The term “hybrid” implies having the best of both worlds. Examples that come to mind include golf clubs, smartphones and environmentally friendly automobiles that save on gas.
In the financial services industry, the word hybrid has been applied to an increasingly broad range of investment products, in-cluding hybrid securities featuring qualities of both debt and equities, hybrid annuities with the stability of a fixed annuity and the potential up-side of a variable annuity, and hybrid mortgages with both fixed and adjustable interest rate components.
Although hybrid financial products are fairly clearly defined, “hybrid” remains a confusing term on the advisory side of the financial industry, especially when combined with “registered investment adviser.”
This is further complicated by the fact that “RIA” seems to refer to an individual but really refers to a corporate structure. The resulting confusion makes it difficult for financial advisers to make informed decisions regarding the options for structuring their businesses.
Before getting into the roots of the confusion, it is important to understand the fundamental construct of the three models under which advisers most commonly operate:
Traditional broker-dealer representative. Advisers either can be employed directly by a wirehouse or be an independent financial adviser affiliated with an independent broker-dealer. Advisers process all transactional/commissionable business through the -broker-dealer as registered representatives of that firm. They also may provide advisory services under the broker-dealer firm's corporate RIA.
Fee-only RIA. Under this model, advisers register with their domicile state or with the Securities and Exchange Commission to form their own RIA. The RIA uses a custodian to hold client assets, and provide back-office service and processing. The advisers working under this RIA may not sell commission-based products because they aren't registered reps of a broker-dealer.
Hybrid RIA. This third structure is identical to the fee-only RIA model, except besides providing advisory services, advisers can process commission-based business because they also are registered reps of a broker-dealer.
Over the past decade, the hybrid-RIA marketplace has grown considerably.
Hybrid RIAs grew to 15% of the industry last year, from 7% in 2004, and the growth rate continues to outpace that of fee-only RIA and traditional broker-dealer models by a wide margin, according to investment services consultant Cerulli Associates Inc.
Indeed, the hybrid RIA sounds like the solution, and for many advisers, it is. The trouble is that seemingly every firm now claims to support this model, and every adviser claims to be one — without agreeing on a consistent definition of what a hybrid RIA is.
Within the industry, several custodians claim to serve the hybrid RIA but in reality serve only the custody function for this type of firm. The registered rep duties of the hybrid RIA's advisers still must be conducted through a separate broker-dealer.
Similarly, a number of independent broker-dealers claim to offer a hybrid-RIA platform, but the majority of the time, they are actually referring either to the traditional broker-dealer model, a joint venture with a third-party custodian or a fee-only RIA custody opportunity.
The confusion about what constitutes a hybrid RIA makes it challenging for advisers to answer the basic question: “Is the hybrid RIA model right for my business?”
The answer is, it depends.
Each model has benefits and drawbacks. The traditional broker-dealer offering provides compliance support, back-office services and practice management resources that an RIA firm usually doesn't have in-house. This model is ideally suited for adviser practices that are expanding their fee-based business or larger firms that are able to work well within the guidelines of the broker-dealer's corporate RIA structure.
Meanwhile, the fee-only-RIA model allows for greater flexibility and control of investment policy but carries with it an increase in liability and responsibility. It is a good fit for firms that have very little commission business (less than 10%) and want to add services beyond the scope that a broker-dealer or corporate RIA might allow (creating a hedge fund, a 1940 Act fund, etc.).
These firms lose access to certain product types and may find that prospective clients have investment positions that they aren't able to manage in their current form (alternative investments, legacy variable annuities, Section 529 college savings plans, etc.).
Finally, the hybrid-RIA model provides the key attributes of both worlds. It is best suited for larger fee-based advisory firms looking for more flexibility and control than a corporate RIA allows but that still want the full suite of products that a broker-dealer offers and the support services that go along with those offerings.
Through this optimized hybrid model, advisers benefit because they are working with integrated technology that supports both sides of their business.
Ultimately, the appropriateness of the hybrid-RIA model is a personal decision based on the unique needs of the adviser.
We consult with thousands of established and prospective advisers, and have found that there is no universal answer.
The right model today may not be the right model in five years, as economic and regulatory environments evolve along with adviser needs. This demonstrates how important it is for advisers to work with partners who can support them as their business not only grows but also evolves in new directions.
The key for advisers is to understand where they want to take their practice and to get the guidance to make informed decisions.
Matthew Enyedi is senior vice president of RIA services at LPL Financial LLC.