Just as you would do before hiring a heart surgeon or anyone who provides a critical service, conducting proper due diligence is a must before enlisting the help of a financial advisor. In this article, we’ll cover which documents that you should ask for, how to navigate through all the clutter, and how to get the skeletons out of the closet regarding disciplinary history.
The Essential Documents
Registered Investment Advisor (RIA) firms must file a Form ADV with either the state(s) in which they do business or the SEC. There are two sections to Form ADV: Part I and Part II.
Form ADV Part I will tell you the basic information about the firm such as:
- Location, hours, telephone number, name of the Chief Compliance Officer, number of employees, etc.
- Number of clients and assets under management (Items 5C and 5D). You’d want to make sure this jives with what the advisor is saying about the size of their practice to make sure they are not exaggerating their success. Be sure to note the difference between the advisor’s personal book of business and the assets that the firm manages. Especially in the case of large investment companies like Merrill Lynch, UBS, Ameriprise, Edward Jones or Wells Fargo, the advisor may only have direct responsibility for a very small portion of the firm’s overall portfolio assets.
- Compensation methods (Item 5E and Item 8). Here you’ll learn all the ways an advisor can get paid, whether hourly fees, flat fees, commissions, or a percentage of assets under management. If you want truly conflict-free advice, it’s best to avoid advisors who get paid commissions for placing money into products.
- The type of business that they are in (Item 6). Some RIA firms, for example, operate as “hybrid” advisors where they also are paid a commission for trades made as a broker-dealer firm. The firm is required to disclose all lines of business it is involved with as well as any affiliations with other financial institutions. You want to make sure they are fee-only advisors.
Let’s say, for example, that the RIA firm recommends an annuity or mutual fund. You should be made aware of the fact that they’re getting compensated for doing so.
Or, let’s say that an advisor operates a real estate business in addition to managing money. This could be problematic if she is not fully dedicated or focused on your portfolio.
- Conduct history – (Item 11) Look here to see if there has been regulatory action against this advisor. You’ll learn if the advisor has been charged with or found convicted of felonies and misdemeanors (such as fraud), if they’ve filed for bankruptcy, or if they have liens against them.
- Where the securities under management are held (Item 9). It’s important that the advisor does not take custody of the assets himself, and that the securities are held at a third party, reputable, name brand firm where there is little risk of theft.
Form ADV Part II goes into depth about what the firm does. Written in plain English narrative format, the ADV Part II (aka, “ADV Brochure”) reveals:
- How the advisor is paid (Item 5).
Many advisors say they are a fiduciary, but their compensation structure will showotherwise. Elaborating on the information in Part I, this will tell you if the advisor is really acting as a fiduciary and putting the interests of clients first. Some compensation arrangements can create conflicts of interest that compromise the advisor’s objectivity.
For example, if the firm is getting kickbacks from Charles Schwab, Fidelity, or TD Ameritrade for referring clients into investments on the Schwab platform (or the other way around), they might be making the decision more for their own benefit rather than yours.
If the advisor pays referral fees to the accountant that sent you her way, perhaps that accountant’s decision was shaded by the allure of getting compensated.
Some broker-dealer affiliations may be material as well, where the advisor is rewarded for sending client trades to certain brokers. You may not be getting the best execution in that case because the advisor may just be pushing the trade to whoever pays him the best.
- Investment style and process. Look here to find out if the advisor has provided you with a clear message about how he or she is claiming to manage money (example: stock selection versus picking mutual funds) and the major risks associated with those strategies. Make sure you’re comfortable with those risks. You should also check the contract you sign very carefully to verify that the strategy assigned to your portfolio is the one that you were presented.
- Conduct History. Any disclosure events will be noted here. Repeated violations are a red flag. If you see anything concerning, you can also perform a Google search and conduct other research to find out more about any wrongdoing the advisor has committed.
- Education and work history (Part 2 B, Brochure Supplement): Reconcile this information with what the advisor tells you to make sure the advisor really is who he or she claims to be.
Getting the Skeletons Out of the Closet
Speaking of disciplinary events, they’re more common than you would think. Most advisors who have been in the business a while have had at least one or two client disputes. That’s not necessarily a deal killer, depending upon the nature of the dispute (example: fraudulent trading vs. a frivolous issue with distribution of a marketing brochure.)
You may obtain ADV documents online by visiting the SEC’s IAPD website. You can search either by the advisor’s name or by firm name. You can see from this example, the search page brings you to the advisor’s latest form ADV filed as well as the Part 2 Brochure.
The advisor is required to provide you with the ADV Part 2 before or at the time that you enter into an agreement with him or her. In addition, the advisor must provide you either with an annual update or summary of material changes within 120 days of the fiscal year end, or anytime a disciplinary event occurs.
You should ask for (and read) these documents instead of just taking the advisor’s word for it. Make it easy on yourself –with so many variables, how can you be sure you have it all covered? Also, having this information in writing puts things in black and white. There can be no confusion after the fact about what was said (or not said) if it’s documented.
Summary: How to analyze the Form ADV
The Form ADV contains a wealth of information about RIA firms and their employees, and must be navigated skillfully to uncover any red flags. The two biggest warning signals are an unusual disclosure history and indicators of potential conflicts of interest such as outside affiliations and compensation arrangements that compromise objectivity.