Seven years ago, Tim Shmidl sold only commissioned investment products to clients through his broker/dealer. But after hooking up with a local accounting firm to offer clients more services, Shmidl realized that being a straight-up registered rep just didn't give him enough flexibility to serve his clients the way he wanted to. It was time to go independent so he could fill out his financial-planning offerings and become a true financial advisor.
Shmidl looked closely at the largest independent b/ds but in the end he chose the much smaller, Fairfield, Iowa-based Cambridge Investment Research.
Cambridge had only 300 reps at the time, but, unlike the bigger b/ds, it encouraged dual registration — as a stockbroker with the NASD and a registered investment advisor with the SEC. Back then, about 70 percent of Shmidl's business was in commissions and the rest in fees. Today, he's proprietor of Prism Financial Group in Overland Park, Kan., and that ratio has flip-flopped, but Shmidl says he doesn't intend to give up his Series 7 license. Having both licenses gives him ultimate flexibility with his clients, he says.
Shmidl and Cambridge were a little bit ahead of their time. Seven years ago dual registration was very rare. Few b/ds allowed it, and the reps who tried it mostly did so as a short-term step in the transition to a fee-only model. But today, this hybrid has emerged as a popular, and profitable, model in its own right. As more traditional brokers turn to advisory business, some of them are straying across the line to the RIA side. Many of these brokers still do substantial commission business, however, and would like to keep it up.
Consulting firm Moss Adams estimates that about 2,000 brokers leave to set up RIAs each year. “It's not a massive migration, but it's no small potatoes either,” says Philip Palaveev, senior manager of Moss Adams. For these reps, dual registration — affiliating with a b/d and setting up an RIA — offers the best of both worlds. Reps can have true independence on the fee side without entirely giving up home-office support or commission clients and products, like insurance, annuities or front-load mutual funds. And they can make good money doing it.
According to research commissioned by Pershing and conducted by Moss Adams, one in eight b/d-affiliated advisors now maintains an RIA, representing about 5,612 advisory firms. Between 2002 and 2004, the study found operating margins for such firms doubled from 8.9 percent to 17.6 percent, and the top quartile of these had $7,000 in revenue per active account and operating margins of 21 percent.
Today, most b/ds — at least 75 percent — allow some form of dual registration, according to a survey by the Financial Services Institute. But the majority of these b/ds encourage their reps to do fee business through their corporate RIAs rather than an independent RIA — quietly making exceptions for very productive advisors, says Palaveev. That's because allowing reps to use an outside RIA is harder to monitor and costlier from a compliance standpoint.
Commonwealth Financial Network, for example, has 1,000 reps, but only 12 independent RIAs work with the b/d. “We would prefer that they use the Commonwealth RIA,” says Wayne Bloom, head of the wealth-management program at the b/d. “But we're an independent b/d, and people don't join an independent so that other people can tell them what to do,” says Bloom. “It forces us to offer a wide range of choices.”
Still, Cambridge, and a number of other mid-sized b/ds like Securities America, Jefferson Pilot, Mutual Service Corp. and Triad Advisors, see offering the independent RIA alternative as a great recruiting tool and have decided the extra cost and liability involved is worth it. These b/ds are embracing the hybrid model and rolling out services to support it. In the meantime, custodians like Charles Schwab are helping newly minted RIAs who want to keep doing some commission business find b/ds like Cambridge and others where they can do that.
Advisors say the b/d-RIA hybrid gives them freedom to choose what products, services and fees are best for their clients. Shmidl, for example, uses commissions for his smaller clients and those that are comfortable investing in a single fund family — that way he can get them breakpoints. Other clients need a little bit of both fees and commissions, he says. This is particularly true when it comes to estate planning, where advisors often need to have access to commission-based insurance products.
Advisors say there are several reasons for choosing to set up an independent RIA rather than use a corporate one: It allows them to demonstrate their independence to clients, it gives them room to create a strong brand identity and offers them the flexibility to move. “An independent company with that brand is something that's going to be portable. So if things change at this or that b/d you will still have that brand you have built around your firm and team,” says David Spinar, chief compliance officer of Securities America, which has about 1,800 reps total, and 1,600 dually registered advisors, 465 of which have their own independent RIA practices.
For Cambridge, the hybrid strategy has been a boon: The firm is one of the fastest growing independent b/ds out there. “In the old days they thought we were crazy and were going to go out of business,” says CEO Eric Schwartz. Instead, the firm has notched revenue growth of almost 40 percent a year over the past six years and should reel in $200 million in revenue in 2006, Schwartz estimates. The firm now has 900 advisors and is adding 100 to 150 a year.
Cambridge offers more flexibility than most, Palaveev says. Not only can reps set up an independent RIA, they can opt to use b/d-affiliated or third-party money managers and hold their assets with one of Cambridge's custodians (Pershing and National Financial) or with third-party custodians like Charles Schwab. Each of these options is a separate program with its own rules, fees and payouts. Because of the additional oversight required, Cambridge takes a haircut on the RIA's fee business to compensate. Reps get payouts between 90 percent and 95 percent depending upon what degree of independence they select, and pay between one and five basis points for service, including fee debiting, fee notification and performance reporting.
“Most b/ds impose restrictions on what kinds of RIAs reps can set up and what they can be used for,” says Palaveev. “Some are more open-minded like Cambridge.” He says there are two major kinds of restrictions they impose. Some b/ds will allow the independent RIA to create financial plans only, not to manage assets. If they do allow the RIA to manage assets, then they may require it to keep its assets with the b/d's custodian or custodians, ruling out third-party custodians like Schwab, Fidelity or TD Waterhouse. “From a compliance standpoint, some b/ds aren't comfortable letting the advisor do too much under their own RIA because they don't feel they can adequately supervise it,” he says.
Custodians like Schwab try to alleviate this concern by setting up informal agreements with b/ds, agreeing to take responsibility for sending all transaction data and all client fees charged back to the b/d in exchange for the referrals they offer. Under NASD notices to members numbers 9444 and 9633, b/ds have an obligation to supervise all of the business an affiliated rep does, including the business done on an outside transaction platform. The b/d is also required to keep records of those transactions. Pershing, which provides clearing services to about half of all b/ds and ranks as the fourth-largest custodian for RIA advisors, is also researching ways to help integrate independent RIA and b/d business to make this hybrid model more efficient for b/ds.
The one big hitch in the hybrid model for advisors is also compliance. Setting up and supervising a standalone RIA takes an increasing amount of time and money. There's the Form ADV that needs to be updated annually, the hiring of a chief compliance officer, books and records maintenance, supervisory procedures, email monitoring and disclosure documents. Shmidl estimates, for example, that it costs him at least $10,000 a year to keep track of compliance for his RIA. Certainly, using the b/d's corporate RIA is cheaper.
It's not for everyone, Shmidl says. It's only worth creating your own RIA if you intend to hire three or more advisors. “If a rep is primarily involved in investment management and doesn't do much financial planning and doesn't see the firm growing much beyond one or two people, then using the corporate RIA is a logical choice.”
If it weren't for the compliance, says Palaveev, everyone would jump on the hybrid bandwagon. “This can't be ignored by b/ds or custodians either. Cambridge has gotten great results with this — allowing RIAs to do fee-business however they choose,” he says. “I think it's catching the eye of many b/ds”
The new b/d exemption — also called rule 202 — that took effect at the end of January should also bring new blood to the hybrid model, Palaveev says. Because it widens the definition of what kinds of advisory activities fall under the Investment Advisers Act of 1940 — adding financial planning and holding discretion over a client account — more reps may find that their firms no longer allow them to position themselves as financial planners and advisors. As a result, they may decide its time to register independently as investment advisors.
The Hybrid Model in Numbers
$716 billion in client assets, one-third of which are managed assets in advisor-owned RIAs and the remainder invested on brokerage platforms
$234 billion in assets under management through their own RIAs, representing 28 percent of all retail RIA AUM.
$482 billion, or 16 percent, of all independent broker/dealer assets.
$6.3 billion in annual revenue, with the average hybrid advisory firm generating revenue of $1.13 million in 2004.
Source: Moss Adams LLP