When working with a broker-dealer, that firm actually holds your assets in-house. Their brokers have access to your funds and assets. The collapse of MF Global highlights the potential risks broker-dealer clients face.

Independent firms hold client assets with third-party custodians (e.g., Charles Schwab or Fidelity). This model creates a system of checks and balances. The independent advisor has discretion to buy/sell securities on behalf of client but cannot use or transfer monies outside client accounts.

Brokers are only held to a suitability standard. They can sell their clients investments and banking products even when they know of better options. Registered investments advisors (RIAs) uphold a fiduciary standard. That means they must place their clients’ interests ahead of their own.

However, it is important to understand that most (approximately 90% of) advisors are also registered as brokers. While they may market themselves as fiduciaries, their engagement documentation will likely indicate their role as a broker (though it may be buried within a large document or specified in the fine print).

Broker-dealers often engage in an opaque web of revenue sharing, commissions, and fee arrangements with internal and external affiliates (e.g., fund companies and trading desks). This creates material conflicts of interest; they may be inclined to allocate their wealth management clients’ assets to products based on their kickbacks rather than the merits of the investments.

In general, independence helps avoid conflicting incentives and temptations to exploit clients. I believe the revenue-sharing agreements many brokerage firms use to receive kickbacks from mutual funds serve as one of the most blatant and common examples.

In particular, it is common for us to encounter brokers and their firms allocating clients’ portfolios to funds with higher fees and poor performance records. In almost all of these cases, we can find the language within the firms’ disclosure documents that highlights these funds kickback part of these fees to the broker or brokerage firm. This article from Barron’s describes this phenomenon, and highlights some of the big-bank firms that engage in this activity. 

Many brokers focus on transactions to generate commissions. While this naturally creates conflicts of interests with clients, a more dangerous aspect of this model is perhaps its piecemeal nature. A comprehensive financial plan should not be based on a series of flavor-of-the-day transactions. This approach is typically very inefficient both from tax and planning perspectives.

I believe genuine advice and robust planning are critical for optimizing one’s financial planning and investments (e.g., retirement).  That is why establishing goals and monitoring performance toward those goals are critical elements of my investment process. This helps me deliver peace of mind so my clients can take comfort knowing I manage their affairs with the care and expertise they deserve.

Given the conflicted nature of the broker model, the primary constraints on business strategy often boil down to legality and liability.  A quick search of the Financial Industry Regulatory Authority (FINRA) arbitration and mediation filings can illustrate the frequency and magnitude of issues clients have with these types of investment firms.

As a fiduciary advisor, independent investment advisors must maintain a code of ethics that sets forth their standards of business conduct.  Taking this a step further in an effort to facilitate the highest degree of transparency, I like to formulate investment policy statements dictating guidelines for the investment strategies and types of investments used with each client. This makes my financial planning and investment process fully transparent so my clients can enjoy more peace of mind.

Brokers often operate on a minimal-disclosure basis with fees explained in small print. After years of seeing portfolios managed by brokerage firms, I am still surprised that many (probably most) prospects I meet with are unaware of the magnitude of investment-related fees and how they are levied. Moreover, few if any brokers compare their performance to standard benchmarks or indices.

My advisory fees and performance are fully transparent. Charles Schwab provides monthly statements which highlight performance. While these statements also depict my quarterly fees in the months they are deducted (Jan/Apr/Jul/Oct), Schwab generates separate invoices detailing how they calculate my fees.

Each client’s financial plan also highlights the fees (a.k.a., expense ratios) charged by the investment funds I use in my clients’ portfolios (i.e., ETFs and mutual funds). Note: I typically lean toward lower-cost index funds for the bulk of my client portfolios.