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How To Irritate Advisors: Tell Them Where to Invest

July 1, 2022

By Jon Henschen, FA Financial Advisor

At least once a quarter, I have a conversation with a manager at a hedge fund, mutual fund or private equity firm who’s doing research on independent broker-dealers. One hedge fund manager recently asked me the reasons broker-dealers tell advisors where they should place clients’ assets. The manager was under the impression that B-Ds did it for compliance reasons.

It’s true that broker-dealers have parameters for how much their advisors can invest in different investments. For example, they might limit 5% of their clients’ portfolio to alternative investments or REITs. But mostly their reasons for moving assets around have nothing to do with compliance and everything to do with increasing asset flow to their largest profit centers.

One of the main reasons advisors leave wirehouses and captive insurance brokers and join the independent broker-dealer or RIA channels is that they want to escape pressure from management to put their clients into proprietary products or platforms. But broker-dealers are serving their own profit motives, too, and an advisor who doesn’t look into those motives can end up going from the frying pan into the fire.

Small and midsize broker-dealers generally don’t nudge advisors to move client assets to their profit centers, but the pressure gets turned up at larger firms—those with more than 2,000 advisors). Some executives are fairly blunt about it. (Consider the likely scenario in which the president of a large broker-dealer tells a two-person team on a visit, “You should move your clients’ advisory assets into the firm’s internally managed platforms.”) But more often the giants take a subtler approach by instead imposing costs on the advisor who doesn’t play ball.

There are three tactics broker-dealers use to steer assets away from accounts that would otherwise be better for the clients:

1. When they charge advisors, say, $60 per mutual fund for holding clients’ assets directly with the fund vendor (an arrangement that saves the clients numerous charges they would otherwise pay when the fund is held in a B-D’s more profitable brokerage account).
2. When they charge the advisor a platform or access fee of 5 to 10 basis points for holding advisory assets at Schwab or Fidelity IWS. The broker-dealer instead wants those assets parked at its clearing firm, where numerous profit centers are embedded into the cost structure. Charging the platform fee helps the broker-dealer make up some of the profit loss on the assets held away from the clearing firm. Clients would often be better served by parking assets with Schwab and Fidelity IWS, which, unlike the clearing firms, don’t impose ticket charges on stocks or ETFs. A firm like Fidelity IWS offers an additional advantage in that it doesn’t use money market cash sweep accounts as a profit center, so all sweep account proceeds go to the client. Cash sweep accounts are a primary profit center for broker-dealers, so clients see only a small fraction of that revenue. Schwab and Fidelity IWS boast a further advantage in that they offer a substantially higher number of no-transaction-fee funds than clearing firms do. (These developments among third-party custodians explicitly threaten clearing firms and could make them obsolete.)
3. When broker-dealers pressure advisors to convert mutual fund assets into advisory assets. Mutual funds are less profitable for broker-dealers than assets held in brokerage accounts under an advisory umbrella. When these assets are moved to the latter platform, the client’s costs can rise from a trailing 25 to 35 basis points to a fee of 1%. Add on administration fees for billing and performance and you push that number up by another 10 basis points or more. In rural parts of the country, “A” share mutual funds paying a trail are often preferred by the advisors and their clients. But broker-dealers won’t likely be content to see advisors’ assets in less profitable investments, and they’ll badger those advisors to convert mutual fund assets into advisory platforms.

Worst Offenders
So which independent broker-dealers are the worst offenders for twisting clients’ arms? Consider the ones focusing on short-term results and not on long-term success:

Firms owned by leveraged private equity. This type of broker-dealer ownership is notorious for using financial engineering to boost profits. Such owners cut staff as a common practice. It doesn’t matter if the firms call their service “shared services” or a “service team,” the results are the same: The advisor-to-staff ratios can run 9 to 1 or as high as 16 to 1 (firms with high quality service have ratios of 7 to 1 or smaller). The intention of such firms is usually to pump and dump or go public within five years (or less). To pump up revenue for a sale, they must direct advisors to move client assets into their more substantial profit centers. Leveraged buyout/private equity owners also often have a high junk bond debt load, so a large portion of their cash flow is put aside to pay interest on their junk debt, which is rated so low it almost always ranks as “highly speculative.” Substantial market corrections can easily cause this type of ownership structure to unravel as the junk bond market implodes and cash flows decline.

Publicly traded broker-dealers. Publicly traded firms can have their loyalties split. They want to please shareholders on one side of the table and advisors on the other. It’s a balancing act. Some firms drip charges onto their advisors and clients slowly over time so they’re less noticeable, but the charges still favor shareholders, not the advisors and clients.

Both of these ownership structures put pressures on advisors to invest in proprietary advisory platforms and custody all their assets in brokerage accounts. These types of owners also have big reasons to take away advisors’ choices to do dual clearing of advisory assets (and remove Schwab or Fidelity as choices) or to otherwise frequently tack on platform and access fees (of 5 to 10 basis points on assets).

Fiduciary Sanctuaries
When a broker-dealer has a fiduciary standard focus, it can offer a sanctuary to advisors, freeing them from this type of asset manipulation.

Financial planners have had to uphold a fiduciary standard on their clients’ investments since June 2020. Since then, we have needed to be increasingly aware of which firms make available the most investment choices at the best prices without conflicts of interest.

Surprisingly, few independent broker-dealers make the cut. But most of the RIAs we work with at our recruiting firm do. Here’s our criteria for broker-dealers or RIAs we could call “fiduciary focused”:

1. They have no proprietary advisory platforms that can be construed as posing a conflict of interest. (We allow some grace on this one if the firm doesn’t push its proprietary platforms or give advisors pricing advantages to use those platforms.)
2. They don’t mark up third-party money managers’ fees.
3. They are friendly to dual clearing with Schwab and Fidelity IWS and don’t impose platform fees on advisors for holding these assets away.
4. They keep the pricing on advisory administration fees, which covers billing and performance reporting, as low as $50 per account annually or keep the basis points on assets at 3 basis points or less.
5. They don’t manipulate advisors by telling them where to put client assets.
6. They don’t charge platform fees to advisors for holding assets directly at a product company (by charging, for example, 5 basis points on turnkey asset management program assets held directly) and don’t put dollar charges on mutual funds (such as a $60 fee for a mutual fund held directly).

Over the last few years, broker-dealers have increasingly expressed frustration with advisors putting a large percentage of their book in mutual funds and put pressure on them to convert those assets into a fee-based platform. In the past, I’ve recommended that advisors looking for new homes consider fiduciary-focused broker-dealers when they are doing a large percentage of their business with advisory assets. But I’ve discovered that these fiduciary-focused companies are also a safe haven even for those advisors with mostly mutual fund business. These firms want advisors to do what is in the client’s best interest whether it’s through advisory or package products. They are not married to any one way to invest and realize both styles of investing can be appropriate and that it’s a matter of personal preference. They also don’t have a profit center bias, so they lack the motive to favor one investment style over another.

Broker-dealers have a choice: continue to do what’s in their best profit interest or do what’s in the client’s best interest. At many firms, the pendulum has swung in favor of profit motives. This has caused an uptick of advisors either getting their own RIA or joining RIAs so they can act in a way more favorable to the clients. Fiduciary-focused B-Ds will continue to attract advisors that want more choices and less expense for their clients.

In the end, the role of an independent broker-dealer is to supervise their advisors; to process advisors’ business, pay trails and commissions in a timely manner; and to keep advisors informed of regulatory changes. No more!

Jon Henschen is founder of Henschen & Associates, a recruiting firm placing advisors to independent broker-dealers and RIAs.