Investment Advisors

Most people don’t realize it, but in the United States the term “Investment Adviser” is a legal term that covers a group of companies that are regulated under the Investment Advisers Act of 1940. A Registered Investment Adviser is a company that is registered either with the SEC (for firms with more than $25 million under management) or the applicable state regulatory body. Each state currently requires Investment Advisers not registered with the SEC but doing business in their state to register with the state.

Under this act, an Investment Adviser is anyone who is compensated for giving advice on investments in financial securities.

Employees of the Registered Investment Adviser who deal with clients are called Investment Adviser Representatives. They must pass an NASD examination and register with either the SEC or their state. I must make a disclosure here: my firm is a Registered Investment Adviser in the state of California.

There is some controversy within the securities industry as to whether broker/dealers are subject to regulation under the Investment Adviser regulations. Broker/Dealers are the regulated traders on the exchanges. By law, broker/dealers are paid commissions on securities transactions, and their employees are called “Registered Representatives”. Registered Representatives also must pass NASD examinations relevant to their area of sales.

In the past, broker/dealers were able to provide investment advice to clients as long as it was in the course of their normal business (trading), and as long as it was appropriate for their client’s needs. Broker/dealers generally have fought being regulated as Investment Advisers, because Investment Advisers are held to a tougher fiduciary standard. An Investment Adviser must recommend the securities that are best for their clients, not just appropriate. As a result, Investment Advisers need to perform a lot more work on understanding the client’s situation and needs before making recommendations. There has been some movement towards holding Broker/Dealers to the same fiduciary standards as Advisers if they provide advice, but nothing has been enacted as of 2006.

Disclosure is a vital component of the regulations surrounding Investment Advisers. Each company must submit a Form ADV to the regulatory body (the SEC or the state), and this form must be updated annually. The adviser is required to provide it to all clients on the initial engagement, and to offer it to clients each year. The form covers everything from information on the firm’s principals to how the firm earns money. It is a tough document to read, but it includes vital information that everyone should understand about their advisor. If your advisor can not provide a Form ADV, then he probably does not work for a Registered Investment Adviser. One way to find out is to ask if the advisor is a Registered Representative. If so, you need to understand that the standard of fiduciary duty is lower than it would be for an Investment Adviser Representative.

Most of us understand that investments can include far more than securities. However, Investment Advisers are only regulated as such for securities industry advice. People giving investment advice on real estate, for example, do not have to register with anyone to give that advice. The key here is to understand how an advisor is getting paid. Do they only get paid if you make a transaction? They could be the most honest person in the world, but in this case they will still have a financial incentive to convince you to buy or sell something. This is the definition of a conflict of interest. Conflicts of interest can be minimized, but are very difficult to eliminate entirely when making investments. This is why trust and understanding how your adviser makes money are so important.