We discussed broker-dealers and agents in the previous two sections. Those are transaction-focused entities - investors typically use them when they already know what securities they want to trade.
But what if an investor needs professional guidance on:
That’s where investment advisers come in.
Let’s start with the legal definition of an investment adviser:
That definition is dense, so it helps to translate it into something more workable.
First, investment advisers are almost always firms (companies), even though the law refers to them as persons. That’s a legal term.
An exception can exist for sole proprietorships. In a sole proprietorship, the owner and the business are essentially the same legal entity. Because of liability concerns (not tested in detail), it’s rare for an investment adviser business to operate this way.
Bottom line: for exam purposes, it’s safe to assume investment advisers are business organizations.
Whether a firm is an investment adviser depends on what it does. A firm generally must meet a three-prong test to be regulated as an investment adviser:
Many test takers remember this as the ABC rule:
Let’s unpack each part.
In the securities world, “advice” often shows up through discretionary accounts. These accounts allow a financial professional to make investment decisions for a client.
A discretionary trade occurs when the professional decides one or more of the following during a securities transaction:
Discretionary transactions are considered advice. Firms offering discretionary services must be properly registered as investment advisers.
Most securities-related advice ties back to the “three A’s” - the action, amount, and/or asset. It doesn’t matter whether the advice is:
Either way, the client is receiving securities advice.
Advice can also be less personal. For example, if you invest in an actively managed Blackrock fund, your money is being invested by professionals at Blackrock. They’re making investment decisions on behalf of many investors at once, not in a one-on-one relationship. Even so, the firm is still making securities decisions for customers, which is considered investment advice.
Analysis is closely related to advice, but it usually involves less direct action after the information is delivered.
Analysis is often provided through a research report. These reports typically include a recommendation such as buy, sell, or hold. The report is distributed to clients, but the analyst who wrote it usually doesn’t follow up with individual clients afterward (many analysts focus on market data rather than client relationships).
Depending on the nature and focus of the analysis, the firm producing these reports may be legally considered an investment adviser. We’ll cover the specifics in a future section.
To meet the definition, a firm must provide securities advice or analysis on a regular basis.
If advice is given only occasionally and isn’t an ongoing part of what the business does, the firm may not be subject to investment adviser regulation.
Also, “regular” doesn’t mean “most of the business.” A firm can’t avoid investment adviser status just because advice is a small slice of revenue. For example, even if only 1% of a company’s revenue comes from investment advice, it can still be a regular part of the business if the advice is provided consistently.
This prong is straightforward: if securities advice or analysis results in compensation of any kind, the test is met.
Investment advisers are most often compensated through one of the following three legitimate and legal methods:
Most advisers use an AUM model, meaning they charge a percentage of the investor’s portfolio each year. For example, a 2% AUM fee on a $1 million portfolio results in $20,000 in annual advisory fees.
Fixed fees are flat charges (for example, $5,000 per year to manage a portfolio). Hourly fees are charged by the hour (for example, meetings with securities analysts for $150 per hour).
Compensation doesn’t have to be cash. If an advisory firm provides investment advice to a law firm in exchange for legal services, that’s still compensation. Under the Uniform Securities Act, compensation can take many forms - anything of value given in return for securities advice or analysis counts.
To build context, here are the five largest investment adviser firms as of 2020:
Many investment adviser firms are part of a larger company that also includes a broker-dealer. For example, Fidelity has both a broker-dealer business and an investment adviser business under one parent company known as FMR (Fidelity Management & Research) LLC. When a Fidelity customer receives investment advice, they’re working with the investment adviser side of the business. If the customer decides to act on that advice, the broker-dealer side executes the trades.
Smaller investment advisers often use an unaffiliated broker-dealer for custodial services (holding customer assets) and trade execution. For example, a small local “mom and pop” investment adviser may hire Charles Schwab’s broker-dealer business to custody client assets and execute trades.
The following video summarizes the key points from this chapter:
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