Who you hire to manage your money may be one of the most important decisions you make. Many investors have been devastated by fraudulent or incompetent investment advisers. Consider these three red flags before putting your trust and money with someone.
Red flags tend to be an indicator that something may be or may become a concern. Below we offer three such red flags when working with or hiring an investment adviser.
Required Standard of Care
There are two different standards of care: the fiduciary standard and the suitability standard. Advisors are legally bound to follow one or the other, depending on their business model. When choosing an investment advisor, it is imperative that you understand and are comfortable with the standard that your advisor is required to follow. Knowing the difference could be critical to safeguarding your money and consequently your financial freedom.
- Fiduciary Standard. Independent registered investment advisors (RIAs) are required by the Securities and Exchange Commission (SEC) to adhere to the fiduciary standard. As a fiduciary, an advisor has a legal obligation to put their client’s interest first, rather than their own or that of their employer. This fiduciary standard is also part of the Code of Ethics for all practitioners holding the Chartered Financial Analyst or Certified Financial Planner™ designations.
- Suitability Standard. The suitability standard means that the advisor is only legally required to ensure the investment vehicle is suitable for the client. This standard is based on rules rather than on principles and ethics. It means that as long as the client meets the net worth and risk profile requirements of an investment vehicle, it is deemed appropriate. The suitability standard is considered a less rigorous standard of practice than the fiduciary standard.
As mentioned, the business model of the advisor generally determines which standard of care is required for a legal defense. This doesn’t mean that those legally bond by the suitability standard don’t invoke the high standard for their business transactions.
Advisor Qualifications
The education requirements to become an advisor are minimal. Therefore, part of your due diligence should be to review the educational background of the advisor and his or her experience. In addition, the attainment of an appropriate professional designation can be important in determining his or her focus and depth of knowledge.
There is a wide range of credentials in the investment industry. However, the Chartered Financial Analyst (CFA) designation is considered the “gold standard” for the investment professional. No other designation is as rigorously focused on the attainment of investment knowledge, analytical skill, and experience prior to publicly using the CFA mark.
Compensation
Beware of advisors that offer to manage your money for “free”. Remember the old adage, “there is no such thing as a free lunch”. Investment advisors are usually paid in one of two ways, either through a fee structure or through commission. Some advisors are in an arrangement where they can receive either or both types of compensation. Under a fee for management arrangement, the client will generally pay a quarterly fee that is calculated as a percentage of the assets your advisor is managing. Advisors that are on a commission schedule typically get paid each time they buy or sell an investment.
During your initial contact or as you assess an existing advisory relationship, you should seek specific information concerning his or her compensation structure. As a client, you must be comfortable with the compensation arrangement and be diligent when monitoring your costs.
Important Note: Remember that when evaluating the investment performance of your portfolio, the management fee or commission costs must be considered. A management fee is deducted from the portfolio and, therefore, is netted out of, or reduces, the overall reported portfolio investment performance. The true impact of the management fee is reflected in the portfolio’s stated investment return. However, a commission paid for a transaction does not reduce the calculated return. A commission is taken before money is invested. Therefore, it is never reflected in the calculated performance of the investment portfolio. When measuring or comparing results, be sure you are utilizing the appropriate numbers.
Summary
When hiring or evaluating an investment advisor, focus on whether the advisor is adequately prepared to meet your needs and whether you are comfortable with their business and compensation model. If any of the red flags give you pause, you may want to reconsider and/or reevaluate the relationship.
Anthony Bykovsky, CFA, an Associate Portfolio Manager at Bedel Financial Consulting, contributed to this article.