We Need Some New Terminology (Part 1)

Those outside of the investment industry — including most clients — usually don’t have the background to understand much of the jargon that is thrown at them by professionals about investments and how they work.  Bridging that communication gap is an essential skill to be covered in later postings; for now, let’s start with a very simple question:

What’s the difference between an investment advisor and an investment adviser?

Nothing, although (at least in the U.S.) the “advisor” usage is common among practitioners, while the “adviser” form is mostly the province of regulators and lawyers.  (That’s why you’ll see some of each in this posting; “advisor” is the normal usage on the site unless a publication is quoted.)

That taken care of:

What are the different kinds of investment advisors?

Oh, boy.  This got hard in a hurry.  The answers to the question will depend on whom you ask, what part of the business they are in, and the degree to which their business model is supported or threatened by proposed changes in the regulatory regime.

In a September 2021 posting, Michael Kitces provided the historical backdrop regarding the regulation of names and activities of would-be advisors — and a call to action, as you can tell from the title, “Why XYPN Is Petitioning The SEC To Implement Title Reform Under Section 208(c).”

Advisors and salespeople

The executive summary provides the basics, but Kitces offers much more in the way of details, tracing the path of regulation from before the Investment Advisers Act of 1940 to today.  The term “investment counsel” was the popular advice-giving term of the first half of the last century, to the point that the Advisers Act prohibited the use of that phrase by a person or firm unless the provision of investment advice was their principal business.

Thus, there was a “clear separation” between advisors and those who were in the business of selling product:

Which at its very core was centered on how firms marketed and held their services out to the public in the first place, with a regulatory framework that forced them to declare whether their primary or principal business was providing brokerage services (with only incidental advice), or providing investment counsel (as fiduciary advisors with no conflicted brokerage services).

This has been the playing ground for an industry tug-of-war ever since.

As brokerage firms changed their business models in response to May Day (when fixed commissions went away in 1975) and technological advances, “the use of the term ‘financial advisor’ suddenly exploded.”  Plus, the rise in popularity of financial planning added to the need for greater clarity regarding the regulatory framework for advisory services.

Then the story gets really messy.  See the Kitces piece for the blow-by-blow, but basically the SEC promulgated a rule in 1975 that was intended to clear things up, which was then vacated by a court, so the SEC responded with a different proposed rule, which never was adopted, leaving the necessary clarifications in limbo.

In 2019, Regulation Best Interest (Reg BI) was issued, which “explicitly chose not to unify the standards for investment advisers and broker-dealers as it was authorized to do under Dodd-Frank.”  (That being the 2010 Wall Street Reform and Consumer Protection Act.)  Reg BI creates a situation where a broker and an advisor are held to different standards for the same activity:

In other words, the current structure of Reg BI allows two “financial advisors” to engage in the same marketing of financial planning services, provide the same financial plan, recommend the same asset allocation recommendations, but implement with different (and in one case, more conflicted and higher cost) products.

And rather than recognizing that the delivery of advice and a comprehensive financial plan should elevate the standard of care on the recommendation of a proprietary product (because of the advice relationship of trust and confidence that has been created), instead the fact that a proprietary product would be sold at the end of the advice process allows the broker to “opt into” a lower non-RIA non-fiduciary standard of care, at the exact moment that a fiduciary standard of care is most intended and necessary to protect the investor from conflicted advice!

According to Kitces, this is an untenable situation, which has been exacerbated by the use of titles in the industry that are indicative of nothing in particular — and the proliferation of dually-registered firms, which can switch hats depending on the circumstances.  While “the founding principle of the Investment Advisers Act of 1940 was to assert a bright-line separation between sales and advice,” that often no longer exists in practice, although most clients aren’t aware that’s the case.

In response, the XY Planning Network (of which Kitces is a co-founder) petitioned the SEC for title reform and revised rules to clarify the standards that determine what constitutes the provision of investment advice — and therefore alter the dynamics of the industry as it currently exists.

About those “advisers”

Beyond the confusion around what to call and how to regulate those who provide investment services to individuals is the broader issue of what kinds of organizations are required to register as “advisers” in the United States.

To illustrate the problem, here are excerpts from the opening section of a Financial Times article, “Investment advisers surpass retail as biggest holders of US-listed ETFs”:

Investment advisers have eclipsed retail traders to become the largest owners of US exchange traded funds, highlighting how professional investors are increasingly using the vehicles to build portfolios.

Nearly two-fifths of US-listed ETFs by value are now owned by investment advisers, according to research compiled by Citigroup.  Wealth managers own 12.7 per cent, with other institutions, such as insurers and pension funds, holding a further 8.8 per cent.

Quick, what percentage is owned by the brokers and/or the registered investment advisors that are the subjects of the section above?  Are they the “wealth managers” that are referenced?  Or are they in the “investment advisers” category?

This kind of uncertainty underlies many press accounts — and industry analyses — because so many different kinds of organizations are lumped together under the rubric of “investment advisers” in the U.S. regulatory regime.

Vanguard is registered that way — or more precisely, several Vanguard entities are — as is the one-person shop on Main Street in a small town.  But size isn’t the only differentiator.

There are asset managers, who deal in individual securities and market their portfolios in a variety of vehicles (including private funds, which are their own special category).  And advisors who rarely “manage” securities themselves (although they may watch a legacy holding of a client), instead investing via those very asset managers.  And some who only do financial planning or provide consulting to institutional asset owners like pension plans and foundations.

A report from the Investment Adviser Association tries to capture the range of different entities using these four “typical profiles” that cover 85% of those registered:

You can see that even these aren’t discreet types.  (Another difficulty arises when trying to calculate the true total assets across a group of advisors or the industry as a whole, since the same asset can be double-, triple-, or quadruple-counted in the aggregate because of the levels of intermediation in the industry.)

While you can get a sense of an individual organization’s offerings from its filings (including its reported assets across certain prescribed categories), because advisors of different stripes are lumped together there isn’t a way to effectively analyze broad trends and issues.

As an example, refer back to the Financial Times article above.  Are asset managers using ETFs more, or advisory firms, or both?  It would be nice to know, since there are a variety of considerations involved, including the effect of shifts in the nature of the advice delivered, the resulting performance, and who gets what fees in the investment chain.  But that’s just one small example of what is lost in the mix when fundamentally different functions are treated as one.

Evolution and categorization

As covered in the posting on forces in the ecosystem, change is to be expected.  The evolution of the industry pressures the established order and the categorizations that have defined it.  But regulatory frameworks are slow to be updated, not the least because different industry subgroups try to protect their own points of view (and turf).

At a minimum, in trying to define and regulate the range of firms proving investment services, we need some new terminology.