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3 Dirty Little Secrets Your Broker Isn’t Telling You

I am asked quite often, "how are you different from my stockbroker?" I love this question. It gives me the opportunity to dish out the dirty little secrets about stockbrokers and brag a bit about myself at the same time.

With trust of Wall Street at an all-time low, I figure now would be a good time to add some more fuel to the fire:

Stockbrokers vs Registered Investment Advisors (RIA)

1) Fidicuary vs Suitability
Did you know that your broker may not be looking after your best interest? Did you know that this is mandated by law? Most large firms are publicly traded, meaning they have stockholders to answer to. By law, firms are supposed to look after shareholders' interests before clients'. In fact, board members of these firms have a fiduciary responsibility to shareholders, not their clients.

What this means is that your broker at Merrill Lynch or Morgan Stanley is only required to make recommendations that are "suitable" to you. What happens if they fail to make suitable recommendations? Typically, the firm will settle in (or out of) arbitration with the client, and the broker may get a slap on the wrist, or pay a small fine.

Registered investment advisors (RIAs) have a "fiduciary" responsibility to their clients. In the simplest terms, it means we have a legal responsibility to put your needs ahead of all others, including ourselves and our firm. If I fail to do that, my assets and my family's assets are at personal risk. TD Ameritrade did a study of investors back in 2006 that showed that:
  • 54% believe that both stockbrokers and investment advisors have a fiduciary responsibility to act in investors’ best interests in all aspects of the financial relationship. Just 26% of investors knew that only investment advisors provide this protection.
  • If investors knew that stockbrokers provided fewer investor protections than investment advisors, 63% would not seek financial advice from them.
  • If investors knew that stockbrokers were not required to disclose all conflicts of interest, 70% would not seek advice from them.
  • If investors knew that stockbrokers were not required to act in their best interest in all areas of the financial relationship, 70% would not use them.
In 2005, the SEC required that brokerage firms offering fee-based advice must make the following disclosure:
“Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits and our salespersons’ compensation may vary by product and over time.”
After reading the previous disclosure, 79% said that they would be less likely to go to a brokerage firm for financial advice.
2) Entirely Different Business Models My business model is very different from the guy down the street at Merrill Lynch. When I started out in this industry 15 years ago, I started as a Financial Advisor (stockbroker) at Morgan Stanley. My typical day was spent looking for new clients. Our bosses (who answer to the board, who in turn answer to the shareholders) wanted us to always be adding new clients. The minimum quota was 10 new clients per month. If we didn't do this, management gave us a hard time.

Even when I was a VP at the firm, this was still required. It was one big sales job. As a result of this, most brokers recommend to diversify your assets and hold on for the long term. (How do you think that strategy has worked out for their clients over the past ten years?)  Their models are based on risk level and suitability and can quickly be generated by software -- this allows the broker to quickly set up an account and move on to the next new client.

In my current role, most of my day is spent crunching numbers. Yes, as a business owner I want to grow my business, but I don't have any quotas to meet. If I want to add one or two clients a quarter and spend the rest of my time analyzing the market, nobody is going to come and yell at me. And if the markets start to get ugly, I can make sure I take care of my clients' needs first (remember I have a fiduciary responsibility) and not worry about adding new clients just to keep my job.

3) Active vs Passive Investment Management
Because the business models are so different, so are the investment strategies. As I mentioned above, most brokers are using asset allocation models for their clients and holding on for the long run -- this is passive investing.

Many RIAs are active investment managers. We adapt the portfolios for changing economic and seasonal conditions. This is the type of strategy that I use for both private clients and investors in the ARTAIS Fund, of which I am the portfolio manager. The ARTAIS model is based on three strategies:

1) Seasonal Sector Rotation: Based on historical season strength of the following sectors: technology, energy and gold. The strategy rotates in and out of the three sectors as seasonal buying/selling occurs. For example: November through January has historically been strong for the technology sector.

2) Ivy Portfolio Theory: Based on the investment strategies used by the Harvard and Yale endowments. Since 1985, both endowments have achieved returns of over 15 percent per year, all while exposing their portfolios to significantly less volatility than the S&P 500. The ARTAIS Fund combines an Ivy Portfolio with a timing model to help reduce the draw down in the portfolio during times of market declines.

3) Risk – Reward Model: An actively managed strategy that reduces exposure to the market when risk is high in the market, while looking for value and opportunity when risk is low. A proprietary algorithm is used to calculate buy and sell signals. By combining the three investment models, the ARTAIS Fund can be over weighted in the strongest sectors of the market during rising markets and avoid the weakest sectors in a declining market. Very different from what most brokers do. ----- Here is a link to the TDAmeritrade Investor Perception Study:   Investor Perception Study