According to a survey conducted from April 12 -16, 2007, the average pre-retiree could not distinguish between a stockbroker and a registered investment advisor in order to determine who they should be listening to for retirement planning. The Consumer Federation of America (CFA), a consumer advocacy organization, and Zero Alpha Group (ZAG), a group of fee-only investment advisers, canvassed 1,073 individuals who “described themselves as investors,” according to Graham Hueber, senior research associate, Opinion Research Corporation, the firm that conducted the “Investor Knowledge of Stockbrokers and Financial Planners” study for ZAG/CFA.

More than half the investors polled—54%—looked “to stockbrokers for more than transactional assistance,” and 29% said that “financial advice is the ‘primary’ service” that stockbrokers offer. Both misapprehensions could spell disappointment for retirees.

Majority Want Protective Laws

Significantly, 92% thought that, for the same type of services, financial planners and stockbrokers should be covered by the “same investor protection rules.” This is where the public is overwhelmingly mistaken. Apparently, if they knew better, more than half would be less likely to use a “stockbroker providing investment advice” if operating under “weaker investor protection rules than a financial planner,” according to the report.

Prudent standards demand that all of your advisers owe their first loyalty to your interests, not their own. The fiduciary standard is what people typically rely on for important issues in medicine, law and finances.

How do you find someone who is dedicated to your goals and objectives?

If they don’t offer advice, what do brokers do? According to the act, a broker is, “Any person engaged in the business of effecting transactions in securities for the account of others, but does not include a bank.” The key word is effecting, which means that brokers make the trades happen. They encourage and facilitate the transaction. Today’s brokers sell financial products to customers for a fee.

By Law, Brokers are not Investment Advisors

While advisors must act in their client’s best interest at all times, brokers do not face this requirement. Brokers must understand their client’s financial picture and direct them towards appropriate products. Advisers are sworn to put their clients’ interests ahead of their own, in accordance with the Investment Advisors Act of 1940. The Act defines an advisor as, “Any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.” The Act specifically precludes brokers from being considered investment advisers.

Like any street, Wall Street has two sides. If retail investors are on the sell side (sold at the offer) then large institutions are on the buy side (bought at the bid.) For them, stock is an investment that must achieve certain returns in the face of various macroeconomic factors.
Generally, buy-side refers to professional money managers, each of which is contractually bound to act as a fiduciary for the people who pay him.

The issue is sometimes confused because investment banks also have buy-side parts to them, which manage money for others. In an effort to stop any leaks and clear up any confusion, investment bank managers create a legal device called a Chinese Wall.  The "Wall"  is a series of policies which aim to prevent information exchange between those selling to the public and those buying for institutions.

Buy-side institutions include:

• Mutual funds
• Pension funds
• Hedge funds
• Institutional firms
• Sovereign wealth funds

The Buy-Side Silence

Who speaks does not know, who knows does not speak - Lao Tzu

Any buy-side analyst can get as much information as any retail investor on a given company. Using only that information would violate prudent standards, however. Institutions know the potential for abuse with sell-side literature and duty to investigate with due diligence any such claims. For some managers, that means reviewing publicly available accounting reports and then analyzing them in a specific, proprietary way.

Other managers will actually visit the companies and talk to employees on a plant tour. These tire kickers think they can get a better idea of whether or not to invest by actually looking over the place. In either case, the buy-side analyst gathers information in order to create his own vision of the future. In effect, the management team of an actively managed fund tries to predict the future. There is no advantage to investing if you don’t know “just a little more.”  The vision they create remains private; no one shares it with the world.

When Advertising Masquerades as Information

Whenever you hear of an upgrade, downgrade or price target, you’re listening to an advertisement. The buy-side keeps its opinions to itself, because it has a duty to do so. Its members have paid for the research they produce. The public has no right to it.

Buy-Side Meets Sell-Side

It used to be that large institutions and small investors were consigned to meet in one place: The New York Stock Exchange. Trading also took place on “the curb” (the AMEX) as well as in Philadelphia. However, New York offered a central location for those with the greatest liquidity needs. Buy-side managers used to place large orders with specialists on the New York Stock Exchange (NYSE) and these firms would gradually execute the orders throughout the course of one or several days. In cases where large blocks of stock needed to change hands, a sudden market order would upset the price to the disadvantage of the institution.

Greater information exchange over the internet and even television made large trades too visible to speculators. Today, your simple online trading platform (which you can get for free from a discount broker) will show you where the liquidity in many issues lies. You can see large blocks of stock offered for sale or you can see prices at which buyers will take thousands of shares. This information makes buy-side managers very uncomfortable, as it should. A smart speculator who sees where liquidity lies or detects changes can insert his own order and make a buy more expensive or a sell less profitable for an institutional manager.

Now, buy-side institutions make their trades away from the prying eyes of speculators in “Dark Liquidity Pools.” This mysterious sounding phrase refers to a series of electronic trades that can take place in small bits on many exchanges across the world without giving anyone a clue that a particular fund is divesting or investing in a company. Contrast this with the orders that retail investors use, and you’ll see that any edge you might have as an individual will be particularly hard won and entirely non-existent if you do not take into account the way that these sophisticated managers work. The moral of the story is simply this: If you engage in retail trading, and you buy a stock from someone, you should ask yourself what that person knew that made him want to sell it to you.

In both bull and bear markets, popular media advise strongly that lower fees guarantee a larger return. After all, if you avoid a 1% fee, then you have 1% more money for yourself. John Bogle, founder of Vanguard funds, advocates that individual investors pare away most all fees and “take what the market gives them.”

Prudent experts know that fees can impede return. On the other hand, the expert has a positive duty to make sure that each part of the trust operates smoothly and that often requires delegation. In order to delegate, the advisor must be sure that the service you get adds value to your overall portfolio, either in terms of safety or return. Additionally, he needs to be sure that the fees each expert delegate charges reasonable and customary fees for the services he delivers.

Most importantly, a Prudent Fiduciary may not have a set opinion about fees or commissions, but instead must investigate which of these are necessary and reasonable.

Actual Benefits, not Manner of Compensation Guide Decisions

As an example, it may not be worthwhile for a CFP advisor to spend an hour or two on life insurance planning for a 40 year old with a spouse and two children when the same work can be done at no additional cost by a competent insurance agent. Incurring a fee over and above a commission on that issue simply does not make sense. The client requires competent planning, and if there was a prejudice about fee only issues, then the cost of the service would be greater than it needed to be.

Perhaps the hottest button for investors is the question of mutual fund and advisor fees. With the availability of very inexpensive ETF’s (Exchange Traded Funds,) some would think that mutual funds are a thing of the past. If no one can choose stocks consistently in such a way as to outperform the market, then paying for these services makes no sense. And the popular press is filled with quotes about managers who can’t beat the market net of fees. In light of the fact that individuals and institutions pay billions of dollars per year to portfolio managers, a Prudent expert must examine this statement carefully. On closer examination, the common thinking about stock pickers may be a bit of journalistic sophistry.

Skilled Managers May Reduce Risk

Those who subscribe to the strong form of the Efficient Market Hypothesis must believe that no manger can gain an advantage in choosing stocks at any time. Each price at every time is perfectly correct because of the accumulated wisdom of “the market.” Those who believe the weak form of the EMH may allow that some managers have skill, but that a given investor could not tell whether a particular manger was lucky or skilled.

In fact, it may be that paying a portfolio expert to choose certain stocks over others is money well spent. A Fiduciary Expert knows and uses various means to determine if indeed the managers are worth their fees.

So while the press may lead you to believe that the only way to invest is through the use of very low cost measures, it’s worth remembering that some valuable services are worth paying for.

Portfolio management serves two purposes; a manager or advisor needs to control risk and work to capture returns. An expert prudently diversifies the portfolio to protect against systematic risk. A good advisor will go to great lengths working to decrease the vagaries of market prices. Market volatility harms those making periodic withdrawals from their accounts. Volatility can as easily aid them, when prices move higher, but safety considerations deal with the downside risk.

Buy and Hold is not the Answer

Academic research over the last half century, as well as recent experience shows us that there may be no ultimate buy and hold strategy. The “solid names” in the stock market can as easily respond to macroeconomic factors as any other stocks. The idea that one could construct a finite portfolio that would last into perpetuity dates from the beginning of the last century, before expertise in portfolio management and asset allocation began.

Earnings power is the second half of portfolio management. Anyone can get some information, like earnings per share number or price to earnings ratio. Not everyone can properly evaluate more esoteric issues like retained earnings and diluted earnings per share. In order to properly evaluate the purchase of a company, these details should be examined for every individual even when the individual must delegate the task.

Dividends May not be a Key to Value

Dividends, a cash back form of earnings may or may not provide more value than stocks which do not pay them. In the early 20th century, transaction prices for any stock trade often represented 6% of the total transaction in trading and spread costs. Someone who wanted retirement income or income for pensioners could avoid those costs if he could find a stock that turned out cash dividends. The income requirement for the portfolio might be had in its entirety or at least augmented by income that was transaction cost free.

Even today, some investors chase high dividend stock issues like Canadian Investment Trusts or try to find the highest interest rate with New Zealand Bonds both of which purport to deliver up to 13% in cash dividends. While investments such as these cannot be categorically denied, the Prudent investor will asses the inherent risk of the return stream before purchasing any. Further, a portfolio with proper asset allocation will have a relatively lower number of such issues compared to the total portfolio value.

Part of the reason that Dividend Reinvestment Programs (DRIPS) have waxed and waned in popularity is the transaction free nature of the reinvestment. Few investors in these programs have a large enough portfolio to properly diversify against the risks they invariably take by over-weighting only dividend reinvestable stocks in order to participate in the program.