Not long ago, becoming a registered investment advisor (RIA) was hardly considered a rep's best career move. In the early years of this decade, many of the registered reps switching to a Series 66 RIA designation had been bounced from major wirehouses and reinvented themselves as fee-only advisors. Route 66 was not the fast lane. “You had a lot of marginal producers going independent,” says Brian Hamburger, a consultant and attorney at MarketCounsel, a regulatory and compliance consulting firm in Teaneck, N.J.
But these days, you're likely to see a lot more high performers going the RIA route. In 2004, while the ranks of other financial-advisory designations were flat or down, the number of RIAs jumped by 20 percent, according to Cerulli Associates. “Now you're seeing an explosion of top producers, which is a pretty new phenomenon,” says Hamburger.
Indeed, a high-net-worth practice makes it easier to jump, says Cerulli researcher Dennis Gallant. “So we're seeing wealthier people who have the scale and revenue potential to go independent and survive.” Moreover, because of stricter controls by wirehouse management and the ongoing tussle over whether brokerage reps can legally claim to be financial advisors, more wirehouse brokers may be tempted to take their wealthy clients and head for Route 66.
The difference between an RIA and a registered rep is confusing to many reps — and clients. For starters, the RIA title covers a range of investment professionals, from money managers who control billions of dollars in assets to one-man advisory firms, dispensing investment opinions to individuals. The key difference is that registered reps are salespeople, who are licensed to sell financial products and are paid by commissions on those transactions. They have a Series 7 license, must be affiliated with a broker/dealer and are regulated by the NASD and the SEC. Reps are only allowed to offer investing advice that is “incidental” to their business. There is a controversy brewing over whether reps can continue to call themselves advisors. (For more see story on page 23.)
RIAs, on the other hand, do not sell products, cannot legally charge clients for transactions and can only be compensated for their services on a fee basis. They can assess flat fees, hourly charges or an annual fee based on the size of the client's portfolio. RIAs are hired to give advice, and while they may manage money or trade on behalf of their clients or buy products for their clients, they are not allowed to collect commissions for those transactions. RIAs can be totally independent. Unless they charge commissions, they needn't be affiliated with a b/d. They must have a Series 66 or 65 and are regulated by the state and/or the SEC, depending on their size.
While the limitations on how Series 7 advisors can dispense financial advice are an important issue, what's driving top reps to Route 66 is not regulatory rules. It's changes in the wirehouse environment that, newly minted RIAs say, made it harder for them to do their own thing at a Merrill or a Smith Barney. “You're so constrained by the bureaucracy,” says RIA David Yvars, who recently left Smith Barney to join Raymond James's investment advisor division. “I can't tell you how many times I brought great ideas to the firm, and they just knocked it down for some small reason.”
The constraints are only getting tighter. After a surge of investor litigation following the dot-com bust and the recent conflict-of-interest scandals (including the ongoing probes into mutual fund sales), firms are pursuing a conservative, lowest-common-denominator approach. Top producers find it increasingly difficult to do anything that isn't strictly vetted by the firm. “We're hearing that some firms are saying, ‘Unless you jump through a lot of hoops, you can't do anything outside of what the firm recommends,’” says Mike Di Girolamo, senior vice president at Raymond James Investment Advisors. “A lot of these reps have 20 years experience and find it hard to operate with a lot of restrictions.”
Another reason that reps are leaving is that the scandals have tainted major wirehouses in the eyes of some clients. “People used to lead with the business card, which used to open doors,” says Hamburger. “Now they keep it in their back pocket until they establish a personal relationship with the client.” Both the scandals and the need to run big firms more efficiently have ratcheted up the level of restrictions and compliance regulations. “Compliance restrictions having to do with NASD rules is becoming more burdensome,” says Di Girolamo. “They're not providing a lot of value for clients who are being managed on a fee basis.”
The new RIAs are willing to take a big leap of faith to gain greater autonomy. While it's possible to build a practice as an independent who mixes securities sales and fee-only advisory services, wirehouse refugees are overwhelmingly choosing to go all the way — letting their Series 7 licenses lapse and adopting a fee-based business model, says Di Girolamo. “We're seeing a big increase in interest in RIAs, more than we expected and most of the growth is coming from reps wanting to go strictly RIA: 80 percent are coming out of wirehouses and dropping their Series 7 licenses and 20 percent are simply switching firms. A year ago the split was 50/50.” Cerulli Associates confirms the trend: Of the almost 14,000 practicing RIAs, the majority (8,951) are no longer associated with a b/d, but are totally independent.
To make the leap pay off, reps need a strong practice. Even though they don't have to split commissions with their employers, their fees (usually 1 percent to 2 percent of assets under management) have to be substantial enough to cover the overhead that the wirehouse used to provide, such as office space, clerical help and technological support. “You're financially able to generate 50 percent to 60 percent more revenue, but you need to deploy those resources smartly,” says Mark Tibergien, a principle with accounting and consulting firm Moss Adams in Seattle. The threshold for successful switchers, he says, is $1 million in gross annual fees — or $100 million to $150 million in assets under management. (Some put the AUM figure lower at around $50 million.)
“The next question is can they emotionally make the leap?” says Tibergien. Can they live without the support network and the name of the big firm? Can they become entrepreneurs?
Brokers headed for Route 66 need to take interest in the nuts and bolts of running their own business. “To be successful, investment advisors have to understand that you have to do everything,” says Ellen Bruno, a consultant with Securities Compliance Advisors in Massachusetts. “It takes an entrepreneurial drive.” Overhead involves everything from renting an office, furnishing it, buying computers and hiring staff. It's down to the nitty-gritty of whether you put together Quick Books or hire an accountant and whether or not to be your own compliance officer. “One client who started a firm last fall is disappointed that he's not having enough time to spend on his first love, which is portfolio management,” says Bruno. “But he has to hire people if he wants to do that.”
David Geller, a former wirehouse rep, five years ago established Geller Capital Management, a fee-only investment advisor firm. “I was a top producer and treated well, but I just grew tired of the bureaucracy,” he says. “Foolishly, I didn't have a lot of fears.” But he had done his homework before starting his White Plains, N.Y., firm in 2000. “I considered doing it for five years, learned a lot about managing the business and about managing money. I survived the worst bear market in history.” He also had a substantial head start: By the time he left, he had already converted 90 percent of his clients to fee-based.
Even as a top producer, Geller would have trouble doing the kind of business he does now back at the wirehouse. He manages a series of proprietary investment funds using his own quantitative discipline. “At the wirehouse, there are so many layers of management to protect the firm that the compliance is extremely oppressive,” says Geller. “Here, I'm responsible. If I have a question, I send my lawyer an email and use appropriate disclaimers.”
Emerald Asset Advisors, an RIA shop in Weston, Fla., invests client assets in hedge fund-like investments created out of a combination of exchange-traded funds and no-load mutual funds. “The decision to become an RIA was client-driven,” says Rob Isbitts, president of the firm. “Our clients had been saying to us for years, ‘We want Emerald to have more direct control over the outcome of our portfolio.’ That means they wanted us to have that discretion.”
Brokers may want to think twice before they sign up for the advisor regulatory regime (see sidebar on page 36), says Tibergien. Instead of annual reviews, RIAs are monitored less frequently. The potential trap, he says: “You can go along interpreting the regs a certain way, and they can come in years later and claim that you did it wrong — and that you did it wrong for many years.”
The pros of being an RIA may not outweigh the cons for many reps. But experts agree that the trend towards independence is not going to subside — especially for reps with high-net-worth clients. “Many people find that their business has evolved already to where they're generating most or all of their income from fees,” says Tibergien. “You have to ask does it make sense to continue to pay as much in tax to the wirehouse for what I'm getting?”
For some, the answer will still be yes. For others, it will be a halfway measure, such as moving to a less restrictive b/d environment. “I don't think fee-only is the right thing for everyone,” says Di Girolamo. “I wouldn't say the whole business is going that way, but I do think it's going to be an increasing percentage.”
Most reps that have made the switch swear by it. “It's a lot more fun because it's mine,” says Geller. “It's my challenge to bring out a better product. And it's a pleasure to not have to do what you're told to do to make a living.”
Heavier Responsibility — and Lighter Regulation?
If you switch from a Series 7 to a Series 66 designation, how does your relationship with clients and with regulators change? The Investment Adviser Act of 1940 basically obliges RIAs to take fiduciary responsibility for their clients, which means putting their needs first.
Reps with more than $25 million in assets must also register with the SEC by filling out Form ADV parts I and II. (The threshold may soon be raised to $40 million.) Below $25 million, the advisor registers with state securities regulators. RIAs who register with the state must do so in every state in which they have at least five clients.
The ADV is a two-part disclosure and anti-fraud document. The first part asks basic questions about you and your business practices. It also asks who “owns” or “controls” the business and asks for disclosure of any disciplinary events involving you or your affiliates, whether you've been sued or suspended. The second part is a brochure or narrative disclosure about how you run your business — how you invest, how you're compensated, what clients can expect from you and any potential conflicts of interest you may have with your clients.
States vary in how aggressively they audit RIAs. But consultants say that larger RIAs, who register with the SEC, can expect a lighter regulatory touch than registered reps now receive at the hands of the NASD. On the other hand, the looser supervision can leave RIAs more vulnerable to liability claims. Because advisors are only likely to be audited every few years, they “are subject to being second guessed by federal or state securities regulators, making those decisions with hindsight,” says Brian Hamburger, a consultant and attorney at MarketCounsel, a regulatory and compliance consulting firm in Teaneck, N.J. “Having all that rope to hang yourself could be dangerous.”
That's why it is important to disclose as much as possible in your ADV. “It should read like a mutual fund prospectus,” says Hamburger. “Failure to write good disclosure is the single largest source of new business for our law firm.” In October, the SEC added some new requirements including that RIAs must write a code of ethics and regularly review their practices. The new rules also require firms to appoint a chief compliance officer — yet another hat the small RIA is going to have to wear.