Custodians' payments to RIAs for fund picks raise eyebrows

'Shareholder service' expenses paid by Schwab and Fidelity from no-transaction-fee funds

Jun 26, 2015 @ 4:15 pm

By Mason Braswell

Registered investment advisers like to promote themselves as being on the side of investors, but a growing number are quietly accepting money from custodians in exchange for recommending certain mutual funds — usually funds that are more expensive for investors. The payment is made to advisers as a “shareholder services fee.”

Under terms of such an arrangement, Charles Schwab & Co. Inc. and Fidelity Investments, the nation's No. 1 and No. 3 custodians for advisers, respectively, pay advisers up to 0.2% of assets held in certain no-transaction-fee mutual funds.

“We think this is one of the most egregious [conflicts of interest] we've seen in recent years, and it seems to be more widely practiced,” said Tom Nally, head of TD Ameritrade Institutional, the No. 2 custodian for advisers, which does not pay such fees. “It's a problem. It adds an element of bias that most clients probably don't understand.”

The payment of shareholder services fees is being driven, in part, by the growth of breakaway brokers, Mr. Nally said. Indeed, brokers at wirehouses are used to receiving trails, or service fees, on mutual funds, and this practice allows them to continue doing that as an RIA.

“To me, it sounds like a commission, and clients approach the adviser operating under the banner of fiduciary expecting those biases to not exist,” Mr. Nally said.

Advisers who accept such payments are required to disclose the arrangement in Part 2 of their Form ADV, which is filed with the Securities and Exchange Commission. The problem, however, is that few investors likely know where to look for such disclosures or how to interpret them.

Ric Edelman, founder of Edelman Financial Services, a fee-only firm that manages about $14 billion in assets, is one adviser who avoids the practice altogether.

“It would not occur to us to collect a fee from the custodian that is directly tied to the client's investment,” he said. “Advisers need to generate revenue, but they need to be careful that the methodology they're using doesn't create a harmful impact on the client.”

Matt Cooper, president at Beacon Pointe Wealth Advisors, agrees.

“We don't participate in that because we would see that as a direct conflict of interest,” he said.

Schwab and Fidelity declined to disclose how many such agreements they have in place with advisers.

Among firms who accept such payments are HighTower Advisors, a firm with $30 billion in assets under management; Mariner Wealth Advisors, with more than $10 billion; GV Financial Advisors Inc., with $1.2 billion; and Encompass Wealth Advisors, a firm founded last year by former Morgan Stanley Wealth Management brokers who had managed $650 million.

“HighTower Advisors has arrangements with its custodians whereby the custodian pays HighTower Securities a fee equal to a fixed percentage of the total assets in certain mutual funds,” the firm's RIA unit disclosed in its investment brochure filed with the SEC. “HighTower Advisors has a potential conflict of interest in recommending to clients that they use a specific custodian and invest their assets in certain mutual funds.”

HighTower's chief executive, Elliot Weissbluth, declined to comment.

The firm does say in brochures, however, that it will offset client fees in certain cases.

Mariner also discloses receiving the payments and the related conflicts.

“Mariner's receipt of this compensation may create conflicts of interest in our recommending investments,” the firm acknowledged on Page 20 of its 30-page investment brochure.

A spokeswoman for Mariner, Christa Spencer, declined to comment. “Not because we think it's bad,” she explained. “We love the program.”

Encompass disclosed that it is paid 0.17% of assets on certain mutual funds on Fidelity's no-transaction-fee program, and GV Financial said it is paid 0.16% of assets for money it directs to the platform.

Repeated telephone calls to Encompass and GV Financial were not returned.

The no-transaction-fee funds are generally more costly in the long term because of expense ratios, observers say. No-transaction-fee funds at Schwab, for example, can run as high as 0.45% of assets, while transaction funds not part of its OneSource platform typically carry a fee of around 0.1%.

A spokesman for Schwab, Rob Farmer, wrote in an email that the custodian has “very few” of these agreements in place and that those firms must disclose the relationship on their ADV.

A spokeswoman for Fidelity, Nicole Abbott, said the payments are made in order to help firms defray the cost of “shareholder support,” which includes back office, administrative and custodial support services.

“These are not selling or promoting mutual funds,” she wrote in an email.

“We don't see this as a growing trend in the industry,” she added.

Regulators have been paying attention, although the ultimate test over the legality of the agreements is how they are disclosed.

The SEC in September brought a case against an Houston adviser, Mark Robare, whom it accused of failing to disclose the 12 basis points he received from Fidelity on assets in no-transaction-fee funds.

An SEC judge ultimately ruled, however, that the wording of Mr. Robare's disclosure was adequate and dismissed the charges. But the message was clear, said Les Abromovitz, an attorney and compliance consultant with NCS Client Services who has no involvement with the case.

“Although the RIA ultimately prevailed in this case, it is imperative that firms fully disclose all revenue-sharing arrangements that create a potential conflict of interest,” he wrote in a note to clients. “Material conflicts of interest must be thoroughly disclosed on Form ADV.”

A spokeswoman for the SEC, Judith A. Burns, did not return calls and emails requesting comment on whether the SEC was still focused on the revenue-sharing agreements.

Critics say that the disclosure may not be enough, even if it is meets the legal standard.

“It's legal if it's disclosed properly, but that doesn't make it right,” said Ron Rhoades, a professor and expert in fiduciary duties of registered investment advisers. “It could affect somebody's judgment in terms of the products that they select for the client.”

“I'm disturbed by it,” he added.

In a well-publicized incident in 2013, New York-based Sontag Advisors, which has more than $4 billion in assets, ended the practice after it was featured in a story by Reuters that shed a negative light on the fees it was receiving.

“It looked dirtier than it was,” Howard Sontag, founder of the firm, said in an interview. “But there's an appearance of impropriety when one points out that if you do X you get paid more than if you do Y.”

He said he thought he was doing the right thing because his firm was using the revenue-sharing agreements to help lower the costs of services he provided to clients. The decision resulted in the loss of a “not insignificant” amount of revenue, and the firm took a “direct hit to the bottom line,” Mr. Sontag said.

“If you take a firm that's our size and just multiply the small dollars by a large quantity, it adds up to a meaningful number,” he said.

Still, Mr. Sontag, who is on the advisory council of Fidelity, said he is happy with his decision to accept the payments no longer.

“We didn't want to be in a situation of having to prove something that what's provable,” he said. “The right place to be is to be able to say, 'We're fee-based and what you see is what you get, and that's it.'”

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