In this latest exclusive commentary from the UHNW Institute, author Bill Woodson considers what is happening in the broker-dealer space.

The following article is by prominent wealth management industry figure Bill Woodson, who is a founder and advisory board member of the UHNW Institute, an organization with which Family Wealth Report is the exclusive media partner. Woodson has produced a number of white papers on issues affecting ultra-high net worth clients and the broader industry. (There is more about the author below this article.)

For more about the Institute, see this link here.

In our ongoing efforts to inform and educate UHNW and family office investors, the UHNW Institute is pleased to provide the following article as the second part of a five-part series on wealth management business models (see The Skinny on Wealth Management Industry Models by Jamie McLaughlin). The goal of these articles is to review the four main industry platforms through which UHNW and family office investors receive wealth management advice and services (broker-dealers, commercial banks, independent registered investment advisors (RIAs), and trust companies). In so doing, we hope to help UHNW and family office investors better understand the industry so that they can make more informed decisions about which industry platforms, firms and advisors are best suited to meet their needs.

Introduction
The following article reviews those firms that broadly fall under the industry platform category of “broker-dealers” (or brokerage firms). Future articles in this series will review commercial banks, independent RIAs, and trust companies separately. The discussion that follows presents important characteristics of firms within the brokerage industry due to, among other things, the heritage of their businesses, how they approach delivering investment advice, advisor compensation, and potential conflicts of interests.   

It is important to note that the views expressed herein should be considered broad generalizations about the brokerage industry. The reasons for this, as reviewed in more detail below, are that many of the firms that provide investment advice to UHNW and family office investors have evolved their offerings to include products and services that span multiple platforms and include brokerage, banking, investment advisory, and trust.  

For purposes of this article, “broker-dealers” refers to the traditional full-service brokerage firms that provide brokerage services (the buying and selling of securities), research, investment advisory (asset allocation, portfolio construction, manager search and selection, reporting), asset management (through both internal and external managers), and related financial planning advice (retirement, estate planning, wealth education, philanthropy, etc.). Many of these firms also provide insurance and annuity products.  
Generally, they include the following types of firms (1):

•    Large “wire houses” such as Merrill Lynch, Morgan Stanley, Goldman Sachs, and UBS;
•    Discount brokerage firm such as Schwab and Fidelity that are increasingly providing investment advisory and financial planning advice to UHNW investors;
•    Brokerage divisions within the large retail banks such as JP Morgan, Wells Fargo, and Citibank; and 
•    Regional brokerage firms such as Raymond James (including Alex. Brown), Stifel, and Edward Jones. 

As an industry, these firms comprise the largest share of client assets within the broader wealth management industry (excluding insurance brokers and independent broker-dealers who principally serve institutions as opposed to private clients), with approximately 175,000 financial advisors and $16.1 trillion in client assets (out of $20.8 trillion) (2).  
Key considerations as they pertain to the brokerage industry/platform to be discussed include:

•    What are their cultural norms?
•    What are their investment and non-investment processes, service platforms and resources?
•    How do they price their services?
•    What are their regulatory roles/responsibilities and potential conflicts of interest?

What are their cultural norms?
Traditional brokerage firms (as defined above) grew up providing securities research, sales and trading to individual and institutional investors and, over the years, have expanded their role with UHNW and family office investors to include investment advisory and financial planning. As a result of their heritage, brand, and product/advisory offerings, there is typically an investment “primacy” in the relationship they have with clients relative to some of the other industry platforms. For example, advisors at brokerage firms tend to be almost exclusively investment professionals who are responsible for delivering investment advice directly to clients as opposed to “relationship managers” who coordinate the delivery of this advice via other investment specialists.  

This is not to suggest that the client representatives who work at firms included in the other platforms are not investment specialists. Rather, it is the primacy of this role by the advisors that, on average, distinguishes broker-dealers from firms associated with other platforms. For general comparison purposes, client advisors at commercial banks and trust companies are often wealth management generalists whose job it is to manage relationships and bring in investment specialists to address investment needs by UHNW and family office clients.  

Compared with commercial banks or trust companies, brokerage firms have an understanding and acceptance that their clients are often more closely tied to their advisors than to the firm.  While this is often also the case with advisors at independent RIAs, it is not the norm at commercial banks and trust companies. Much of this has to do with the nature of the relationship advisors at brokerage firms have with their clients and the primacy of the investment advice/service they are providing to UHNW and family office investors.  
 
Commercial banks and trust companies, more commonly than brokerage firms and independent RIAs, provide products tied to the institution itself such as lending, deposits, custody and fiduciary services. Brokerage firms, in contrast, are principally providing securities trading and investment advice where the value is more heavily influenced by the individual providing it as opposed to the institution and its inherent capabilities. While this is, of course, not always the case - indeed commercial banks and trust companies also provide important and valuable trading and investment advice to UHNW and family office investors - it is the relative contribution of the “advisor” versus the “platform” that distinguishes brokerage firms from commercial banks and trust companies.  

As a consequence of the independence advisors at brokerage firms enjoy with respect to their clients, there is a greater disparity in the nature of the advice and services they provide to their clients than, for the most part, at commercial banks, independent RIAs and trust companies.  For example, some advisors might be more transactional in nature than broad-based investment advisory. This is often driven by their interests and skill-set as well as the types of clients they attract.  

Brokerage firms (based in the US) are also unique relative to the other platforms such as commercial banks, independent RIAs and trust companies in that, by-and-large, their advisors are paid based on a percentage of the revenue they generate from clients as opposed to via salary and bonus. This compensation structure changes greatly the relationship between the firm and its advisors and is one of the reasons for the unique firm/advisor dynamics described previously where the advisors often “own” the clients as opposed to the “firm.” Under this compensation structure, brokerage firms have more limited financial-managerial influence over their advisors than commercial banks, independent RIAs and trust companies. This has both advantages and disadvantages, as it increases linearly the direct financial incentive for advisors to generate revenue from clients. 

What are their investment and non-investment processes, service platforms and resources?
There has been a significant evolution in the broader wealth management industry over the past many decades and the historic business models of brokerage, banking, trust and independent investment advisory have merged considerably (see the recent article on the “History of Wealth Management” by Jamie McLaughlin and Robert Casey). Many firms across all four of these major industry platforms can and do provide all or most of these services directly or indirectly including brokerage (research, trading and execution), investment advisory (asset allocation, portfolio construction, and financial planning), trust (fiduciary services), and banking (deposits, lending and custody).  

Furthermore, dual registration (broker-dealer/registered investment advisor) allows for firms and advisors to be both “brokers” and “advisors” held to different standards based on the business they conduct across clients (or with the same client). As a result, broad and clear distinctions between the services each of the firms/advisors provide based on the industry they fall into (commercial bank, brokerage firm, independent RIA, or trust company) have, for many firms, become blurred or dissipated entirely.

As would be expected given the primacy of the investment relationship with clients, brokerage firms have significant investment resources available to UHNW and family office clients, particularly in the areas of research, stock trading and execution, asset management via both internal and third-party managers, and alternative investments. They have also made significant investments in technology to allow investors to trade electronically, conduct their research and receive reporting and portfolio analytics (as have all of the larger wealth management firms that provide investment advice and services for private clients). 

Many brokerage firms (and select commercial banks and trust companies) also invest a great deal in developing their own internal or exclusively-partnered investment strategies that they market to UHNW and family office clients. These include internal asset management solutions, structured notes for capital markets trading strategies, and distribution arrangements (i.e. selling agreements) with third-party investment firms such as private equity.  

Finally, as the role of investment advisor has shifted to providing more holistic wealth management, brokerage firms have also made significant investments in providing financial, estate, tax, philanthropic, and wealth education planning and advice to clients often for no incremental fee. The relevance and importance of these broader planning services have made them ubiquitous across most of the larger wealth management firms regardless of industry platform.  

How do they price their services?
Because of the evolution in the industry toward providing a broader array of financial advice and services to UHNW and family office investors, brokerage firms have had to expand the ways in which they charge for their services. Historically, these firms charged commissions for securities research, sales and trading (for example cents-per-share for the purchase and sale of securities). However, as they expanded their offerings to include investment advisory and financial planning, they developed asset-based advisory fee pricing models similar to RIAs.  

While commission-based pricing models are still prevalent within brokerage firms, they tend to be client-preference driven as opposed to an industry pricing model. Clients who are transactional in nature and are using traditional “brokerage” services are still able to pay for these services on a commission basis. Others who are using the firm and its advisors for investment advisory services and financial planning can do so for an asset-based fee. Indeed, it has been a preference by the firms and the regulators to move towards more asset-based fees, as opposed to commissions, as this provides more predictability in revenue and reduces some of the inherent conflicts where revenue is tied more directly to recommendations to buy and sell securities. 

Brokerage firms (and most commercial banks and trust companies) also generate revenue from the sale of third-party asset management funds including mutual funds, separately managed accounts (SMAs), and alternative investments. Pricing for these investments can include fees charged directly to the investor by the firms and retrocessions from the third-party asset managers.

What are their regulatory roles/responsibilities and potential conflicts of interest?
The evolution of the wealth management industry whereby firms are increasingly offering many of the same wealth management services (including securities brokerage), and where firms and advisors can be both “brokers” and “advisors” under different regulatory regimes, has caused a great deal of confusion among investors and potential for unidentified conflicts of interests. This perplexity can come from investors’ lack of understanding about the regulatory standards under which the advice is being given, the true costs of an investment recommendation, or the financial incentives advisors might be receiving to sell a particular investment solution.  

For example, with respect to roles and responsibilities, investment professionals who recommend the purchase and sale of securities to clients exclusively as a “broker or dealer” (3) must adhere to different professional standards than when they are acting as an “investment advisor” (4) for clients. This delineation, while confusing for some investors, is based on legitimate differences that apply based on the advice and services they are providing.  When acting as a “broker,” investment professionals (regardless of the industry platform from which they operate) must meet certain suitability, disclosure and other standards when making recommendations to clients. However, when acting as an “investment advisor” these same professionals have a formal fiduciary duty to clients, in addition to suitability and disclosure requirements, and must always “act in their clients’ best interests.”  

As a result of the confusion these different regulatory regimes can cause, there has been a great deal of effort by both firms and regulators to improve investor education. The focus of these efforts has been on making sure there is adequate disclosure about roles and responsibilities, compensation arrangements, and potential conflicts of interest. The SEC recently clarified one of these distinctions by implementing the “Regulation Best Interest Rule” (https://www.sec.gov/news/press-release/2019-89).  Under Regulation Best Interest, broker-dealers will be required to act in the best interest of a retail customer when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer. This new Rule will enhance the broker-dealer standard of conduct beyond existing suitability obligations and make it clear that broker-dealer advisors may not put their financial interests ahead of the interests of a retail customer when making recommendations.

Conclusion
Given the increasing similarities in how financial services firms advise and serve UHNW and family office clients, it is more difficult than ever for investors to identify appropriate service providers based solely on industry platform. Therefore, UHNW and family office investors should focus less on the industry platform a particular firm is associated with and more on the relative differences in cultural norms, resources and platforms, advisor make-up, and compensation/incentive structures.  

UHNW and family office investors should strive to understand these differences as they are applicable to what they are looking for in terms of advice and services relative to the type of investor they are (e.g., delegatory vs. controlling, level of wealth and sophistication, importance of independence, breadth of services required, etc.). Understanding themselves is therefore just as important to investors as knowing about the different platforms and firms.  Indeed, this is often one of the most important considerations when making decisions about which firm and/or advisor is best suited to serve them.

Footnotes

1,  This list is not meant to be all-inclusive or representative of all the various brokerage businesses that serve UHNW and family office investors.   Rather, it illustrates the types of firms included as part of this paper’s categorization of “broker-dealers” or “brokerage firms.”
2,  Envestnet Industry Trends, April 2019.  
3,  The Securities Exchange Act of 1934 ("Exchange Act") governs the way in which the nation's securities markets and its brokers and dealers operate.  Section 3(a)(4)(A) of the Exchange Act generally defines a "broker" broadly as any person engaged in the business of effecting transactions in securities for the account of others.  Unlike a broker, who acts as agent, a dealer acts as principal. Section 3(a)(5)(A) of the Exchange Act generally defines a "dealer" as any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.
4,  The US Investment Advisers Act of 1940 (“Advisers Act”) governs “investment advisers.”  Section 202(a)(11) of the Advisers Act defines an investment adviser as any person or firm that is (1) engaged in the business of (2) providing advice to others or issuing reports or analyses regarding securities for (3) compensation. A person must satisfy all three elements to fall within the definition of “investment adviser.” 

About the author

Mr Woodson is Executive Vice President, Head of Wealth Advisory and Family Office Services for Boston Private.  He has more than 25 years of experience within financial services and joined Boston Private from Citigroup where he served as head of the Family Office Group for Citi Private Bank in North America. Prior to joining Citi Private Bank, Mr. Woodson held senior private banking and family office positions at Credit Suisse and Merrill Lynch where, among other responsibilities, he ran a multi-family office (MFO) business and managed ultra-high-net-worth and family office clients. Mr. Woodson was also a founding member of myCFO, an integrated wealth management firm started by a number of well-known Silicon Valley technology executives.
Mr. Woodson began his career in a Big Four public accounting firm as a tax professional, where he spent almost a decade providing domestic and international tax advice to ultra-high-net-worth individuals, families and closely-held businesses. He earned a master’s degree in accounting from New York University’s Leonard N. Stern School of Business and a bachelor’s degree in economics from University of California, Irvine.