Financial systems are built on trust. That trust boils down to a complex web of interrelationships between people and institutions, sometimes clear, often conflicted. Every trade has a counterparty, every lender has a borrower, and every investment advisor has a client.

For investors who entrust their financial futures to advisors, here are answers to five questions you might want to know to ensure that your advisor is working in your best interests.

1.  How do I identify an investment advisor?

In the United States, financial advisors are regulated by the Securities Exchange Commission in accordance with the Investment Advisors Act of 1940. An advisor so registered is known as a Registered Investment Advisor, or RIA. The advisor also falls within the jurisdiction of FINRA, the Financial Industry Regulatory Agency and can be identified by the Series 63 license overseen by FINRA.

The Advisors Act stipulates the conditions under which a person must register as an advisor and the rights and responsibilities they incur by so doing. Basically, anybody who approaches you and offers to provide advice and services for your investment portfolio, in exchange for a fee, is an advisor who must register under the Act.

2.  Are advisors and brokers the same?

The short answer is: no. Advisors and brokers are different. The important thing for you to know is that they are held to different standards of performance in regard to your portfolio. Specifically, a broker, who typically works for a securities company under the auspices of the 1934 Securities Exchange Act, does not have a fiduciary obligation to you by virtue of being a broker (note, however, that a single person can in practice be both a broker and an advisor). The fiduciary obligation is a very high standard that holds fiduciaries accountable to invest the assets of their beneficiaries with the same diligence and care as they would to their own personal financial affairs. Since the line between brokers and advisors can get very blurred at large multi-faceted financial firms, it is important for you to know when a professional is representing him or herself as an advisor and when as a broker.

3.  How do advisor fees work?

Unfortunately, the world of fees in financial services firms is an opaque one indeed. When you set up a portfolio you are typically faced with a whole cornucopia of expenses: mutual fund management fees, trading commissions, custody fees, and so on. Now, an advisor might offer to manage all these different moving parts for you, which can often provide a great amount of peace of mind. He or she would then suggest the structure of a so-called “wrap fee”, where you will pay the advisor something like 1% or 1.5% as an annual fee (paid as a percentage of the total volume of assets under management) and the advisor will handle all the separate payments. While that is convenient and an important part of an advisor’s total service proposition, the advisor is always obligated to make the process transparent. In other words, the investor always has the right to know the exact amount of all the different fees so as to be comfortable that they are reasonable in light of the service provided.

4.  Will the advisor charge the same percentage fee for a $50,000 account as for a $50 million account?

The answer to this is very likely not. Advisors often present their fee structures on a sliding scale. Investors with smaller portfolios will pay a larger percentage of their assets in fees than those with multimillion dollar accounts. While that may sound unfair, it is actually pretty logical. Money management is an example of what we call a “scalable” business. Meaning every incremental dollar of revenue generated requires only a fraction of a dollar more in cost, with the fraction decreasing as total volume grows.  For example, if an advisor charges 1% for a $50,000 account, she will earn $500 every year for her troubles. On the other hand, 1% of $50 million is $500,000, and it does not cost the advisor $450,000 more to manage the larger account than the smaller one.

5.  Do advisors have fee arrangements with the funds they select for my portfolio?

Advisors may not have arrangements with the funds they manage on behalf of investors that would compromise their objectivity and duty of care (as discussed in question #2 above). In practice, advisor – fund relationships can be tricky waters. In some cases, the fund manager might provide services of value, such as high quality research, that could benefit the advisor’s management of your portfolio. These services fall broadly under the heading of “soft dollars” and they are legal within certain restrictions. But that does not alter the fundamental responsibility the advisor has to evaluate each asset solely in terms of its individual merits and its appropriateness in conjunction with other assets in the portfolio.

Investment advisors perform a valuable service. If you have a good advisor, the chances are that the advisor will be an important person in your life – never far away as you buy a house, send the kids to college, and prepare for a fulfilling retirement. Make sure you know the lay of the land before you make the commitment.

Do you have a financial advisor? Do you think you should have one? Tell us what you think.

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