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The SEC needs to clean up its semantics before accusing RIAs of inflating AUM

Advisors stretching for the $100-million mark advisors need to be told what assets to count and which ones are merely hanging out

Monday, January 28, 2013 – 4:39 AM by Guest Columnist Jack Waymire
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Jack Waymire: A high percentage of investors, in particular investors with larger asset amounts, believe bigger is better.

Brooke’s Note: Please allow me a chuckle. Us journalists almost always ask RIAs what asset they have under management in interviews. Often we get blasted for asking for this information because it is deemed impertinent — and we’re made to feel like we’re asking a man his jock size or a woman her…never mind. I have been blasted, too, for running an AUM amount provided by an advisor that differs (usually it’s much higher) from the ADV that an alert reader checks. We generally err on the side of trusting our readers about what assets they say they manage. So it is with some amusement that we present this column showing that we as journalists are not really causing the AUM problem. It’s more like we’re caught in the crossfire.

SEC definitions and business practices have been changing due to Dodd-Frank and scams that have damaged investors. The commission is expanding disclosure requirements and tightening the information that is reported by advisors — no more vague responses due to questions that were subject to interpretation. See: Cheat sheet for recent SEC regulatory changes and amendments.

However, before the SEC expands its scrutiny, it should clean up the confusion that impacts the calculation of assets under management, AUM. The goal should be a clear, uniform definition of what exactly it means to say that an advisor manages assets. It needs to make sense to investors when they view the information supplied by multiple advisors.

SEC prestige

Some advisors deliberately fudge their numbers to appear bigger than they really are to hit the coveted $100 million mark so they can be regulated by the Secutities and Exchange Commisssion and not states. This is blatant misrepresentation. Does an inflated AUM number mislead investors? Sure it does. Investors gravitate to AUM because it is an easy number to understand.

There is a certain amount of prestige associated with SEC registration. A high percentage of investors, in particular investors with larger asset amounts, believe bigger is better. For example, investors may believe that bigger firms have more resources than smaller firms; that firms are big because they deliver superior results; or that big firms are safer choices than small firms. See: RIAs switching to state registration may be examined by a second regulator, too

Then there are aggressive advisors who include assets that do not belong in the number. An example of this would be including assets inside variable annuity contracts. See: Study: Variable annuity providers show some gains in tackling RIA market.

But some advisors are genuinely confused about such calculations. For example, do they include assets in partnerships? How about proprietary products?

Deconstructing the AUM code

Most of the confusion is tied to the ADV definition for regulatory assets under management. The SEC says the AUM number is based on continuous and regular supervisory or management services to securities portfolios (Part IA, 5F). See: What advisors should know about the next sweeping change: the switch from SEC oversight to state regulation.

Let’s break this definition down.

Continuous is pretty straightforward. The services must be continuous as in the ongoing management of portfolios of securities. That excludes one-time services that occur when reps sell investment products. I believe the word “regular” means the same thing as continuous. For example, an investor receives a performance report on a “regular” basis — each calendar quarter.

Supervisory or management, on the other hand, may be more confusing. I assume supervisory covers non-discretionary assets and management covers discretionary assets. This belief is based on the SEC’s requirement that RIAs list non-discretionary and discretionary assets separately on their ADVs. However, there is no supervision of non-discretionary assets. Advisors provide advice and monitor performance, but they do not supervise. That is reserved for discretionary relationships that have assets that are managed by advisory firms. See: 6 reasons why RIAS can’t — or don’t want to — have track records.

Management appears to be a relatively clear term. It covers discretionary assets when the advisory firm is clearly the decision-maker. Discretion is based on a limited-trading-authority clause in service agreements that allow advisory firms to conduct research, make buy/sell decisions, and execute transactions without client approval in advance. See: How a Chicago RIA grew to more than $700 million by carving out a client niche of wirehouse execs.

A matter of discretion

Next is the use of the term securities portfolios. Based on the traditional definition, this refers to portfolios that are invested in stocks, bonds, and cash equivalents. Mutual fund shares are not thought of as securities. See: The SEC will often 'tell’ advisors what compliance issues deserve attention.

But, in its glossary, the SEC expands this definition when it says: _Your firm also has discretionary authority if it has the authority to decide which investment advisors to retain on behalf of the client. The definition of securities portfolios is no longer limited to securities when AUM includes investment advisors who are the actual money managers. Consequently, AUM includes assets that are invested through pooled and separate-account managers.

This creates another layer of confusion, because RIAs also have non-discretionary relationships with investors who use mutual funds and other types of professional money management. For example, an RIA may recommend the purchase or sale of a mutual fund, but have no discretionary authority to execute the transaction on its own. See: Why many RIAs should start a mutual fund, considering the limitations of SMAs.

The broad definition of AUM that is emerging from the clutter is that they include discretionary and non-discretionary assets that are invested in securities, mutual funds and other types of pooled or separately managed accounts. Therefore, AUM should be AUMA —as in assets under management (discretionary assets) and advisement (non-discretionary assets). And, for assets to count, the service agreement must be between an investor and an RIA, not a broker-dealer.

Lastly, the advisory firm’s method of compensation is a fee, not a commission. Why fees? Because fees compensate advisors for continuous and regular services. Based on this definition, the addition of advisory assets to the AUM calculation is not a way to inflate firm assets. Every investor has to choose between discretionary and non-discretionary relationships when they select financial advisors. Regardless of the relationship they choose, both types of assets should be included in the AUM calculation.

Jack Waymire spent 28 years in the financial services industry. For 21 years he was president of an RIA that provided wealth management services to more than 50,000 individual and institutional investors. He is the author of “Who’s Watching Your Money?” and the founder of PaladinRegistry.com, a website that provides free advisor research, ratings and reports to investors. He is a columnist for Worth magazine and a contributor to major financial websites, and is frequently quoted by the media.

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Richard Cox

Richard Cox

January 28, 2013 — 9:00 PM

Some noted exceptions to the Variable Contracts comment. We find that in the circumstance where a financial planner is dual registered as both a RIA/RR and has entered into an advisory agreement to provide financial planning services for a fee it could be interpreted that even Variable Annuities (because they are defined as a security) and additional services offered under the RIA planning engagement, may subject those assets to inclusion. We surmise that regardless of commission compensation or the absence of fee based compensation, would not necessarily exempt those assets. Further, if the Annuity owner has allowed the RIA/RR specific rights to discuss the contract with the issuer and allow investment direction may likewise subject those assets to the SEC definition of AUM. From our review the RIA compensation method can be potentially used as proof of a supervisory relationship when an advisory fee is changed the client, but lack of feed based compensation or the presence of commission based compensation does not exclude such assets. One must examine the client relationship, and if the client has engaged the Advisory Representative under a planning engagement, it may require an examination of the services provided under such agreement. If routine monitoring and updating of the financial plan also includes the re-evaluation of assets or regular rebalancing to a target allocation, inclusion may be triggered. In these examples an advisory relationship may exist and could subject commission based brokerage accounts or variable contracts to inclusion of AUM. So, what is included when an advisor is doing the calculation? We contend it is Covered Assets under any SEC definition of rendering investment advice, supervision, or direction over any security, regardless of compensation.

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