Glasses of water

When Two Hats Are Not Better than One

Glasses of water

As a registered investment adviser that is regulated under the Investment Advisers Act of 1940, one of the fiduciary duties that Index Fund Advisors owes to its clients is to seek out best execution for their trades. We fulfill this requirement by placing client assets with well-established brokerage firms, such as Schwab, Fidelity, and TDAmeritrade that regularly provide us with data showing that they are meeting the standard of good execution of client trades. For mutual funds, this is not an important issue since all traders receive the same price at the market close, but it is an important consideration when clients begin with a portfolio of equities or exchange-traded funds that we liquidate prior to placing them into one of the IFA Index Portfolios.

Occasionally, we review the portfolios of prospective clients where the same firm is acting in the dual capacity of their investment advisor and their broker. We consider this to be a serious red flag, and a recent press release from the U.S. Securities and Exchange Commission (SEC) reinforces that opinion. The SEC sanctioned two investment advisory firms for failing to seek best execution on client trades placed with their in-house brokerage divisions.

First, the SEC found that New York-based A.R. Schmeidler & Co. (ARS), which is a dually registered investment adviser and broker-dealer, failed to reevaluate whether it was providing best execution for its advisory clients when it negotiated more favorable terms with its clearing firm. This resulted in ARS retaining a greater share of the commissions it received from clients. ARS agreed to pay more than $1 million to settle the charges.

A separate SEC investigation found that Gregory W. Goelzer and his Indianapolis-based dually registered firm Goelzer Investment Management (GIM) made misrepresentations to its clients about the process of selecting itself as the broker for its advisory clients. The firm failed to seek best execution for its clients by neglecting to conduct a comparative analysis of brokerage options as was promised in its Form ADV. Goezler and GIM agreed to pay nearly $500,000 to settle the charges.

Andrew Ceresney, the Co-Director of the SEC’s Division of Enforcement, stated that these two cases should send a clear message to dually registered investment advisers and broker-dealers that they will not be given a free pass with regard to seeking best execution for their clients. Marshall S. Sprung, Co-Chief of the SEC Enforcement Division’s Asset Management Unit added, “There is a clear conflict of interest when investment advisers execute client trades through their broker-dealer arm. The unit is focused on pursuing dually registered firms that fail to address this conflict through robust disclosure, best execution analysis, and compliance procedures.”

At IFA, our advice to investors is to simply avoid this conflict of interest by avoiding dually registered firms. One problem we have often seen when reviewing these situations is an excessive level of trading (churning) in client accounts, which is exactly what we would expect when the adviser receives a payment for each trade placed. Another reason to steer clear of dually registered firms is to reduce the probability of becoming a victim of financial fraud. As we have pointed out many times, one of the red flags of the Ponzi king Bernie Madoff was his dual role as both adviser and custodian of assets.

If you would like to learn more about the importance of holding your assets at reputable firms that have never required a federal bailout, please call us at 888-643-3133.