In Your Best Interest or Your Advisor's? Part I

In the last few years we have seen a sharp increase of questions about how investment firms, including ours, make money from their clients. A 2011 survey by Cerulli Associates and Phoenix Marketing International found that nearly two out of every three investors were confused about how they were paying their advisors.

This issue has made headlines again in 2012, as a high-ranking Goldman Sachs employee resigned publicly through an Op-Ed piece in The New York Times, citing corporate culture as the primary reason for his departure. The employee stated “the interests of the clients continue to be sidelined in the way the firm operates and thinks about making money.” If this occurs at Goldman Sachs, whose clients include the most sophisticated financial firms in the world, it can certainly also occur at any physician’s chosen investment firm.

In the first piece of this two-part article, we will provide two questions to ask your financial advisor. The intent is to help you gain a better understanding of how they make money from you and how they work for, or potentially against, you.

Question 1

Does your advisor owe you a fiduciary duty as a client, or are they held only to a “suitability” standard?

Most physician investors are not aware of the fact that brokers and investment advisors are held to different standards when it comes to the duty they owe clients. Registered Investment Advisors (RIA), such as OJM Group, are held to a “fiduciary standard.” This means we are required to make recommendations that are in a client’s best interest.

Contrast this duty to the suitability requirement that dictates that brokers are simply required to make recommendations that are suitable based on the facts at the time of the interaction. On the surface, this may seem like a subtle difference; however, the end result can have a substantial impact on the client.

Example

Client A contacts his broker and expresses an interest in investing $50,000 in U.S. growth stocks. The broker invests the client’s assets in Fund XYZ, which charges a sales load of 5.75% with operating expenses of 0.68% annually. The client will immediately pay a one-time fee of $2,875 on the trade on top of the recurring fund management fee. In this case the suitability standard has been met.

Client B contacts his RIA with the same request. The investment advisor purchases an ETF with a gross expense ratio of 0.18% and pays a commission of $8.95 on the trade. This client pays his RIA a management fee of 1% of the assets, which equates to $500 per year on $50,000. The advisor has met the fiduciary standard.

In our very realistic example, the front-loaded fees paid by Client A are significant enough that it would require a commitment of approximately nine years to this fund family before that commission is equal to the sum of advisory fees paid by Client B.

Question 2:

Can your advisor provide a detailed explanation of how he or she is compensated?

Do they receive commissions on any of the investments they will be recommending? Beyond “commissions,” compensation can come from sales charges on mutual funds or from a higher operating expense on a specific class of funds.

An RIA typically has access to an institutional class of funds, which will charge a lower expense than the retail shares commonly offered by brokers. Private equities, structured notes, hedge funds and non-traded real estate investment trusts (REIT) can offer various fee arrangements that may not be transparent. These investments may have a higher point of entry for an investor under the brokerage model in order to compensate the sales person facilitating the transaction.

An RIA operating under the fiduciary standard may be able to offer the same investment at a lower cost simply due to the fact that they are not taking a cut before your money goes to work for you.

Example

Client A is approached by his broker to invest in a non-publicly traded REIT. The client sends in a check for $100,000, and the security is priced at $10 per share, thus the client receives 10,000 shares. The broker receives a 7% commission from the REIT sponsor.

Client B is approached by his RIA to invest $100,000 in the same privately held REIT. The advisor charges a 1% management fee and does not accept compensation from the REIT sponsor. In this scenario, the commission is returned to the RIA client in the form of a reduced purchase price for the shares.

Client B receives a discounted price of $9.30 from the sponsor and is able to purchase 10,752 shares of the same REIT with his $100,000 investment. Client A would be required to hold the investment for approximately seven years before his 7% commission matches the sum of fees paid by Client B to his advisor.

Potential conflicts of interest

We recognize that this is not a complete list of the questions you should be asking your current or prospective advisor. One of our objectives in this article was to help you identify the potential conflicts of interest in a traditional brokerage relationship. An RIA typically will charge a fee that represents a percentage of the assets managed and does not receive compensation from the investments that are recommended.

Our hope is that by asking the questions we have referenced in the above article, investors will have a greater understanding of the potential factors that may influence the recommendations of their advisor.

In part II of this article we provide three additional questions to help you assess the nature of you relationship with your financial professional.

David Mandell, JD, MBA, is an attorney, author of five books for doctors, and principal of the financial consulting firm OJM Group, where Andrew Taylor works as a Certified Financial Planner and investment advisor. To contact the authors for a free consultation or to receive a free (plus $10 shipping and handling) copy of For Doctors Only: A Guide to Working Less and Building More, please call (877) 656-4362.

Disclosure:

OJM Group, LLC. (“OJM”) is an SEC registered investment adviser with its principal place of business in the State of Ohio. OJM and its representatives are in compliance with the current notice filing and registration requirements imposed upon registered investment advisers by those states in which OJM maintains clients. OJM may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. For information pertaining to the registration status of OJM, please contact OJM or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov).

For additional information about OJM, including fees and services, send for our disclosure brochure as set forth on Form ADV using the contact information herein. Please read the disclosure statement carefully before you invest or send money.

This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.