The fee-based brokerage account has frequently been a target for investigations in the financial services industry. In 1995, the Securities & Exchange Commission released a statement to the effect that fee-based accounts served to better align the interests of the financial advisor with the interests of investors. Since that time, it has become clear that no eveyrone agrees. Read on for the pros and cons of a fee-based brokerage account.

The Root of the Issue
Historically, commission-based brokerage accounts were (and continue to be) criticized because brokerage firms earn commissions when investors make trades. This no-trade-no-fee approach provides a powerful incentive for brokers to get investors to trade, which encourages boiler room tactics. The fee-based brokerage account, once hailed as the antidote to this problem, has come under fire because, according to regulators, some clients in these accounts are not trading enough. (To learn more about fee-based investing, read Introduction To Fee-Based Brokerage Accounts and Wrap it Up: The Vocabulary And Benefits of Managed Money.) Regulators point to the low level of account activity and say that some investors are paying higher fees than they would pay in traditional commission-based accounts.

From a regulatory standpoint, a complicated series of definitions, legalities and regulations can be summarized by sorting investments into two categories: advisory products and non-advisory products. With advisory products, the advice provided by financial services professionals is considered to be a material part of the process. Investors are essentially paying for advice and getting commission-free trades as part of the package. With non-advisory products, the regulators view the advice as incidental.

These fairly straightforward concepts become problematic when applied to the fee-based brokerage account. While it is classified as a non-advisory product, in practice many advisors include ongoing advice as part of the package of services they provide to their fee-based brokerage account clients. This approach lets investors make an unlimited number of trades without paying commissions or worrying about the motivation behind their advisor's recommendations.

However, according to the regulators, investors in fee-based brokerage accounts are paying for trading, not advice. From a regulatory standpoint, products that do not come coupled with advice receive less scrutiny. Less regulation would seem like a good thing from an investment advisor's point of view, but it doesn't quite work out that way in practice. With regulators viewing commission-free trading as the primary component of the product, and advice as a minor issue for which advisors are not being paid, advisors no longer have any incentive to invest the time and effort required to help clients explore their financial needs, create an appropriate asset allocation strategy, design a portfolio, or provide ongoing oversight. As a result, most investors may be better off putting their assets into a discount brokerage account and paying for each trade as it is made - often at a cost of less than $10 per trade, versus up to 1% of assets in a fee-based brokerage account.

Under this new interpretation of the rules, the only way for advisors to get paid and stay out of trouble with regulators is to encourage the investors to trade. Of course, encouraging investors to trade raises the specter of potential conflicts of interest - the exact issue that fee-based accounts were invented to help advisors avoid. Thinking about it from an economic perspective, the regulators' goal of ensuring that investors pay less under a fee-based system than under a commission-based system seems reasonable for investors, but what about from an advisor's point of view? This situation transforms the advisor's role. Instead of seeking to provide the best possible advice, the advisor becomes a salesperson.

Conclusion - Your Portfolio
Regulatory issues aside, does a fee-based brokerage account have a place in your portfolio? The disconnect between the regulatory stance and actual practice makes this a difficult question to address. At the moment, the answer largely depends on your perspective, your objectives and the quality of the advice you are receiving from your financial services professional.

If you trade frequently and appreciate a few tips from your advisor, both you and the regulators may be happy with the status quo. If you want unbiased advice, comprehensive financial planning services and commission-free trading, the situation is a bit more complex. Despite the fact that regulators discount its value, many advisors do help their fee-based brokerage clients create comprehensive financial plans with ongoing advice and portfolio monitoring. If you can find such an advisor, or if the industry officially creates an advisory version of the fee-based brokerage account, the fee-based brokerage may still work for you. If you don't want advice and don't trade frequently, working with a financial advisor and putting your money in a fee-based account may not be the right approach.

Related Articles
  1. Executive Compensation

    How Restricted Stocks and RSUs Are Taxed

    Many firms pay a portion of their employees’ compensation in the form of restricted stock or restricted stock units.
  2. Mutual Funds & ETFs

    The ABCs of Mutual Fund Classes

    There are three main mutual fund classes, and each charges fees in a different way.
  3. Investing Basics

    5 Common Mistakes Young Investors Make

    Missteps are common whenever you’re learning something new. But in investing, missteps can have serious financial consequences.
  4. Mutual Funds & ETFs

    The 4 Best American Funds for Growth Investors in 2016

    Discover four excellent growth funds from American Funds, one of the country's premier mutual fund families with a history of consistent returns.
  5. Your Practice

    Advisors: $240B in Fees Up for Grabs by 2030

    Advisors have an opportunity to win generational assets over the next 15 years. Here are some tips on how to cater to different demographics.
  6. Products and Investments

    A Guide to DIY Portfolio Management

    These are some of the pillars needed to build a DIY portfolio.
  7. Investing

    What Investors Need to Know About Returns in 2016

    Last year wasn’t a great one for investors seeking solid returns, so here are three things we believe all investors need to know about returns in 2016.
  8. Your Practice

    Top Insights Into Winning More Wealthy Clients

    The upcoming young and wealthy client class is like none other when it comes to wealth advising preferences. Here are some hints to what these folks want.
  9. Investing

    The Three Most Notorious Rogue Traders

    The conviction of former Barclays trader Tom Hayes has once again shone the spotlight on rogue traders. Here are three of them.
  10. Mutual Funds & ETFs

    The Top 5 Buffalo Funds for Retirement Diversification in 2016

    Discover the top five Buffalo Funds for retirement diversification in 2016, with a summary of each fund, including manager and performance information.
  1. Does OptionsHouse have mutual funds?

    OptionsHouse has access to some mutual funds, but it depends on the fund in which the investor is looking to buy shares. ... Read Full Answer >>
  2. Does mutual fund manager tenure matter?

    Mutual fund investors have numerous items to consider when selecting a fund, including investment style, sector focus, operating ... Read Full Answer >>
  3. How do financial advisors help you avoid escheatment?

    Financial advisors can help you avoid the escheatment of your financial assets by regularly reviewing all of your accounts, ... Read Full Answer >>
  4. Are hedge funds on the buy side or the sell side?

    Hedge funds are considered to be on the “buy side” rather than the “sell side” because they actively participate in the markets ... Read Full Answer >>
  5. Why do financial advisors dislike target-date funds?

    Financial advisors dislike target-date funds because these funds tend to charge high fees and have limited histories. It ... Read Full Answer >>
  6. Some of the Best No-load Funds to Consider

    Some of the most well-known no-load funds are the DoubleLine Total Return Bond Fund (DLTNX), Vanguard Short-Term Investment-Grade ... Read Full Answer >>
Hot Definitions
  1. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  2. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  3. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  4. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  5. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  6. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
Trading Center