We discussed broker-dealers and agents in the previous two sections. Those are transaction-focused roles - investors typically use them when they already know what securities they want to trade.
But what if an investor needs professional guidance on 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 let’s unpack it.
First, investment advisers are almost always firms (companies), even though the law uses the term persons. Here, “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 legally the same entity. Because of liability concerns (not tested on the exam), it’s rare for an investment adviser 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. A firm must meet a three-prong test to be regulated as an investment adviser:
Many test takers remember this as the ABC Rule: advice, business, compensation. Let’s look at each part.
Advice and analysis are familiar terms, but in securities regulation they have a specific focus.
You may 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 investment advice. Firms offering discretionary services must be properly registered as investment advisers.
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 has power of attorney and places trades on the client’s behalf. Either way, the firm is providing advice.
Advice can also be less personal. For example, if you invest in an actively managed Blackrock fund, Blackrock’s professionals make investment decisions for the fund. Even though those decisions aren’t tailored to one investor, the firm is still making securities decisions on behalf of customers, which is considered investment advice.
Analysis is closely related to advice, but it typically stops short of taking action for a specific 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 usually doesn’t follow up with individual clients afterward (many analysts focus on market data rather than client relationships). Other financial professionals and self-directed investors may use this analysis to evaluate an investment.
Depending on the nature and focus of the analysis, the firm producing the reports may be legally considered an investment adviser. We’ll cover the details in a future section.
The next part of the three-prong test is as a regular part of the business. To be regulated as an investment adviser, a firm must provide securities advice or analysis on an ongoing basis. If advice is given only occasionally and isn’t a continuing part of what the firm does, the firm may not be subject to investment adviser regulation.
Providing advice as a small portion of a business model doesn’t avoid the investment adviser designation. 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 firm consistently provides that advice. “Regular” doesn’t mean “primary” - it means ongoing.
The last part of the 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 legitimate methods:
Most advisers use an AUM model, collecting 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 portfolio). Hourly fees are charged per 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.
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 chooses to implement the 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 use 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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