Shift Towards Fee-Based Services Raises Oversight Issues

Terry Flanagan

Broker-dealers are struggling to retain control of advisors who are increasingly empowered to make their own decisions and trade securities in client portfolios, following a trend towards fee-based relationships and away from brokerage or commission-based relationships.

“From the broker-dealers’ perspective, this trend is a compliance nightmare as they must have a system and process to track trading activities of their advisors and portfolio holdings in accordance with both the firm’s policies and the client’s investment policy statement,” said Rob Klapprodt, president of Vestmark, a provider of investment management software.

As part of this larger trend, portfolios directly managed by the financial advisor on a discretionary or non-discretionary basis—collectively known as advisor directed programs—are growing the fastest.

While the shift is creating opportunities for advisors as well as broker-dealers, it is also creating significant compliance challenges.

According to the Money Management Institute (MMI), a national association for the managed investment solutions and wealth management industry, assets across the managed accounts industry increased by 7.6% in 2011 as compared to the growth rate of the S&P of 2.1% or the Russell of 1.0%.

This indicates that assets are flowing into fee-based accounts at a rate greater than can be accounted for by overall market appreciation.

“About $200 billion in assets flowed into advisor directed programs last year, with rep as manager programs seeing 12% year over year growth,” said Klapprodt.

One of the major impact areas is the growth of hybrid advisors, who are registered with the Securities and Exchange Commission for fee-based services on the registered investment advisor side of the business, and with securities regulator Finra on the commission-based side.

Earlier this month, Finra fined four big banks for selling leveraged and inverse exchange-traded funds “without reasonable supervision and for not having a reasonable basis for recommending the securities”.

The action suggests that buy side as well as sell side market participants should have a thorough knowledge of any products that will eventually make it into the hands of the end-user investor.

“With anything perceived as complex, you need to have adequate training—regulators are looking at whether people understand the risks,” said Tony Davidow, ETF strategist at Guggenheim Investments, which manages $125 billion including $12 billion in ETFs. “There is a spotlight on ETFs because the sector has grown so rapidly. That’s not necessarily a bad thing.”

The hybrid business model is a natural evolution of the commission- and fee-based business models.

This challenge is magnified by the fact that fee-based advisory relationships often span both Finra and SEC regulatory requirements, depending on their model and accounts offered.

“In the world of managed accounts and fee-based programs, broker-dealers need to be aware of client-mandated restrictions,” said Klapprodt at Vestmark. “They must maintain oversight over client portfolios.”

Vestmark has introduced compliance capabilities for fee-based accounts within its flagship VestmarkONE platform.

The capabilities span pre-trade compliance, post-trade compliance, enforcement of client-specific restrictions and guardrails across discretionary and non-discretionary advisory programs.

“We are providing broker-dealers with the compliance functions needed to monitor their wealth management initiatives,” said Klapprodt.

A major compliance issue is the Order Audit Trail System (Oats), established by Finra as an integrated audit trail of order, quote and trade information for Nasdaq and OTC equity securities.

Finra uses this audit trail system to recreate events in the life cycle of orders and more completely monitor the trading practices of member firms.

“Firms that are moving toward allowing non-discretionary trading by their reps/advisors in fee-based settings must ensure they have a solution to remain Oats compliant,” said Klapprodt.

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