The investment advisory profession is facing a number of serious policy issues that could dramatically alter the manner in which it is regulated and transform the high ethical standards that have been a hallmark of the profession for decades.
Financial services reform [has been high on Congress'] priority list in the wake of the seismic changes wrought by the subprime debacle. Other developments, notably the Bernard Madoff scandal involving a $65 billion Ponzi scheme, have created a perfect-storm environment for consideration of unprecedented changes to the manner in which investment advisers are regulated.
Possibilities that were nearly unthinkable a short time ago are now open for active discussion and potential action. In congressional hearings examining the Madoff scandal, [Securities and Exchange Commission] officials have spoken openly about the need to “harmonize” investment adviser and broker-dealer laws and regulations and suggested the creation of a self-regulatory organization for investment advisers.
In January, the Senate Banking Committee convened a hearing to confirm Mary Schapiro as SEC chairman. Ms. Schapiro, the former chief executive of [the Financial Industry Regulatory Authority Inc.], lamented that “far fewer resources are available for inspection and oversight” of investment advisers than for broker-dealers.
The SEC, which among other roles serves as the regulator for the investment advisory profession, has been heavily criticized for its role in the Madoff scandal and for its alleged failure to regulate firms and practices that contributed to the financial crisis.
How the regulation of investment advisory firms would be affected by reforms would obviously depend upon many devilish details. What is clear is that, in the context of the broad discussion taking place in the policy arena, the odds have in-creased that a fundamental restructuring of securities laws and regulations will occur.
If and when Congress takes action in this important area, it could alter the fundamental fiduciary standard governing the advisory profession while subjecting advisory firms to costly oversight by Finra, the self-regulatory organization for the brokerage industry.
In light of the Madoff scandal, it is abundantly clear that the environment is ripe for legislation and regulations that could dramatically change the current framework governing the investment advisory profession.
DYSFUNCTIONAL GIANT
In terms of sheer numbers, the U.S. investment advisory profession is a giant. The profession consists of more than 11,000 SEC-registered firms that collectively manage more than $40 trillion for nearly 20 million clients. Clients run the full spectrum, from individuals and families who want a financial professional to handle their investments to institutions such as pension funds, state and local governments, corporations, banks, insurance companies, mutual funds, endowments, foundations, and hedge funds.
Simply looking at the vast amount of assets entrusted to investment advisers, it is clear that the performance of the profession is critical to the financial health and future well-being of millions of people.
Despite its size, the investment advisory profession has not done an adequate job of explaining what it is and what it does. Few investors understand the core characteristics of an investment adviser or appreciate the key differences between investment advisers and other financial services providers.
Even “specialists” in the financial media are not well-informed and many tend to characterize large mutual fund or brokerage complexes as “typical” investment adviser shops. Many policymakers, including members of Congress who have responsibility to craft laws governing investment advisers, have little understanding about the basics of the profession.
For these reasons, some might think of the investment advisory profession as a “sleeping giant” that has yet to reach its full potential by engaging in advocacy and educational efforts commensurate with its size.
Perhaps a more fitting description is that of a “dysfunctional” giant. Investment advisory firms come in all shapes and sizes. There is enormous diversity even among investment advisory firms that appear to be similar.
By and large, advisory firms do not conduct business with each other. It should come as no surprise that the advisory profession often is described as “fragmented.” Accordingly, many investment advisers do not feel any particular kinship with each other, despite the fact that the law treats them similarly. This leads to an insular mentality and a lack of solidarity in pursuing a common agenda.
Challenge No. 1: The diversity of firms. The investment advisory profession is characterized by its variety. On one level, the size of advisory firms runs the gamut from very small to very large. Even among firms that are similar in size, there can be huge differences in investment philosophy, clientele, business structure and services.
Here's a simple example that demonstrates the wide gulf that tends to separate investment advisers:
Everyman Wealth Management Co. is an investment advisory firm located in Smalltown, USA. Ernest Everyman, 68, a certified public accountant, founded the firm in 1976 when his accounting clients increasingly began asking for investment advice.
His son, Ernest Jr., is also a CPA and, among other duties, serves as the firm's chief operating officer. The firm employs two others who primarily perform administrative functions. The firm has 190 accounts and manages $140 million in client assets, primarily for individuals. The firm provides financial planning, investment, tax and accounting services.
Global Financial Co. is an investment advisory firm with offices in New York, Los Angeles, London and Hong Kong. The firm is majority-owned by a European bank. The firm concentrates on institutional clients, including public funds, central banks, insurance companies, endowments, foundations and retirement plan sponsors.
The firm offers a variety of investment products, including mutual funds, hedge funds, wrap fee programs and separate accounts. The firm has an affiliated broker-dealer that is used primarily to distribute the firm's mutual funds. The firm has more than 1,500 employees and manages more than $300 billion in client assets.
Everyman and Global illustrate the solidarity challenge confronting the investment advisory profession. They are very different enterprises. Their clients are different. Their investment services are different. Their resources and focus are different.
What, if anything, do Everyman and Global have in common? Are there any compelling reasons that they should work together to achieve shared goals? Do they even have any shared goals? Why should either firm be concerned about achieving solidarity with the other?
Challenge No. 2: The lexicon challenge. At a very basic level, the lack of a broadly accepted and well-understood lexicon contributes to the solidarity challenge facing the investment advisory profession.
Terms used to describe those who provide investment advisory services include the following: investment adviser, asset manager, investment manager, portfolio manager, financial adviser, financial consultant, money manager, wealth manager, investment counsel and financial planner.
The lexicon challenge (and related investor confusion) is further exacerbated by complexities related to various professional designations. While federal laws and regulations do not specify any minimal certification or educational requirements for investment advisers, there is an array of certifications, accreditations and designations that investment professionals can acquire to burnish their credentials.
For example, the chartered financial analyst and certified financial planner designations are well-recognized, established designations that require significant time and effort to attain, including successful completion of certifying examinations.
Challenge No. 3: Alphabet soup. Washington is home to hundreds of trade groups and associations. Like investment advisers, they come in every size and shape. There are high-profile groups like AARP and the National Rifle Association, as well as scores of lesser-known organizations like the National Candle Association, the Popcorn Board and the International Carwash Association. Virtually every industry and interest group has a membership organization that represents its collective interests.
At their core, associations work to advance and promote the interests of their members by serving as the liaison between industry and government. Membership organizations typically perform a wide variety of other services for their constituencies and may be involved in one or more of the following activities: providing information, research and statistical data; education/professional development; developing standards, codes of ethics and certification programs; and providing a forum to discuss common problems and solutions.
A number of groups compete to represent investment advisers, including the following:
• Investment Adviser Association: represents more than 500 SEC-registered investment advisory firms that collectively manage more than $9 trillion in client assets
• Investment Company Institute: represents U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds, and unit investment trusts.
• Financial Planning Association: represents financial planners, attorneys, accountants, bankers, insurance agents, stockbrokers, investment consultants, money managers and others involved in the financial planning process.
• Securities Industry and Financial Markets Association: represents 650 financial services firms, primarily broker-dealers.
• Managed Funds Association: represents the hedge fund industry and attracts professionals [from] hedge funds, funds of funds and managed-futures funds.
• American Bankers Association: the largest association that represents the banking industry [including] community, regional and money center banks and holding companies, as well as savings associations, trust companies and savings banks.
The confusing conglomeration of organizations representing investment advisers contributes to the general lack of understanding about the advisory profession. If you are a member of Congress, and two different groups (or more) purporting to represent the interests of investment advisers come to you with very different positions, what are you to conclude? What policies are you supposed to support? Whose side are you on? On the other hand, if you are a member of Congress and every SEC-registered investment adviser in your district comes to you with a unified message, it increases the odds that you will appreciate and understand their concerns and positions on key issues.
Challenge No. 4: The GDI Syndrome. As a general proposition, investment advisers are fiercely independent. They are highly intelligent and well-educated GDIs (gosh-darn independents). They tend to be self-reliant and self-supporting. They have worked hard to get where they are. They revel in intensive research and creative thought. Many would be flattered to be referred to as “contrarian.”
By nature, they are tough. The business of making investment decisions for clients is not easy. Investment advisers must deal with a host of complex and ever-changing issues. Unless an investment adviser has a solid understanding of the markets and specific securities, and the acumen and discipline to focus on and follow a consistent investment strategy — not to mention the management skills to operate a business — things can unravel rather quickly.
Independent, tough — and auto- nomous. Investment advisers tend to abhor the herd mentality. Instead, they admire those who really “know their stuff” and who demonstrate originality based on thorough and objective analysis. Many have developed unique approaches to investment research and portfolio management based on rigorous analysis and steady application.
Challenge No. 5: Aversion to publicity. The traditional investment advisory business is based on a high level of discretion and confidentiality. Older generations of investment counselors would not even acknowledge their advisory clients when passing them on the street. Advertisements were eschewed as vulgar. Speaking with reporters was generally avoided if at all possible.
These historical tendencies of the investment advisory profession are somewhat at odds with well-run advocacy and educational initiatives that by definition need to highlight the profession, its attributes, and details of relevant issues. Advocacy results generally are tied to concerted, visible and oftentimes widely publicized activities.
A trade organization can provide “cover” for individuals and firms that would prefer not to be on the front line of particular advocacy debates. The investment advisory profession must come to grips with the reality that public discourse — from dealing with the financial media to meeting with policymakers — is a necessary element of effective advocacy.
Challenge No. 6: Who likes regulation? Sometimes, the issues just aren't that “sexy.” Most advocacy issues are tied directly to legislative and regulatory policies. The reality is that many advisers view legal, regulatory and compliance issues as nothing more than a detraction and distraction from their primary job of serving clients.
Moreover, legal and regulatory issues may be complex and difficult to grasp for senior management not immersed in the day-to-day nuances of compliance. As such, there is a natural tendency on the part of many investment advisory firms to avoid — or at least ignore — nascent legal and regulatory matters and conclude that it's “someone else's job” to try to deal with them.
Let's return to our original questions. Do Everyman Wealth Management Co. and Global Financial Co. have anything in common?
Are there any compelling reasons that Everyman and Global should work together to achieve any shared goals or objectives? Should either firm be concerned about achieving solidarity with each other?
The answers are yes, yes and yes.
Everyman and Global are both “investment advisers” within the meaning of the Investment Advisers Act of 1940. Even though their firms appear to be completely dissimilar, both are in the business of providing investment advisory services to their clients. They are subject to the same SEC registration and disclosure requirements. Both owe a fiduciary duty to their clients.
Both are subject to regulations under the Advisers Act, including the compliance program, code of ethics, proxy voting, privacy, custody, insider trading, books and records, and advertising rules. They are subject to examinations by the SEC.
They both have serious risks related to non-compliance. They both face potentially negative consequences if the laws and regulations governing the profession become overly burdensome or are not appropriately tailored to the investment advisory business.
Everyman and Global also can benefit from positive perceptions of their profession — by investors, the media, and policymakers. They both have a critical stake in promoting high ethical standards for their profession. And they both can gain from organized and collective efforts to promote a better understanding of their profession.
Given these shared core characteristics, Everyman and Global have enormous incentives to work together.
David G. Tittsworth is executive director and executive vice president of the Investment Advisers Association. Reprinted from "Investment Management: Meeting the Noble Challenges of Funding Pensions, Deficits and Growth," edited by Wayne H. Wagner and Ralph A. Rieves (John Wiley & Sons Inc., 2009).
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