/ TERMS & FAQS

What is an RIA?

A registered investment adviser (RIA) is an investment adviser who has registered with the Securities and Exchange Commission (SEC) or the state in which they do business. According to the SEC, an Investment Adviser is “a person or firm that is engaged in the business of providing investment advice to others or issuing reports or analyses regarding securities, for compensation.”

While this may be a great technical description, you’re likely no clearer about what an RIA is and what they do than you were before reading that definition.

Ultimately, three things define RIAs; registration requirements, compensation, and that they are fiduciaries. In today’s post, I’ll walk through each of these three areas to give you a better idea of what it means to be an RIA.

Registration Requirements

The most straightforward area is registration, so let’s start there. What does it mean to be registered? The investment adviser requirements have many rules and just as many exceptions to these rules.

Still, to register with the SEC, RIAs need to have $100 million in assets under management (AUM), or they need to be the adviser to a mutual fund. If the adviser has between $25 million and $100 million in AUM, the adviser will register at the state level instead. When an adviser is ready to register with the SEC, it will file a Form ADV. The adviser then remains registered by filing an ADV update each year.

What an RIA is Not

Before we get into what an RIA is, it may help to discuss what an RIA is not. First of all, you have to be registered, which requires meeting specific requirements and following all applicable rules. This means that anyone cannot just call themselves an RIA. It’s also why, in general, you should place more value on the investment advice you get from an RIA than you should from your uncle telling you about a fantastic investment opportunity over Thanksgiving dinner.

So, any random person cannot call themselves an RIA, but there are other professionals providing investment advice, and not all of them are RIAs. This may then lead you to wonder how RIAs are different. You can think of registered persons or firms providing investment advice as fitting into one of two overarching categories: investment advisers and broker-dealers.

The broker-dealers are the ones fulfilling orders by buying and selling particular securities. The SEC still has some authority over broker-dealers, since the SEC’s job is to protect investors; however, the primary entity overseeing the licensing and regulation of broker-dealers is the Financial Industry Regulatory Authority (FINRA). While brokers (the people at a broker-dealer buying and selling securities for clients) have previously referred to themselves as advisers, the SEC recently banned this practice.

The role of an investment adviser is to manage client accounts. Even if you work with an investment adviser, the securities in your portfolio will still be held by a broker-dealer. The investment adviser then acts as an intermediary between the customer and the broker-dealer - directing the broker-dealer to buy or sell specific securities.

If the broker-dealer is the one making the trades, whether you have an investment adviser or not, then why would you need an investment adviser? Though you can certainly work with a broker, RIAs are different from brokers because they are fiduciaries and compensated differently. Here’s what those two terms mean and why it matters.

RIA Compensation

RIAs and brokers are compensated quite differently. RIAs are generally compensated through management fees. These management fees are a percentage of the client’s assets under management (AUM). Management fees vary, but a one percent fee is reasonably typical. If an investment adviser is a fee-only registered investment adviser, this means the adviser’s sole form of compensation is the management fee the client is paying. An adviser who serves only as an RIA cannot earn commissions. Arguably, the fee-only model has fewer conflicts of interest. The problem for the average investor is that the fee-only model is often, though not exclusively, available to high net worth clients.

The reason the RIA compensation structure is so important is that it differs quite a bit from how others in the industry are compensated.

Broker-dealer compensation can include commissions, advisory fees, shares of management fees for mutual funds, 12b-1 fees, and trailer fees. I won’t get into the definition of each of these fees, but the point is that broker compensation may occur in many different ways. Brokers are also often incentivized to buy or sell certain products or services or to reach a certain number of clients or assets.

You may have also heard of a third kind of compensation offered by a fee-based investment adviser. This is typically offered by advisers who are dually registered as both RIAs and broker-dealers. The term fee-based sounds an awful lot like fee-only, but these two terms mean very different things. Fee-based advisers charge a management fee, but they can also charge flat fees, hourly fees, and performance-based fees. Fee-based advisers can also receive compensation through brokerage commissions, insurance commissions, and the sale of certain mutual funds. Essentially, a fee-based adviser can charge fees like both a fee-only adviser and a broker-dealer.

While the commission-based or fee-based compensation models have the potential for more conflicts of interest, working with these individuals can have other benefits. For example, brokers often can offer more products than an RIA.

It’s worth noting that while brokers and fee-based advisers can charge many different types of fees, that doesn’t mean they will charge all these fees. Whoever you choose to work with, it’s essential to know all of the fee details.

Fiduciary Duty

The other major defining characteristic of an RIA is that an RIA is a fiduciary. A fiduciary has to act in the best interest of the client, and the investment advice a fiduciary provides must be in the best interest of the client. This means an RIA cannot put his or her best interest above that of the client.

Not everyone providing investment advice is a fiduciary. The alternative to fiduciary duty is the suitability standard, which brokers must abide by. The suitability standard requires that brokers make recommendations “consistent with the best interest of the underlying customer”.

On the surface, these two terms sound similar - so what’s the difference? An example may help.

Let’s say you go to your RIA, who is a fiduciary. You’re trying to choose between investment A, B, and C. Given your current financial situation, all of the investments could be suitable, but investment A is the best choice for you. Your adviser is required to tell you that investment A is best for you. It is your adviser’s fiduciary duty.

Now let’s say you had the same question about whether you should choose investment A, B, or C, but instead of going to an RIA, you went to a broker. This broker is held to a suitability standard. Even though investment A is arguably in your best interest, all three investments are suitable. The catch is that if you choose investment B, the broker will earn more than if you decided on investment A or C. The broker, therefore, recommends investment B. This broker is still meeting the suitability standard.

A fiduciary is required to act in your best interest, while a broker is only required to give suitable advice.

This is not to say that a fiduciary cannot make a mistake. Whether or not an adviser is a fiduciary, he or she can’t know how an individual stock will perform. An adviser may think one stock is best for your portfolio given the information she has, but it may end up performing poorly. This does not mean the adviser is not acting as a fiduciary. It just means she’s human.

On the other hand, if you’re about to retire, which is ideally a time to have a more conservative portfolio, and your adviser puts your entire portfolio in high-risk micro-cap stocks and loses almost all of your money, your adviser is not fulfilling their fiduciary duty. This behavior was not in your best interest, and the adviser could face the consequences of this behavior.

I will say that just because a dealer only has to maintain a standard of suitability, doesn’t mean that the broker can’t also choose to act in your best interest. It’s like doctors and the Hippocratic oath. Doctors must take an oath, which includes the line “first, do no harm”. Doctors have, therefore, sworn a promise that their primary objective is not to harm people. This does not mean that everyone who is not a doctor is looking to cause harm, simply that doctors are held to a higher standard.

The Takeaway

There are advantages and disadvantages, no matter who you choose to advise you. If you decide to work with an RIA, the key things to know are that they’re registered with the SEC or the state they reside in, that compensation typically occurs through management fees, and they are required to act in your best interest.

The world of finance is complex. Many terms sound similar but mean completely different things. Plenty of other words seem like they say different things but are used interchangeably. If you have hired or are considering hiring someone to manage your portfolio, you should take the time to know the requirements this person must abide by and how he or she is compensated.

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Leo Smigel

Based in Pittsburgh, Analyzing Alpha is a blog by Leo Smigel exploring what works in the markets.