To participate in that world, investors generally engage the services of a broker or dealer in some form or fashion, making a review of those terms an interesting place to begin exploring.
Brokers
Brokers and dealers are the U.S. regulatory terms and, as is often the case with legal terms, they are not very intuitive to many people. While the words are often seen together, they actually represent two different entities. A broker executes orders on behalf of clients. To the regulators, this means the entity through which investors hold a brokerage account. To investors, it generally means the person who helps them buy and sell securities. A bit of confusion occurs here, as the industry also has lots of terms for a person who helps investors buy and sell securities, including financial advisor, investment advisor, and registered representative. For the moment, we’ll stick with the strict legal definitions to provide a baseline for further exploration.
Think of the legal entity that facilitates security trading as an agent acting on behalf of investors. When you want to buy or sell a security, the entity (in the case of online brokerage accounts for example) that helps you make that transaction is your agent. When you pay a commission to make a trade, you are making that payment to an agent. The terms agent and broker can be used interchangeably.
Full-Service vs. Discount Brokers
Brokers come in two general types, full service and discount. Full-service brokers provide one-on-one personal service. This includes providing specific investment recommendations in addition to planning and advice services that range from retirement planning, long-term care planning and estate planning to the formulation of a personal investment strategy that will help cover the cost of a child’s education, a home purchase or other financial goals. Ongoing assistance can include face-to-face meetings and periodic checkups to revisit progress toward goals. For novice investors or those too busy to plan for themselves, full-service brokers offer an array of useful services and information.
Dealers
While a broker facilitates security trades on behalf of investors, a dealer facilitates trades on behalf of itself. The terms “principal” and “dealer” can be used interchangeably. So, when you hear about big financial firms trading in their house accounts, they are acting as dealers.
Some of these dealers, known as primary dealers, also work closely with the U.S. Federal Reserve to help implement monetary policy. Primary dealers are obligated to participate in the auction of debt issued by the U.S. government. By bidding on treasury bonds and other securities, these dealers facilitate trading by creating and maintaining liquid markets. They assist in the smooth functioning of domestic securities markets as well as transactions with foreign buyers.
Dealers also play a self-governing role, to ensure correct functioning of securities markets. They are regulated by the Financial Industry Regulatory Authority (FINRA), which is responsible for administering exams for investment professionals. Some of the better-known exams include the Series 7, the Series 6 and Series 63. The Series 7 permits financial services professionals to sell security products, with the exception of commodities and futures. The primary focus of the Series 7 exam is on investment risk, tax implications, equity and fixed-income securities, mutual funds, options, retirement plans and working with investors to oversee their assets. The Series 6 designation enables investment professionals to sell mutual funds, variable annuities and insurance products. And the Series 63 enable them to sell any type of securities in a specific state. Obtaining these licenses is the first step financial services professionals need to take to get into the securities business. (For related reading, see: Breaking Down Financial Securities Licenses).
Putting It All Together
Most firms’ investors would recognize act as both brokers and dealers, and are therefore referred to as brokers-dealers by industry regulators. These firms include the primary dealers and other traditional Wall Street organizations, as well as large commercial banks, investment banks and even small independent boutique firms that cater to the wealthy.
Brokers-dealers play an important role in the financial markets, as these firms provide the infrastructure that facilitates stock trading. In fact, if you want to buy stock, you must open a brokerage account through a brokerage firm. The brokerage firm makes sure you have enough money in your account to conduct a trade, facilitates the trade by interacting with the stock exchange where the stock is traded, provides the computer systems that enact the trade and keep records of the trade. It also handles the financial transaction between the buyer and the seller and facilitates future transactions (dividends, stock splits, corporate actions such as those that occur when preferred securities are called or stock splits take place).
The Bottom Line
With the depth and complexity of industry offerings and the ever-changing nature of the industry itself, knowledge is power. The greater your grasp of the industry’s vocabulary, the more you can be sure you understand how the industry functions. This includes developing a better sense of how your investments work, the services you get in exchange for the fees that you pay, who or what provides those services and what you can expect should a dispute end up in court.
To prevent such a mishap, follow a three-step “trust, but verify” process:
1. Talk with home office product specialists. Advisors should schedule in-depth conversations with home office product specialists in key product areas. It’s helpful to take detailed notes, especially if interviewing at more than one firm.
For example, if an advisor uses outside managers, it’s important to verify not just that the managers are on the prospective firm’s platform, but that they also are available in the exact investment programs the advisor uses.
For example, if an advisor requires a particular mutual fund or SMA in the Broker as Portfolio Manager program, it’s important to verify that the fund is available in that program. Offerings in the UMA and mutual fund wrap programs should be evaluated separately.
Advisors should also obtain details on how products and platform fees are structured, so they can determine how much they’d likely charge clients at the prospective firm and how much they’d probably net.
Home office visits are often an excellent way to meet with product specialists at prospective firms. If an advisor is attending a group meeting, it’s useful to schedule separate meetings with any relevant product specialists not included in the group meeting. It’s also beneficial to keep the contact information of key product specialists.
Open items not covered in these initial meetings need to be addressed prior to the move. A more extensive round of due diligence will be scheduled once an advisor has decided to switch firms. Any issues with the transfer of investment products must be identified and planned for in advance of the move.
2. Talk with advisors at prospective firms. Advisors should speak with reps at the prospective firm who do similar types of business, including those at other branches. After all, you’re researching the prospective firm’s platform; these advisors have no vested interest in whether or not you join it. There’s no need for prospective advisors to share more than first names and the type of firm they are currently within these conversations.
Advisors can focus their questions for advisors with the prospective firm on their experience with different products and technology. The more specific the questions, the better.
How available are home office product specialists? What do you have to do to setup a seminar? What resources are available? How long does it take compliance to approve a seminar? What do you like about this firm? What firm were you with before, and how does it compare? If you could change one thing about this firm, what would it be? What kind of advisors don’t really fit in here?
3. Test drive the prospective firm’s technology. How user friendly is it? Can advisors execute their investment programs easily? Advisors should make a list of the things that they normally do on their current firm’s workstation and compare it with what the prospective firm has to offer. Are there any additional capabilities that their current firm lacks?
A thorough due diligence process is critical to an advisor’s ability to select the right firm. This process should never be rushed. And of course, advisors shouldn’t neglect “big picture items” — such as the firm’s ongoing support for technology upgrades and its overall commitment to the wealth-management business.
Following are a few examples:
Alternative investments. Recently, and in past years, we have seen brokers-dealers go out of business as a result of regulatory violations involving alternative investment products that were either fraudulent or that went bad. It is more important than ever for advisers who offer alternatives to evaluate how their broker-dealer handles these products, as many have pulled back on which companies and on how much of certain products they allow their advisers to sell. Joining a firm that understands the role of alternatives and focuses on due diligence can help advisers offer appropriate products while also keeping them safe from regulatory trouble. There are still brokers-dealers out there that specialize in providing alternatives and that haven’t had regulatory troubles.
Advisory hybrid focus. Brokers-dealers that offer a hybrid option for their advisers have an increasingly popular value proposition (see “Hybrid offers best of both worlds,” InvestmentNews, Nov. 18). Becoming a hybrid adviser allows advisers to maintain their securities license to transact commission-based business through the brokerage firm, while also operating under a fee-based model as their own registered investment adviser. Firms that offer a hybrid platform have many options, including built-in technology, costs that take advantage of economies of scale, a broad universe of product offerings, and support in areas of compliance and practice management, as well as the multiple revenue sources afforded to RIAs maintaining a broker-dealer relationship.
Low-cost provider. For advisers who conduct smaller amounts of securities business as a supplement to another business, such as an insurance or certified public accountant practice, a provider that offers a platform with lower fees may be a cost-efficient option, offering just enough support to make the affiliation worthwhile.
Retirement marketplace. Brokers-dealers that specialize in retirement offer education, technical support, access to employer groups and/or informational resources specific to 403(b) or other specialized retirement-planning services. Finding a firm that keeps up with the latest products and provides sales ideas, as well as marketing and compliance support, can help advisers to stay on top of a changing marketplace while building their practice.
Although not every broker-dealer is focused on a specific niche, I have found that advisers with a targeted audience or specific needs are best served by aligning with a firm that not only understands their business, but that can help position their practice to bring it to the next level. In fact, I often hear from advisers who once felt held back by their broker-dealer and have since built their business to new heights by joining a firm that is a better match and that could help unleash their potential.
With thousands of brokers-dealers out there, odds are, there is one that aligns with each adviser’s practice.
Defining a Broker
There are two types of brokers: regular brokers who deal directly with their clients and broker-resellers who act as intermediaries between the client and a larger broker.
Regular brokers generally are held in higher regard than broker-resellers. That’s not to say that all resellers are inherently bad, just that you need to check them out before you sign up. Regular brokers such as those who work for TD Ameritrade, Capital One Investing, and Fidelity are members of recognized organizations such as the Financial Industry Regulatory Authority (FINRA) and the Securities Investor Protection Corporation.
Full-Service or Discount Brokers
There is a further distinction between full-service brokers and discount brokers. As the name suggests, full-service brokers routinely offer individual advice and recommendations, and these services don’t come cheap. A full-service broker does much of the legwork for the investor.
Discount brokers generally leave you to make your own decisions, although many offer the option to solicit a broker for advice on a particular trade for a fee.
Some recommend a full-service broker for new investors. But frankly, it’s often not feasible for a young person to go with a more expensive full-service broker.
Today’s online discount brokers typically provide a vast array of tools for investors of all experience levels. You’ll learn a whole lot more about investing if you do the legwork yourself.
Costs and Fees
If you’re under 30, chances are you’re limited by your budget. Trade execution fees are important, but there are other brokerage fees to consider. Knowing the fees and other charges that might apply to you is essential to making the most of your investment dollar. Here are some costs to consider:
Minimums: Most brokers require a minimum balance for setting up an account. Online brokers typically have the lowest minimums, ranging from $500 to $1,000.
Margin Accounts: A new investor might not want to open a margin account right away, but it’s something to think about for the future. Margin accounts usually have higher minimum balance requirements than standard brokerage accounts. You also need to check the interest rate that your broker charges when you make a trade on margin.
Withdrawal Fees: Some brokers charge a fee to make a withdrawal, or won’t permit a withdrawal if it will drop your balance below the minimum. On the other hand, some allow you to write checks against your account, although they typically require a high minimum balance. Make sure that you understand the rules involved in removing money from an account.
Fee Structures
Some brokers have complex fee structures that make it harder to figure out what you’ll be paying. This is particularly common among broker-resellers who may use some aspect of a fee structure as a selling point to entice clients.
If a broker seems to have an unusual fee structure, it’s all the more important to make sure that it’s legitimate, that it will suit your best interests, and that the fee structure complements your investing style.
If the rates seem too good to be true, read the fine print in the account agreement and fee summaries. Additional fees can be hidden there.
Investment Styles
Your choice of broker should be influenced by your investment style. Are you a trader or a buy-and-hold investor?
Traders don’t hold onto stocks for a long time. They’re interested in quick and dirty gains based on short-term price volatility, and they may make many trade executions over a short time span.
If you envision yourself as a trader, you’ll want to look for a broker with very low execution fees, or trading fees could take a big bite out of your returns.
Also, don’t forget that active trading takes experience, and the combination of an inexperienced investor and frequent trading often results in negative returns.
A buy-and-hold investor, often called a passive investor, holds stocks for the long term. Buy-and-hold investors are content to let the value of their investments appreciate over longer periods of time.
Many investors will find that their investing style falls somewhere between the active trader and the buy-and-hold investor, in which case other factors will become important in picking the most appropriate broker.
As an alternative to a human broker or broker-reseller, it’s worth investigating the pros and cons of using a robo-advisor.
The Bottom Line
There are a number of factors to consider when picking your first broker. With Investopedia’s online broker reviews, we’ve created the most comprehensive toolset to help traders of all styles make informed, efficient, and intelligent decisions on the right online broker.
Your first broker won’t necessarily be your broker for life. Your life will change, and your needs as an investor may change along with it. But you have a much better chance of making money as an investor if you put in the time it takes to choose the right broker to start with.
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