The Four Kinds of Practitioners You Can Hire
From The Truth About Money, Part XIII – How to Choose a Financial Adviser.
Vice President, Investments.
The industry has conjured up a variety of titles. All are designed to impress, some to obfuscate. But no matter what a person might call him- or herself, there are really just four kinds of advisers.
That might be surprising, considering the vast array of professional designations that now exist in the industry. While conducting research for this book, we found 95! They’re all displayed in Figure 13-1, but the important point to note is that none of them are bestowed by federal or state regulators.
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Practitioner #1: Registered Representatives
You know who this is, even if you don’t realize it. Registered Representatives are more commonly known as stockbrokers.
The Crash of 1929 and the Great Depression that followed were caused, in part, by lack of federal rules and oversight. To solve the problem, Congress created the Securities and Exchange Commission in 1934.
Then, on the theory that thousands of brokerage firms and hundreds of thousands of stockbrokers were far too numerous for a single regulator to effectively supervise, the industry was permitted to regulate itself.
I know this sounds silly — like asking the fox to guard other foxes — but the idea has been in place for nearly 80 years. The Financial Industry Regulatory Authority, which operates under the auspices of the Securities and Exchange Commission, is called a self-regulatory organization, and is responsible for licensing and supervising the business activities of all brokerage firms and stockbrokers.
No company may engage in the business of underwriting securities or executing securities transactions (meaning, it can’t buy or sell investments for consumers) unless it is a FINRA member.
To become licensed, your application must be sponsored by a brokerage firm, and you must pass a FINRA-administered examination.
FINRA issues licenses covering every area of the securities industry, including commodities futures, options, municipal securities, and supervisory licenses for those who manage others (such people are known as “principals”).
The most common licenses held by those who work with consumers are:
Series 6: Limited Representative Securities license. This permits the representative to sell mutual funds. If the representative also holds a Life and Health Insurance license issued by a state regulator, the representative may also sell variable annuity products.
Series 7: General Securities Representative license. Representatives holding this license can sell stocks, bonds, and municipal securities, as well as options contracts, mutual funds, and ETFs. (Again, the representative may also sell variable annuity products if he also holds a Life and Health Insurance license issued by a state regulator.)
Series 63: Uniform Securities Agent State Law license. Even though a candidate passes the Series 6 or Series 7 examination, he or she cannot sell products to consumers until he or she also passes the Series 63 examination, which is required to receive a state securities license.
FINRA calls a person who holds these licenses a registered representative because he or she is registered with FINRA and is a representative of the brokerage firm with which he’s affiliated.
Pay particular attention to that last phrase. Stockbrokers legally represent their brokerage firms.
Brokers are considered by FINRA and the SEC to be product salespeople whose job is to represent the best interests of their firms.
According to the regulators, brokers sell investment products in order to earn commissions; they are not paid to give advice, and any advice they do give is considered “incidental” to the sale of their products.
Don’t believe me? Then read this disclosure, which the SEC requires on the monthly statements that are issued by brokerage firms:
Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours … [M]ake sure you understand … the extent of our obligations to disclose conflicts of interest and to act in your best interests … [O]ur salespersons’ compensation may vary by product and over time.
Indeed, registered representatives generate commissions for themselves and their firms through the sale of investment products.
The most common investment product sold by brokers are mutual funds, so let’s examine closely how brokers earn a living.
Mutual fund commissions are set by the fund companies themselves; neither brokers nor brokerage firms can alter them. There are three basic ways you can pay those commissions: when you buy shares, when you sell them, and annually.
Let’s explore them.
Mutual Fund Sales Charge #1: Front-End Load
Also known as Class A shares, or up-front load, you pay at the time you invest. There is no fee for reinvesting dividends or capital gains, and you can withdraw your money at any time without charge (at the then-current value, which may be higher or lower than when you invested).
Although the legal maximum is 8.5%, virtually all stock funds charge 5.75% or less, and almost all bond funds charge 4.75% or less.
Furthermore, front-load funds offer several discounts:
Breakpoints are essentially volume discounts; the more you invest in one fund family, the lower the load. Discounts often start at $25,000, and the more you invest, the bigger the discount. Breakpoints typically occur when you invest $100,000, $250,000, or $500,000, and most funds waive their loads entirely when you invest $1 million or more.
Letter of Intent. If you open an account today with a small amount but plan to invest more within the next 13 months, you are entitled to the breakpoint today, thus giving you a discount on today’s investment even though you have not yet invested enough money to actually qualify for it. (If you fail to fulfill your LOI, the fund will retroactively collect the higher fee from your account.)
Rights of Accumulation give you a discount based on the total amount of money you invest — and not just in that fund, but in any fund in the same fund family. Thus, if you are investing $15,000 in a fund but previously have invested $35,000 in other funds of the same family, you are entitled to the $50,000 discount level on the $15,000 investment you are making today.
You also are permitted to add together all the investments made by members of your household for purposes of calculating the biggest ROA discount.
Free transfers. All fund families allow investors to move money between funds with no additional load, provided the money stays in the same family.
Note that a small transfer fee might apply, and unless it’s a retirement account, the transfer will be considered a taxable event.
Five Common Broker Tricks
Federal rules require all front-end load mutual funds to automatically award the above discounts to investors. However, the higher the load, the higher your broker’s commission — which can tempt some brokers into playing tricks on you:
Trick #1: Splitting Registrations to Avoid Breakpoints
Instead of opening a joint account with husband and wife for $250,000, the broker opens two accounts, one in each name, for $125,000 each. This avoids the $250,000 breakpoint, meaning you pay a higher load and the broker gets a higher commission. It’s illegal.
Trick #2: Failing to Award Rights of Accumulation
An investor who already has a large account in a fund family opens a new, small account for her children, but the broker fails to apply the discount to the new account, which she’s entitled to by virtue of the existence of the larger account. It’s illegal.
Trick #3: Failing to Disclose Letter of Intent Availability
A broker allows a client to open an account with a small amount, knowing that the client intends to add to the account within 13 months, but does not execute the trade with the proper LOI discount. It’s illegal.
Trick #4: Recommending an Investment Amount Slightly Below a Breakpoint Level
A broker tells a client to invest $95,000 into a fund, failing to disclose that if the client were to invest just $5,000 more, the entire investment would receive the $100,000 discount level. (Quite often, due to the discounts, investing $100,000 can cost less than investing $95,000.) It’s illegal.
Trick #5: Churning
This occurs when a broker encourages a client to move money from one fund family to another. A move within the family would not generate a commission, but a move to a new family does. If there’s no economic justification to support the recommendation, the generation of the new commission is called churning. It’s illegal.
If you think any of these tricks have been played on you, inform your broker of the error and your account will be quickly corrected. If your broker is slow to cooperate, notify the branch manager or the fund directly. The law is on your side, and you’ll have no problem getting it fixed.
The last thing your broker wants is for you to contact the federal regulators, for any of the above violations could cost your broker his license.
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