Originally published in Financial Advisor

By Mark Hurley

Since the wealth management industry’s founding, independence – free of all of the constraints and conflicts that are endemic to traditional providers of advice – has been at the core of its very being. It was started by thousands of budding entrepreneurs who went off on their own and hung out a shingle.

But few of them did so because they wanted to make a lot of money.  Rather, they recognized that anything but truly independent, non-conflicted advice is, well, useless and they were tired of what they saw happening to unsuspecting consumers.  So they instead started their own firms so they could be different.

In recent years, however, the term “independent” has been expropriated by so many different types of advice providers – brokers, agents, you name it – that it is now bastardized beyond recognition. Yes, the same geniuses with more conflicts than the Real Housewives now proclaim that they are “independent” financial advisers.

But it is understandable why they are doing this.  The focus groups that they conduct with prospective clients have taught them that they are held in about as high esteem as that of Lois Lerner at a Tea Party convention.  So they have reinvented – or at least repackaged – themselves so as to try and blur the difference between what they do and the advice provided by truly independent advisers.

Some independent wealth managers are shedding their independence

Unfortunately, at the very same time this is happening, an unsettling trend has emerged within the industry.  More than a few firms appear to be slowly shedding their independence. And should this trend become more widespread, it is unclear to me how the industry’s participants will be that much different – or independent – than brokers at wirehouses or regional B-D’s.

Sounds a bit outrageous?  Well, what exactly does it means when one says a financial adviser is independent? I think to answer this question you have to start with what financial advisers actually do.

At their core, they are problem diagnosticians and solvers.  Clients come to them because they do not even begin to know all of the issues that they should be worried about.  A financial adviser “diagnoses” their problems and then develops and implements very personal, customized solutions.

Now consider what adding the term “independent” implies.  It suggests that the adviser both (i) has complete freedom to recommend and implement what he or she believes is best for the clients and (ii) has no financial conflicts that could in any way influence the advice provided.

To meet the first test a wealth manager must be controlled by the people who work at the firm and it is solely they who decide what advice the firm provides to its clients and how to implement it. In other words, the people who advise clients are the decisionmakers and are not influenced by any outside parties.

The second test, however, is a bit more complicated.  More specifically, financial conflicts come in all kinds of shapes and forms and some are even structural.  Moreover, there is also more than a little gray surrounding all of this.

Obviously, if what you get paid for advice is affected by in what you invest a client’s assets it is a somewhat dubious to claim that you are giving non-conflicted advice.  This alone disqualifies all “fee-based” firms from claiming to be independent.  It is kind of hard to argue when you are getting a massive commission for pushing a client into a product that the remuneration had no affect the advice that you provided.

Most independent brokers are not “independent”

It is likewise a bit disingenuous to claim to be independent if some outside gatekeeper limits the investment choices available to you for implementation. And because of this, it’s unclear to me how most independent brokers can be thought of as “independent”.

More specifically, IBDs provide a wide range of essential services and technology to their registered reps’ businesses and often make payouts as high as 90%. But how can they do this and still make money? Well, the IBDs charge a toll – a really big one – to the money managers on their platform.

Certainly, many of the best money managers – in particular, those that have limited capacity – won’t even consider paying such kickbacks. This, in turn, dramatically limits the choices that the brokers have for client solution implementation.

Compare this with firms that actually are independent.  They have no such gatekeepers and, in turn, have used their independence (and the lack of any such tolls) to bludgeon money managers into giving their clients a better deal.  Institutional classes of mutual funds are a good example of this and were created solely because the best advisers demanded them.

Even some independent Fee-Only firms aren’t quite “independent”

So what are we left with?  Clearly, most Fee-Only wealth managers who largely custody with one or more of the big four (i.e., Fidelity, Schwab, TDAmeritrade and BONY/Pershing) and that have a team of experienced and qualified professional staff who own their firms are independent.

However, even some of these appear to be headed down a slippery slope.  More specifically, several firms (including some large ones found on several “Best Wealth Managers” lists) now offer premium-priced, in-house investment products.  Although there are many variants of such offerings, the most popular ones appear to be those that purport to protect clients from another 2008-2009 crash while at the same time claiming to retain most of the market’s upside.

Of course, the area of product development by wealth managers is by no means black and white.  Many wealth managers directly invest their clients’ assets as part of their service and do a great job of it.  They have a duty to find ways to improve client outcomes and the readily available investment options are often less than ideal for solving certain client problems.

Moreover, creating products to address specific client problems can be very expensive for wealth managers. And it is not unreasonable to pass through the incremental costs to the clients who need these products.

Unfortunately, some firms have gone far beyond this.  They are now fabricating extremely complicated quantitative derivatives-based products. Even worse these products make them a boatload more money than if they just collect their traditional advisory fees.

So why are they doing this?  Certainly, a small minority of these firms have rapacious owners.  For many years these individuals have squeezed every dollar they could out of their firms and cramming house product down client throats is just another way of maximizing profitability while still pretending to provide independent advice.

However, it appears most of these owners are instead driven by a combination of frustration, boredom and hubris. Many have big firms and the law of large numbers has finally caught up with them.  While they continue to add clients, their relative growth rates are understandably shrinking, frustrating the daylights out of their owners.  Getting into the product manufacturing business appears to be a way to grow much faster rather than having to gradually build a much bigger firm.

Equally important, more than a few of their owners are bored.  They have been operating wealth managers for so long that, for them, the idea of slowly growing by adding one client at a time over the next decade is about as attractive as having a colonoscopy without an anesthetic. And creating and managing very sophisticated in-house products is so much more interesting.

Obviously, it is kind of bizarre (if not delusional) that so many wealth managers believe that they actually that they can do a much better job of investing client funds in  extremely complicated strategies involving derivatives than most outside money managers.  But then again, never let it be said that the owners of wealth managers lack self-confidence.

Regardless, it is clear that these firms are slipping out of the gray and into the black.   In effect, they are evolving from wealth managers into investment managers that use their financial advisors to distribute their products. And how they are different than firms like Goldman Sachs or JP Morgan or even the wirehouses is beyond me.  More strikingly, perhaps the traditional providers of advice are not alone in pretending to be independent.

Mark Hurley is founder and CEO of Fiduciary Network.