We discussed broker-dealers and agents in the previous two sections. Those are transaction-focused roles: investors typically use them when they already know which securities they want to trade.
But what if an investor needs professional guidance - what to buy or sell, how much risk to take, or whether their portfolio fits a specific goal? 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 practical terms.
First, investment advisers are almost always firms (companies), even though the law refers to them as persons. “Person” is a legal term that can include business entities.
An exception exists 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 uncommon for an investment adviser business to operate as a sole proprietorship. For exam purposes, it’s generally safe to treat investment advisers as business organizations.
A firm’s activities determine whether 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:
Many test takers remember this as the ABC Rule: advice, business, compensation. Let’s break down each part.
Advice and analysis are familiar words, but in securities regulation they have a specific focus.
You might remember discretionary accounts from other licensing exams. 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.
More broadly, most securities-related advice ties back to these “three A’s”: the action, amount, and/or asset. It doesn’t matter whether the advice is given directly in conversation or whether the professional obtains power of attorney and then places trades for the client. In either case, 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 for many investors at once, not in a one-on-one relationship. Even so, the firm is still making securities decisions on behalf of customers, which is treated as investment advice.
Analysis is closely related to advice, but it usually stops short of taking action for the client. Analysis is often delivered through a research report. These reports commonly include a buy, sell, or hold recommendation and are distributed to clients. The analyst who writes the report typically doesn’t follow up with individual clients afterward (many analysts focus on market data rather than sales). Other financial professionals and self-directed investors may use the analysis to evaluate an investment.
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 details in a future section.
The next part of the three-prong investment adviser test is as a regular part of the business. A firm must provide securities advice or analysis on an ongoing basis to be regulated as an investment adviser. If advice is provided only occasionally and isn’t a continuing part of the business, the firm may not be subject to investment adviser regulation.
Providing advice as a small part of a business model does not avoid the investment adviser designation. For example, even if only 1% of a firm’s revenue comes from investment advice, it can still be a regular part of the business if the advice is provided consistently. “Regular” doesn’t mean primary or majority; it means ongoing.
The last part of the three-prong test is for compensation. If securities advice or analysis results in compensation of any kind, this prong 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 client’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 client’s 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. For example, an advisory firm could provide investment advice to a law firm in exchange for legal services. The Uniform Securities Act makes clear that compensation can take many forms. If anything of value is provided in return for securities advice or analysis, it’s compensation.
To add 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 implement the advice by placing trades, the broker-dealer side executes the transactions.
Smaller investment advisers commonly 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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