always held to the fiduciary standard, while stockbrokers may or may not be subject to that standard, depending on a variety of factors.  

While brokerage firms make money when an investor sells or purchases an investment, the RIA merely can recommend an investment. They cannot actually purchase anything, and – unlike a stockbroker – don’t receive sales commissions when an investor buys an investment.

Since RIAs are fiduciaries, they must always act in the client’s best interest, and put their client’s interest above their own. That means an RIA cannot recommend an investment to the client with an expectation that the RIA will profit from that recommendation, in the form of a sales commission. The RIA must disclose any conflicts of interest, between his or her own interest and that of their clients, and obtain the client’s informed consent to waive such conflicts of interest. A serious conflict of interest is when the RIA receives compensation from any source other than the investor – the RIA’s client – for an investment or transaction that the RIA recommends to the investor whose fiduciary he or she is.

RIAs need to be registered with the Securities and Exchange Commission or, if a small operation, with their state regulators. As a fiduciary, an investor knows, by law, the recommendations from an RIA must be in the investor’s best interest.

Many investors are growing more comfortable receiving advice from fiduciaries. Because of that, RIAs are growing.

The high growth of RIA has raised a difficult question. Are RIAs growing so fast, are firms hiring people to give advice who have the same level of expertise as customers may be used to?

And, while in theory an RIA is required to give the investor the advice they believe is best for the investor, in practice this might not always be true.

In mid-November this year, the SEC issued an alert on the RIA industry that included some warnings for investors considering using them.

The SEC issued an official risk alert warning about inadequate supervision at multi-branch RIA, and the problems it could lead to for people who use them[i].

Shortly thereafter, the Investment Adviser Association, a trade group for the RIA industry, issued a report[ii] about the rise of multi-branch RIA’s. It estimated that almost 38% of RIAs registered with the SEC had branch offices.

SEC’s Office of Compliance Inspections and Examinations expanded on the alert about possible problems with advisors working out of multiple offices.

The alert stated: “… More specifically, some of the advisers had not fully implemented policies and procedures addressing advisory activities occurring in branch offices and in geographically dispersed operations.”

The problem is like many other businesses. The corner store you go to staffed by the family who have owned it for years will probably know your needs better than the big department store miles away.

The majority of RIAs are still small businesses, averaging about eight employees. But it is a fast-growing business, the SEC estimates $6 trillion is controlled by RIAs.

The SEC risk alert report concluded: “In sharing the information in this Risk Alert, OCIE encourages advisers, when designing and implementing their compliance and supervision frameworks, to consider the unique risks and challenges presented when employing a business model that includes numerous branch offices and business operations that are geographically dispersed and to adopt policies and procedures to address those risks and challenges.”

The main problems dealing with the quick expansion of some RIAs are three-fold:

1. Keeping a close eye on the investor’s portfolio.

In almost half the cases the SEC looked into, the advisor was not spending the proper amount of time monitoring each client’s investment. Sometimes that could prove costly by something as simple as recommending mutual funds, when there was a cheaper rate in the same class if more research had been done.

Inattention can also have investors incur additional expenses they did not approve like wrap fees, when they get charged when RIA advisors may not have fully explained their fees, or sub-advisors recommend trades without factoring in the cost without checking with the main advisor.

Sometimes, with so many clients, advisors will implement automatic rebalancing to make sure the investment is taken care of. Unfortunately, that can mean mutual funds assessing short-term redeeming fees. Again, fees the client was not expecting.

2. Possible conflict of interest may not be monitored as much when there are people in branch offices.

The main point of using an RIA is that the advice is going to be solely in the best interest of the investor.

If an advisor in a branch office has a financial interest in recommending a client invest in a certain stock or mutual fund, it is much harder to discover when the advisor is not close to the main office. Such financial interest typically gives rise to a conflict of interest, which must be adequately disclosed to the client prior to the investment recommendation.

3. Without full knowledge of the rules, RIA advisors could recommend improper investments.

The advisor could recommend unregistered or private investments not suited to the investor’s portfolio. An investor may be looking toward investing in low-risk securities, but the inexperienced or reckless advisor could recommend high-risk investments, thus going against the entire reason for going to an RIA.

These shortcomings can result in a lower than expected return for the investor.

Here are some tips to make sure you are dealing with a quality RIA:

  • Find out if the RIA you are looking into is a branch or a main office. The main office usually has more experienced advisors and enforce more tightly the compliance practices to safeguard your investments.
  • If seeing fees in your statements that you were not made aware of, or are unexpected, immediately contact the advisor and seek an explanation.
  • Ask about the compliance practices of the RIA and if can get a copy of their policies. Also ask how many times the advisor is reviewed by the company for compliance.
  • If there is an investment you are not familiar with, make sure to ask what type of investment it is. Investors need to know if being advised to invest in something private, unregistered or maybe untraded before agreeing.

If the advisor is not doing their due diligence for the investor, it means the investments may not produce the return the investor is looking for.

There is a reason RIAs are gaining in popularity. Investors are looking for advice where the person is solely thinking about what is best for them.

However, with more RIAs, that means irregularities can crop up. That is why investors who are concerned about potential red flags and do not receive full and adequate answers to their questions from their RIAs should contact an experienced attorney to review their portfolio and answer their questions.

Alan Rosca is a securities lawyer with Goldman Scarlato & Penny, P.C. and an adjunct professor of securities regulation at Cleveland-Marshall College of Law in Cleveland, Ohio.

 

[i] Observations from OCIE’s Examinations of Investment Advisers: Supervision, Compliance and Multiple Branch Offices*, November 9, 2020. https://www.sec.gov/files/Risk%20Alert%20-%20Multi-Branch%20Risk%20Alert.pdf

[ii] Investment Adviser Association 2020 Evolution Revolution: A profile of the Investment Adviser Profession. https://higherlogicdownload.s3.amazonaws.com/INVESTMENTADVISER/aa03843e-7981-46b2-aa49-c572f2ddb7e8/UploadedImages/resources/Evolution_Revolution_2020_v8.pdf

 

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