Investment advisers | Definitions | Laws & regulations

We discussed broker-dealers and agents in the previous two sections, which are two transactional-focused entities. Investors seek out these entities when they know what securities they’ll be trading. But, what if an investor needed professional guidance on what securities to buy or sell? Or how much risk they should expose themselves to? Or if they’re properly invested for a specific goal? That’s where investment advisers come into play.

Let’s start out with the legal definition of an investment adviser:

Definitions

Investment adviser: Any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as a part of a regular business, issues or promulgates analyses or reports concerning securities

That’s a lot to take in, so let’s boil the definition down. First, investment advisers are almost always firms (companies) although they’re referred to as persons. Remember - this is a legal term! An exception exists for sole proprietorships; these are businesses structured in a way that the business owner and the business itself are basically the same entity. Due to legal liabilities (which you don’t need to be aware of for the exam), it’s very rare for an investor adviser business to be structured as a sole proprietorship. Bottom line - it’s safe to assume investment advisers are always business organizations.

The actions of a business determine if it meets the definition of an investment adviser. There’s a three-prong test a firm must meet in order to be regulated as an investment adviser:

Provides advice or analysis on securities
As a regular part of business
For compensation

Many test takers remember this as the ABC Rule - advice, business, compensation. Let’s break down each of these a bit more.

Advice and analysis are terms most people are familiar with, especially outside of finance. But, what do these terms mean with securities? You might remember discretionary accounts if you’ve prepared for another licensing exam, which are accounts that allow financial professionals to make investment decisions for their clients. In particular, a discretionary trade occurs if a financial professional decides one or more of the following during a securities transaction:

Action (buy or sell)
Amount (how much)
Asset (what security)

Discretionary transactions are definitely considered advice, and companies offering discretionary services must be properly registered as investment advisers. Most securities-related advice is specific to the “three A’s” - the action, amount, and/or asset. It doesn’t matter if the advice is provided proactively to the client during a conversation, or if the professional obtains power of attorney and subsequently makes the trades on behalf of their client. It’s all advice in one way or another.

Definitions

Power of attorney: Legal authority provided to a third party to take action on behalf of an individual

Advice could be less intimate and direct. For example, what if you put your money in an actively managed Blackrock fund? Your money will be invested by a well-paid and highly-educated individual working on behalf of Blackrock. They manage your money alongside thousands of other investors, so it’s not as personal as a one-on-one relationship. Regardless, companies like Blackrock make investment decisions on behalf of their customers, which is considered investment advice.

Analysis is very similar to advice, but with less action taken after the analysis is provided. When analysis is created (typically through a ‘research report’), a buy, sell, or hold recommendation is typically made. These reports are disseminated to clients, but the analyst creating a research report typically does not follow up with specific clients after (most analysts focus entirely on stock market data, not sales). Many times, analysis is used by other financial professionals or independent investors to determine the quality of an investment.

Depending on the nature and focus of the analysis, the company creating these reports may be legally considered an investment adviser. We’ll learn more about the specifics in a future section.

The next part of the three-prong investment adviser test - as a regular part of the business. A business must provide securities advice or analysis on a regular basis to be considered and regulated as an investment adviser. If advice is provided only on a handful of occasions and it’s not a continuous focus of the business, it’s quite possible the company wouldn’t be subject to investment adviser regulations.

Providing securities advice or analysis as a small part of a business model does not avoid the investment adviser designation. For example, what if only 1% of a company’s revenue comes from investment advice? While it’s a small part of the company’s revenue, it would still be considered a regular part of the business if investment advice was provided consistently to customers. Regular does not necessarily mean the primary or majority of a business; all that’s required is it occurs on an ongoing basis.

The last part of the three-prong investment adviser test - for compensation. This one is pretty simple; if securities advice or analysis results in compensation of any form, this meets the test. Investment advisers are most often compensated through one of the following three legitimate and legal methods:

Assets under management (AUM)
Fixed fees
Hourly fees

Most advisers are compensated on an AUM model, meaning they collect a certain percentage of an investor’s portfolio in annual fees. For example, a 2% AUM model with a $1 million portfolio would result in $20,000 in annual advisory fees. Fixed fees are exactly what they sound like; for example, an adviser charges a flat annual fee of $5,000 to manage a client’s portfolio. Hourly fees are similarly straightforward; for example, a company offers meetings with its securities analysts for a $150 hourly fee.

Compensation doesn’t necessarily mean cash. What if an advisory firm provided investment advice to a law firm in return for legal representation? The Uniform Securities Act makes it clear compensation can take many forms. If anything of value is provided to a company in return for securities advice or analysis, it’s considered compensation.

To help you build additional context for what an investment adviser is, 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 a broker-dealer business and an investment adviser business under one parent company known as FMR (Fidelity Management & Research) LLC. When a Fidelity customer is provided investment advice, they are engaging with the investment adviser side of the business. If the customer agrees to implement the advice and do the recommended securities transactions, the broker-dealer part of the business executes the trade.

Smaller investment advisers commonly utilize the services of 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 hold their clients’ assets and execute trades.

Sidenote

SEC Release IA-1092

In the late 1980s, the Securities and Exchange Commission (SEC) and the North American Securities Administrators Association (NASAA) jointly developed Release IA-1092. The intent of this publication was to reinforce and amend the current legal definition of an investment adviser. At the time, there were numerous entities essentially operating as investment advisers, but claiming registration and regulation did not apply to them.

IA-1092 reaffirmed the investment adviser definition, and explicitly identified certain entities as meeting the definition, forcing them to comply with relevant rules and laws. Those identified parties are:

Financial planners
Regardless of the amount of securities advice provided, financial planners are considered investment advisers. Even if securities recommendations represent 1% of a financial planner’s duties, they are subject to investment adviser registration and regulation. While it’s possible a financial planner does not discuss securities (and therefore would not be subject to investment adviser regulation), the SEC and NASAA both view financial planners as investment advisers unless proven otherwise.

Pension consultants
Pensions are retirement plans that generally pay their retirees through the end of their life (visit the investors chapter for more on this). In order to ensure an organization has enough funds to fulfill this obligation, financial consultants are hired to provide guidance. One of the best ways to grow money over time is through investing in securities. When a pension consultant is hired, their advice (or even management of the pension) almost always involves securities. Therefore, they are required to register and are regulated as investment advisers.

Entertainer & athlete advisers
It’s well known that many celebrities and professional athletes make significant sums of money in their careers (Lebron James has earned nearly $1 billion over his career). Their representatives are known to offer more than advice on contracts. Many provide investment advice on securities as a regular part of their relationship with their client (sounds like an investment adviser, right?). There’s good reason to explicitly include these entities as investment advisers, especially in regard to athletes. Between 2004 and 2019, it’s estimated professional athletes lost roughly $600 million to some form of fraud (usually related to investing).

The following video summarizes the key points from this chapter:

Key points

Investment adviser

Firms that provide securities advice as a regular part of their business for compensation
ABC rule:
- Advice on securities
- Business activity (regular)
- Compensation

Discretionary order

A financial professional chooses any of the following for a client:
- Action (buy or sell)
- Amount (how much)
- Asset (what security)

IA-1092

Additionally defined as investment advisers:
- Financial planners
- Pension consultants
- Athlete & celebrity advisers