In the early days of the Registered Investment Adviser (RIA), financial advisors who didn’t affiliate with a broker-dealer had no way to actually manage investment accounts on behalf of their clients… short of having clients open “retail” investment accounts with direct-to-consumer “retail” brokerage platforms, and grant their advisor a limited power of attorney to call in (pre-internet!) and place trades on their behalf, which was a win for the client (who had their portfolio managed), the advisor (who had a platform to manage their client portfolios), and the brokerage firm itself (that generated trading commissions every time an advisor traded on behalf of their clients). In the decades since, the nature of RIA platforms has evolved tremendously, from advisors phoning in trades to an entire ecosystem of RIA custodians providing trading, billing, and supporting technology for RIAs to use… but still all predicated on a model where the brokerage-firm-as-RIA-custodian profits from advisors at the expense of their clients.
In this guest post, Yang Xu – CEO of TradingFront which competes for RIA custody services in partnership with Interactive Brokers – explores how the RIA custodian business model continues to evolve, why the recent onset of zero-commission trading has merely shifted how (but usually not whether) clients are paying for trading, and how advisors can do their due diligence to understand the real investment costs that clients may face (and revenue sources that RIA custodians still generate) through the platforms that RIAs purportedly use for “free” (as in the end, “free” rarely ever is).
“Pay-to-play shelf-space agreements” are one way that RIA custodians offer No-Transaction-Fee (NTF) funds, which effectively embed trading costs within the mutual funds themselves (with little way for advisors or their clients to identify what the exact breakdown of what those 12b-1 and sub-TA costs may be). And with the shift to ETFs, that have their own unique rules regarding revenue-sharing to RIA custodians, new “data agreement” flat fees (potentially up to $650,000 per agreement from each asset manager to each advisor platform!) are now emerging as a way for RIA custodians to generate revenue in exchange for providing data that shows asset managers how their products are really being used.
Another major indirect cost of RIA custodial platforms is found in interest earned (or rather, not earned) on client cash holdings. Because when cash is maintained in a client account, it is often by default “swept” into a proprietary mutual fund of the RIA custodian, or even a bank deposit account of a subsidiary bank owned by the RIA custodian, yielding net interest income – the difference between what the cash position actually earns, and the lesser amount that is paid to the client – that is collected by the RIA custodian. Which for some RIA custodians is so large, that net interest from client cash actually forms the majority of the entire RIA custodian’s revenue and profits!
In recent years, another growing source of revenue for RIA custodians to generate from advisors and their clients is Payments For Order Flow (PFOFs), which custodians receive for selling the placement of client trade orders to high-frequency trading firms. And while directed trading to high-frequency trading firms can potentially improve trading efficiency (even with the drag of PFOFs), RIAs generally have very limited means to assess the actual quality of execution (which is actually becoming more difficult because rising PFOF and a rising volume of trades occurring off the traditional exchanges actually makes it systemically harder to benchmark good trade execution in the first place!).
Of course, the reality is that RIA custodians are businesses that can and should be able to generate revenue and profit from the services they provide. Still, though, the current model of RIA custodians generating such ‘indirect’ revenue from the clients of advisors, coupled with a dearth of any requirements to disclose financial statements and pricing (at least for non-publically-traded RIA custodians) make it difficult to research what RIA custodians are truly charging and whether it is a fair and competitive price to the available alternatives. Which, ironically, raises the question of whether advisors may soon even seek out RIA custodians that require RIAs to openly pay (fully disclosed) trading commissions and platform fees, if only to ensure full disclosure and a clear understanding of all expenses for the advisory firm and its clients (and an opportunity to price-shop for other RIA custodians that may offer advisors and their clients a better deal)?
The bottom line, though, is simply to understand that ‘free’ services rarely (if ever) exist when those services entail work, which certainly includes the business of brokerage and RIA custodial firms. And for financial advisors who aim to provide full disclosure of all expenses in the interests of their clients, and want to make good decisions on behalf of their clients regarding which platforms to affiliate with, it’s crucial to peel the layers of the onion and gain an understanding of the underlying costs that clients are incurring with their platform of choice… a due diligence process that applies to not only selecting investments for client portfolios but also where those portfolios are custodied and traded, too.