What is the Difference Between RIAs and Brokers? (Reg Bi)

Investors trade securities with the help of either Registered Investment Advisors (RIAs) or brokers. Many RIAs have dual registration – your financial advisor might be both. RIAs and brokers have different professional obligations to you as a client and various opportunities to make money from your portfolio. Awareness of these differences is essential to avoid fraud and financial misconduct.

What Do Stockbrokers Do?

Brokers fulfill several functions in the financial industry. They might research securities and keep their investors up to date on price fluctuations. Most importantly, they facilitate trading activity through principal trades and agency trades.

Principal Trades

In a principal trade, the customer orders a security transaction that falls within the broker-dealer’s inventory. The broker will either purchase or sell from its own inventory to directly satisfy the customer’s order. This solution is preferable to an agency trade – the broker has more incentive to execute trades within their own broker-dealer.

Agency Trades

Agency trades are more involved than principal trades. In an agency trade, the customer orders a particular security transaction from the broker, and the broker goes outside of their broker-dealer to bring the trade request to the appropriate market. If a client wishes to buy a security at a certain price, the broker needs to find someone wishing to sell at the same price and vice versa. To complete the trade, the broker must report the transaction to the appropriate clearinghouse.

How Do Stockbrokers Make Money?

Brokers usually charge a per-transaction commission. Ideally, brokers use their expertise to ensure their investor gets the best price possible for their trade. This insight ostensibly justifies commissions.

Typically, brokers earn a commission equal to 1% to 2% of the trade’s value. Riskier trades – like leveraged ETFs, non-traded ETFs, or variable annuities – often come with much higher commissions, sometimes as high as 10%. Broker commissions fall within a customer-provided fee schedule, and the customer receives a trade confirmation for every transaction. 

Suitable Trades

Brokers can recommend trades to their investors, provided they meet FINRA’s suitability standard. FINRA Rule 2111 specifies that an investment must meet an investor’s financial goals and risk tolerance. It’s unfortunately common for brokers to recommend unsuitable trades. A consultation with a securities attorney is often the first step to begin recovering losses.

Registered Investment Advisers

What Does a Registered Investment Adviser (RIA) Do?

An RIA typically provides advice on securities transactions to high net-worth individuals and institutional investors. Depending on how much money they oversee, RIAs must register with the SEC or their state securities regulator.

How Do Registered Investment Advisers Make Money?

RIAs often charge portfolio management fees calculated at an agreed-upon percentage with each client. The fees usually amount to a certain percentage of the client’s total assets under management or AUM. They may also choose to charge an hourly or a one-time, flat fee.

AUM fees are often billed quarterly and subtracted from the client’s account. The advisory fees are assessed on the total portfolio value at the end of each quarter. Some advisers deduct client cash balances from the total portfolio value used for assessment, while others use a reduced fee percentage for cash balances.

Securities attorneys advise clients to carefully assess their accounts to make sure their RIA is actually applying an investment strategy and not simply collecting a fee without executing transactions.

RIA Professional Titles

Only investment advisers should refer to themselves as “financial advisors.” Brokers may have also referred to themselves as financial advisors before the SEC passed Regulation Best Interest in 2019. Investment advisors are also known as asset managers, investment managers, and wealth managers. RIAs have passed an exam that qualifies them to provide financial planning advice.

RIAs offer more comprehensive financial guidance and often have full discretion to buy or sell securities in their investors’ portfolios at will. But unlike brokers, RIAs do not typically place the trades themselves.

RIAs and the Fiduciary Duty: Key Differences in Regulation

In the United States, investment advisers must adhere to the Investment Advisers Act of 1940, which calls on advisers to act as fiduciaries. Fiduciary duty, which is legally enforceable under the Advisers Act Section 206(1)/(2), prohibits advisers from “employ[ing] any device, scheme or artifice to defraud any client or prospective client.” Adhering to a fiduciary standard means that RIAs must always put their client’s best interests first. That means providing investment advice based on what is best for the client, not what may be most profitable or beneficial for the advisor. RIAs must also disclose any conflicts of interest. The SEC may bring an enforcement action against an RIA that breaches its fiduciary duty.

Brokers are Not Fiduciaries: Regulation Best Interest

This is the most critical distinction between RIAs and brokers: Brokers are not held to as high of a legal standard for their securities recommendations. FINRA’s suitability standard is easier to satisfy than the fiduciary standard. This is a controversial point in the securities industry, and policymakers like Senator Elizabeth Warren have championed the idea that brokers should also be fiduciaries. 

In 2019, Regulation Best Interest enhanced professional obligations. Under Regulation Best Interest, brokers must act in their client’s best interest when they recommend an investor roll over their investments from an employer’s 401(k) plan to something like an IRA. Regulation BI also requires that broker-dealers (not individual brokers) ensure investors only buy trades that are in their best interest, but it does not strictly define “best.” In 2019, SEC Chairman Jay Clayton stated, “Many different options may in fact be in the retail investor’s best interest, and what is the ‘best’ product is likely only to be known in hindsight.”

Zero-Commission Trading

You may have heard about the advantages of zero-commission trading and how it makes it possible for smaller retail investors to try their hand at investing. In these cases, brokerage firms like Robinhood make their money through Payment for Order Flow (PFOF). PFOF allows brokerages like Robinhood to sell their trade orders in bulk to market-makers. Market makers profit from having a large stream of orders. This system does not incentivize Robinhood to get the best price possible for each trade, and critics say this goes against the interest of investors. PFOF’s days might be numbered. Moreover, recent regulatory actions highlight alleged failures by Robinhood to consistently recommend suitable trading strategies.

Investor Education and Protection

Knowledge is power. The more you know about your broker or RIA, the better you can protect yourself from manipulation and conflicts of interest. If you believe your broker or RIA may have failed to uphold either the suitability standard or their fiduciary duty, you may be able to recover your losses with the help of a securities attorney and FINRA arbitration.