The investment advisory industry has become a complex labyrinth of “contractual models” and “platforms” that advisors are supposed to navigate in order to discover how to best build and manage their practices. The various combinations of technologies, investment services, operations, and regulations are constantly packaged and repackaged in different forms and under different names by custodians, clearing firms, broker/dealers, and third-party turnkey managers. Sometimes this process creates much needed solutions that serve advisors and their clients. Just as often, it seem, it also results in unnecessarily complex infrastructures resembling a “toll booth” where a third party positions itself in the middle of the business and charges for the right to pass. As a result, advisors struggle to determine which model is best for them. Should they be with a broker/dealer or have an RIA? Should they consider a hybrid model? What kind of broker/dealer should they join? Which RIA should they use–their own, their broker/dealer’s, or the turnkey asset manager’s?
Any affiliation should be straightforward. An advisor should be able to easily determine where he will find the best combination of resources, economics, and business philosophy and, therefore, where he belongs. The decision in my mind comes down to five questions in a very specific sequence, and a sixth question that runs in parallel and holds more weight than all the others. The questions are:
- Do you want to be a business owner?
- Are you comfortable being your own compliance officer?
- Do you seek or need the input of a third party influencing your business and your professional decisions?
- Do you see a strategic role for commission-based business in your practice?
- How will you achieve scale to economically support your own reporting, billing, compliance, and vendor selection functions?
These five questions act as a decision tree that should lead to a model that allows you to achieve both your professional and personal goals. Each model represents a unique combination of risks and rewards and essentially trades varying degrees of control and independence for support and resources.
At some point, you also have to ask the last and very important question: “Where will you feel a sense of cultural belonging?” At any point in the process, this question can trump all others. After all, people normally don’t leave their communities for another city just because one local economy is doing better than another. Similarly, if an advisor feels that she belongs in her current organization and that her friends and the people she respects are in that organization, then she should not leave it. The opposite is also true: if an advisor no longer feels that she culturally belongs, if her friends are not there any more, and that the people she respects are elsewhere, then she should change her affiliation right away, almost no matter what the other factors are.
There are four general contractual models in the industry based on the level of independence and the responsibilities assumed by the advisors and their firms. The critical decisions center on the relationship between the advisor and his broker/dealer, the “ownership” of the client relationship, the strategic decision-making power, the product decisions, the responsibility for operational infrastructure, and the ultimate control of the business. There are nuances to each model, but the chart above summarizes the similarities and differences between each.
The Ownership Question
The single biggest reason to be independent is to own and control your practice and to be fully responsible for its success or failure. This takes a level of risk tolerance and self reliance that not all advisors possess. Advisors who are not passionate about building a practice of their own should never try to be independent. Without passion, independence is just a long list of chores.
It’s been said that MBAs never become business owners because if you analyze the decision to start a business very carefully it rarely makes sense. If you are stuck comparing the value of your deferred revenue plan to the equity valuation of your practice if it was independent, you should probably not be independent. If you cannot bear the thought of your branch manager telling you that you need to add this and that fund to your client accounts then you probably are on your way to independence anyway.
Independent advisors who practice as RIAs need to be prepared to be their own compliance officers and make their own compliance decisions. Advisors who are with an independent broker/dealer will also need to look into the field supervision question of who will be their OSJ, which is an often overlooked decision in the selection of a broker/dealer.
It is also important to separate comfort and capability; many advisors have the comfort but may not have the ability. There are more than 9,000 RIAs registered with the SEC and over 6,000 of those have under $1 billion in assets, meaning that there are many advisors who are comfortable with the cost and the risk. As the RIA channel grows and adds more clients it will inevitably add more client complaints and regulatory scrutiny. Risk management is an inseparable part of the business.
Most firms who become new RIAs outsource the initial registration as well as the development of policies and procedures to a compliance consulting firm. The cost of this initial compliance investment ranges from $20,000 to $30,000. The firm will also need to hire an attorney to draft its standard client agreements. Finally, errors and omissions insurance is available to RIAs but is more expensive than the equivalent on the broker/dealer side. Compliance should be a value-added service for a broker/dealer although it can also be a point of friction. The critical factor is going to be whether the compliance department fully understands the advisor’s business and circumstances surrounding a decision or enforcing a policy created with the “lowest common denominator” in mind.
Whether or not advisors decide to affiliate with a third party is often based on their past experience. Advisors who have had a bad experience have a hard time believing that another party can actually have any constructive input into their business. Advisors have to consider the issues of control and influence before selecting a third-party affiliation. Some will never trust a third party and do not want any other party influencing their decisions. These advisors will never fully be comfortable with a broker/dealer. However, these same advisors generally forfeit some of the scale, bargaining power, and constructive input that a third party can bring to their practice.