TRANSPARENCY IN THE INVESTMENT INDUSTRY: PUBLIC PERCEPTION OF BROKERS AND INVESTMENT ADVISERS

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1 TRANSPARENCY IN THE INVESTMENT INDUSTRY: PUBLIC PERCEPTION OF BROKERS AND INVESTMENT ADVISERS Leisa Flynn University of Southern Mississippi G. Wayne Kelly University of Southern Mississippi Patrick A. Lach Eastern Illinois University Abstract This study investigates two components of investment advice that are largely absent in the debate over imposing a fiduciary standard on brokers: transparency and broker/adviser education. We find that individuals are confused by titles used by investment professionals and remain confused regarding the differences between Investment Advisers and brokers, even after being educated on the different legal standards that apply to each. Sampled individuals were better able to identify the responsibilities of a "broker" relative to more ambiguous titles, such as "financial advisor" and "financial planner." Respondents overestimated the education required to become a broker or Investment Adviser: more than half believed that brokers should have a college or graduate degree and 70 percent reported Investment Advisers should have a college or graduate degree. Based on these results, we believe that regulators should focus on regulating transparency first so that consumers can make an informed decision when hiring an investment professional. Current Draft: April 7, 2016 JEL Classification: G18: G20; G28 Keywords: Government Policy & Regulation; Market Transparency; Retirement Savings; Financial Literacy Leisa Flynn is a Professor of Marketing at the University of Southern Mississippi. Address: Department of Marketing and Merchandising, Joseph Greene Hall, 306, 118 College Drive #5091, Hattiesburg, Mississippi, Office Phone Office Fax: Electronic Mail: leisa.flynn@usm.edu. G. Wayne Kelly is a Professor of Finance and Department Chair at the University of Southern Mississippi. Address: Department of Finance, Real Estate and Business Law, Joseph Greene Hall, 314, 118 College Drive #5076, Hattiesburg, Mississippi, Office Phone Office Fax: Electronic Mail: gary.kelly@usm.edu Contact Author: Patrick A. Lach is an Associate Professor of Finance at Eastern Illinois University. Address: School of Business, Eastern Illinois University, 600 Lincoln Avenue, Charleston, Illinois, Office Phone: Office Fax: Electronic Mail: plach@eiu.edu.

2 TRANSPARENCY IN THE INVESTMENT INDUSTRY: PUBLIC PERCEPTION OF BROKERS AND INVESTMENT ADVISERS Abstract This study investigates two components of investment advice that are largely absent in the debate over imposing a fiduciary standard on brokers: transparency and broker/adviser education. We find that individuals are confused by titles used by investment professionals and remain confused regarding the differences between Investment Advisers and brokers, even after being educated on the different legal standards that apply to each. Sampled individuals were better able to identify the responsibilities of a "broker" relative to more ambiguous titles, such as "financial advisor" and "financial planner." Respondents overestimated the education required to become a broker or Investment Adviser: more than half believed that brokers should have a college or graduate degree and 70 percent reported Investment Advisers should have a college or graduate degree. Based on these results, we believe that regulators should focus on regulating transparency first so that consumers can make an informed decision when hiring an investment professional.

3 1. Introduction How Americans receive investment advice has become a topic of great interest since the 2008 recession. In particular, debate often centers on how investment professionals are compensated and the standard of care owed to the client. For example, some investment professionals are required to act in the best interest of the client (the fiduciary standard), while others only have to provide advice that is suitable for the client (the suitability standard). Additionally, some investment professionals are compensated solely through commissions received from products they sell while others derive compensation only through fees charged directly to clients (e.g. hourly or annual retainer fees). Two types of investment professional are available to the general public in the United States: brokers and Investment Advisers (IAs). The Investment Advisers Act of 1940 requires individuals who provide investment advice for compensation to register with the Securities and Exchange Commission (SEC) as an Investment Adviser. To be considered an Investment Adviser, a person must give advice regarding securities, be in the business of giving advice, and receive compensation for doing so (15 USC 80b - 2 (a)(11)) 1. The Act of 1940 also created several exclusions to this rule such as professionals like lawyers and accountants whose advice is incidental to their profession. This same exclusion extends to Brokers. The standards of care that brokers and Investment Advisers must provide differ significantly. Brokers are held to a suitability standard, meaning that any recommendations they make must be reasonable based on the client's investment objectives. Investment Advisers 1

4 TRANSPARENCY IN THE INVESTMENT INDUSTRY 2 are required to act as fiduciaries, meaning they must put the interests of the client ahead of their own. While the Investment Advisers Act of 1940 does not contain the word "fiduciary," the Supreme Court concluded in 1960, "The Investment Advisers Act of 1940 thus reflects a congressional recognition 'of the delicate fiduciary nature of an investment advisory relationship,' as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser consciously or unconsciously to render advice which was not disinterested." 2 Given the significant difference in the standards of care Investment Advisers and brokers owe to their clients, recent efforts have emerged to hold brokers to the fiduciary standard. This debate began in earnest via discussion of including a uniform fiduciary standard in the Dodd-Frank Wall Street Reform and Consumer Protection Act of Ultimately, a uniform fiduciary standard was left out of the Dodd-Frank Act, but the act required the SEC to examine, among other things, retail investors understanding of the differences between brokers and Investment Advisers and whether or not the exclusion for brokers should be eliminated from the Investment Advisers Act of This study cited several pieces of evidence suggesting individual retail investors are unaware of the differences between brokers and Investment Advisers, and the standards of care each group owes to their clients. The SEC study cited multiple examples of investors showing confusion about the different titles that brokers and Investment Advisers use. 3 2 S.E.C. v. Capital Gains Research Bureau, 375 U.S. 180 (1963). 3 The entire 208 page study can be found at

5 TRANSPARENCY IN THE INVESTMENT INDUSTRY 3 While much of the current debate in the U. S. centers on the fiduciary standard, serious debate is taking place in other countries regarding the ways investment professionals are compensated for advice. On January 1, 2013 the United Kingdom implemented the Retail Distribution Review mandating a fee-for-service model that prohibits commissions from the sale of financial products. 4 On July 1, 2013, Australia followed suit with reforms known as the Future of Financial Advice. 5 In addition to compelling investment professionals to adopt a feefor-service model, the Retail Distribution Review and the Future of Financial Advice required investment professionals to follow a fiduciary standard of care. While the United Kingdom and Australia banned commissions and implemented fiduciary standards, the brokerage community in the U.S. strongly resists the uniform fiduciary standard and the issue remains unresolved. One criticism raised by the brokerage industry is the cost of compliance with a new fiduciary standard. 6 Others, including speaker of the House, Paul Ryan, 7 extend that argument saying that many brokers would discontinue work with small retail clients due to increased costs of compliance and a reduction in revenue. Commissions can have a significant impact on the broker incentives, imposing huge agency costs on consumers. Although agency costs in corporate settings have been discussed at length in academic literature (most notably by Jensen and Meckling (1976)), relatively little has been written about the agency costs arising between brokers and their clients. While Barber, Odean, and Zheng (2005) find that mutual fund inflows decrease as the size of the sales load (commission) increases, Christoffersen, Evans, and Musto (2013) find that mutual fund inflows 4 See 5 See 6 See 7 See

6 TRANSPARENCY IN THE INVESTMENT INDUSTRY 4 increase as the percentage of the sales load paid to a broker increases. The results of Christoffersen, Evans, and Musto (2013) show the influence that brokers' incentives have on the products they recommend to clients. This creates a conflict of interest between the broker and the client resulting in agency costs. Unfortunately, the consumer is often unaware of this conflict because brokers very seldom use the term "broker" as their title and instead use terms such as "financial advisor," "wealth manager" or "financial planner." While regulators and Brokers debate the merits of a uniform fiduciary standard, the profusion of professional titles that Brokers use when offering services to the public has been generally ignored. Section 3(a)(4)(A) of the Securities and Exchange Act of 1934 defines a Broker as "any person engaged in the business of effecting transactions in securities for the account of others. Since Brokers are in the business of completing securities transactions, an exception from the Investment Advisers Act of 1940 excludes "any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no compensation therefore" (15 USC 80b). Although Brokers do not have to register as Investment Advisers since their investment advice is often considered "incidental" to the process of selling securities, many brokers use titles that suggest otherwise. For instance, many brokers will use the term "financial advisor," which implies that they are in the business of providing financial advice, rather than the business of completing securities transactions. In a joint report to the SEC, Siegel & Gale, LLC and Gelb Consulting Group found that participants were confused regarding titles such as "financial planner," "financial advisor," or

7 TRANSPARENCY IN THE INVESTMENT INDUSTRY 5 "investment adviser." 8 The RAND Institute for Civil Justice conducted an SEC-sponsored study which found that investors were confused by titles like "financial advisor," "financial advisor," and "financial consultant." 9 Interestingly, the RAND study found that even financial professionals were confused by the titles used by other investment professionals. Furthermore, a study by Cerulli Associates found that over 60 percent of investors are either unsure of how their financial professional charges for advice, or they think that the advice is free. 10 Since investment professionals seldom provide advice free of charge, this implies that more than half of investors are not sure how they pay for advice, suggesting widespread opacity in the investment industry. Although the RAND and the Siegel, Gale, and Gelb studies found that individual investors are confused by titles such as "financial advisor," to our knowledge, no study has suggested alternative titles for brokers and investment in order to help the public understand the compensation structure and the standard of care owed the client. We investigate a title for brokers that is seldom used in practice, "investment sales representative," to see whether or not that designation helps consumers identify a financial professional who acts as a fiduciary. We find that, when presented with a list of titles commonly used by investment professionals, consumers are more likely to identify an "investment sales representative" or a "broker" as one who is in the business of buying or selling investment products relative to titles such as "financial advisor" or "wealth manager." Also, consumers are less likely to identify an 8 The title of this report is Results of Investor Focus Group Interviews About Proposed Brokerage Account Disclosures and is available at 9 The title of this report is Investor and Industry Perspectives on Investment Advisers and is available at

8 TRANSPARENCY IN THE INVESTMENT INDUSTRY 6 "investment sales representative," or a "broker" as someone who is in the business of providing financial advice or is a fiduciary. We emphasize the term "financial advisor" since anecdotal evidence suggests this is the most common term used by brokers when offering services to the public. We find that consumers are more likely to identify a "financial advisor" as a fiduciary compared to an "investment adviser" or an "investment adviser representative." In other words, an Investment Adviser, who is required by law to act as a fiduciary, and who correctly claims to be an "investment adviser representative" is less likely to be viewed by a consumer as a fiduciary relative to a broker using the unregulated, marketing term "financial advisor." Brokers are exempt from the Investment Advisers Act of 1940 as long as investment advice they provide is "solely incidental." However, more than half of our respondents reported that the primary job function of a "financial advisor," a title often used by brokers, is providing investment advice. Regulators are currently debating whether and how they should regulate a broker's business structure by forcing them to abide by a fiduciary standard. Based on our results, we believe that regulators should first focus on regulating transparency so that consumers can make an informed decision when hiring an investment professional. Transparency of investment professionals titles is important for regulators to consider in the contentious debate about designating brokers as fiduciaries. One major argument from the brokerage side of the debate is the cost of compliance, which ranges from creating and storing best interest contracts to the outright prohibition of some products and services. Given cost-based objections to the implementation of a fiduciary standard, requiring more transparent titles for brokers presents a far more cost-effective alternative to implementing a

9 TRANSPARENCY IN THE INVESTMENT INDUSTRY 7 fiduciary standard. Furthermore, more transparent titles could be implemented swiftly, unlike the debate over a fiduciary standard, which began in the summer of 2010 and still has not been resolved. Besides unclear professional titles, the minimum education required of investment professionals is another issue that has been overlooked in the debate over a fiduciary standard. In most states, no formal education is required to become a broker or an investment adviser except for passing one or more exams, typically the Series 7 and 65 exams. The Series 7 exam can be passed with as little as three weeks of study according to Keir Educational Resources, one of the leading providers for study materials for professional certification exams. 11 Furthermore, according to FINRA, "The Series 7 Examination is designed to assess the competency of entry-level General Securities Representatives." 12 Similarly, according to the North American Securities Administrators Association (NASAA),"The Series 65 is a test of a candidate s competency as an entry-level investment adviser representative." 13 Little debate has addressed whether or not managing investments, and in some cases and individual's life savings, should require additional education beyond three weeks of study for an exam designed for an "entry-level" employee. In addition, to our knowledge, the public's understanding of these education requirements has not been investigated. Requiring an investment professional to act in the best interest of an investor may be a trivial pursuit if the investment professional lacks the education or training to be able to judge what is best for the client. 11 See

10 TRANSPARENCY IN THE INVESTMENT INDUSTRY 8 Our respondents seem to agree with this sentiment. When asked what level of education they think is required of a broker, more than half responded with a college or graduate degree. When respondents were asked what level of education they think is required to be an investment adviser, more than two-thirds believed that a college or graduate degree is required for an individual to become an investment adviser. Respondents were also asked what the minimum education level should be for brokers and investment advisors. More than 70 percent of respondents thought that brokers should have a college degree or higher, while 82 percent thought investment advisers should have a college degree or higher. Jackson Nickerson of the Olin Business School at Washington University has found that when a government entity sets out to solve a problem, they fail to correctly identify the problem 90 percent of the time. The current debate at the Department of Labor and Securities and Exchange Commission appear to support Dr. Nickerson's rule. Regulators appear to be debating the question "Should all investment professionals be required to make investment decisions that are in the best interests of their clients?" Based on the results of our survey, a more appropriate type of question would "Does a high school drop-out who passes an exam designed for entry-level securities professionals have the education, training, and experience to make a distinction as fine as 'good, better, and best' in an area as complex as modern investment theory?" 2. Background and Hypotheses After the Standard & Poor's (S&P) 500 declined by more than 43 percent between March 1, 2008 and February 28, 2009, regulators began to scrutinize how Americans receive investment advice. This process began in the early stages of drafting the Dodd-Frank Wall

11 TRANSPARENCY IN THE INVESTMENT INDUSTRY 9 Street Reform and Consumer Protection Act of This Act did not mandate a uniform fiduciary standard, but called for the SEC to conduct a study to determine, among other things, whether investors are confused between the standard of care required of brokers and investment advisers. This report cited three studies from the Chartered Financial Analyst Institute, RAND Institute for Civil Justice, and a joint study from Siegel & Gale, LLC and Gelb Consulting Group (Henceforth, SSG). 2.1 Titles Used by Investment Professionals The RAND and SSG studies both showed investors were confused by the numerous titles used by brokers and investment advisers. This is not surprising since even the Financial Industry Regulatory Authority (FINRA) has acknowledged the ambiguity of job titles used by investment professionals. They warn investors to "be aware that Financial Analyst, Financial Adviser (Advisor), Financial Consultant, Financial Planner, Investment Consultant or Wealth Manager are generic terms, and may be used by investment professionals who may not hold any specific credential." 14 Additionally, all three studies cited by the SEC indicated that investors did not know which groups are held to a fiduciary standard and which are not. While the RAND and SSG studies both documented investor confusion with titles currently used by investment professionals, to our knowledge, no study has proposed a solution to this confusion. In this study, we gauge investor understanding of different job titles identified by FINRA. Next, we provide respondents brief descriptions of what brokers and investment advisers do and an explanation of the standards of care required of each, and then we test respondent s understanding of the descriptions with follow-up questions. In addition, 14

12 TRANSPARENCY IN THE INVESTMENT INDUSTRY 10 we explain to the participants the level of care owed to clients by each titular category. We expect to find individual investors unable to significantly distinguish which titles belong to brokers and which belong to investment advisers, even after being given the definitions of both positions. This expectation is informed partly by the RAND study, which noted that even professional investors were confused by the titles used by brokers and investment advisers. This leads to the first hypothesis of the study: H1: Participants will be confused by the titles financial advisor, financial planner, and wealth manager, which are often used by brokers To mitigate this confusion we propose a less ambiguous title, investment sales representative, to test whether investors are able to more easily classify these individuals as brokers. This leads to our second hypothesis: H2: Participants are more likely to associate the title investment sales representative with a broker relative to an investment adviser. Anecdotal evidence from the investment industry shows that brokerage firms often use the term "investment sales representative" when recruiting potential employees. However, the same firms will use the title "financial advisor" when marketing to clients. In other words, it appears that the phrase "investment sales representative" is meant to give potential employees an idea of what will be required of them as brokers, while the title "financial advisor" is meant

13 TRANSPARENCY IN THE INVESTMENT INDUSTRY 11 to build trust between a brokerage firm and potential clients. We believe respondents given a list of potential job functions will view the primary job function of a financial advisor as providing investment advice. This leads to our next hypothesis: H3: Participants will select "providing investment advice" as the primary job function of a financial advisor. 2.2 Professional Education In most states, the minimum level of education needed to become a broker or an Investment Adviser is lower than the education requirement needed to become a hairdresser or an electrician. 15 Electricians are required to complete several years of apprenticeship work under the supervision of a licensed electrician while brokers and investment advisers face no such requirement. 16 Most states do not require a high school diploma or a Graduate Equivalency Degree (GED) to become a broker or an investment adviser. No minimum education requirement exists to qualify to sit for the Series 7 or Series 65 exams. Furthermore, the Series 7 and 65 exams are both designed to prepare individuals for "entry-level" positions and tasks although many people who work one-on-one with clients do not attain education beyond this level. When asked to describe the minimum education level of brokers and investment advisers, we expect participants in our study will overstate the requirements. This leads to the fourth hypothesis: 15 See for more information on the requirements to become an electrician or a hairdresser in the Commonwealth of Kentucky. 16

14 TRANSPARENCY IN THE INVESTMENT INDUSTRY 12 H4: Participants overestimate the education requirements needed to become a broker or an investment adviser. We also expect that participants in our study will respond that an investment adviser needs a higher level of education than a broker, consistent with investors thinking a higher education level is needed for an investment to serve the best interests of the client, rather than simply suitable for a client. Subjects will believe that more education is required to plan the financial future of a family, for example, rather than to execute a stock trade. This leads to a fifth hypothesis: H5: Participants characterize an investment adviser as being held to a higher education level than a broker after being educated on the requirements of each. We also ask participants to indicate their opinion of what the minimum education level ought to be to become a broker or an investment adviser. We believe that participants will answer that brokers and investment advisers should have a college degree or higher, leading to our next hypothesis: H6: Participants will report that they believe brokers and investment advisers should be required to have a college degree or higher. Finally, participants provide their opinions regarding the minimum level of education needed to become a broker or an investment adviser, relative to that of a Certified Public

15 TRANSPARENCY IN THE INVESTMENT INDUSTRY 13 Accountant (CPA). We use the CPA credential as a benchmark because it is widely recognized and because CPAs, like investment advisers, often assist people in making financial decisions. The education needed to become a CPA varies between states but typically requires a college degree and 150 credit hours, as well as credit hours of accounting. We expect that respondents will view CPAs, brokers, and investment advisers similarly, and agree that brokers and investment advisers should be held to education standards similar to CPA. Therefore, our final hypothesis is: H7: Participants will agree that brokers and investment advisers should be held to a level of education comparable that of Certified Public Accountants. 3. Methodology The survey was developed from an existing, validated scale and from newly created items. The Perceived Knowledge scale is a brief, summated measure that can be adapted to any knowledge category and gauges a person s sense of how much they know about that category. A sample question reads, Among my circle of friends, I'm one of the "experts" on investing and investments, (Flynn and Goldsmith (1999)). It has been shown to be reliable and valid through many studies. The rest of the items were developed for the survey for the first time. The first group of new items was designed to measure how the subjects understood titles that are commonly used by financial industry workers and what the primary job functions of financial advisors are. An example was, Which of the following receives a fee or commission for buying or selling an investment for a client? Check all that apply. The response categories were

16 TRANSPARENCY IN THE INVESTMENT INDUSTRY 14 Financial Advisor, Investment Adviser, Certified Financial Planner, Broker, Wealth Manager, Investment Sales Representative, Financial Planner, and Investment Adviser Representative. The response categories were randomized for each question. After a baseline of actual knowledge was obtained the survey presented descriptions of the actual job functions of both brokers and investment advisers as follows: A broker is a person who is paid a fee for making financial securities transactions on behalf of their clients. For example, a broker may receive a commission to purchase a mutual fund for a client's account. A broker is generally not held to a fiduciary standard which means that they are free to act in their own interest and not the best interest of their clients. For instance, a broker can recommend an investment which pays a high commission even if there are investments that are nearly identical which pay a lower commission or no commission at all. An investment adviser is a person who is paid a fee by a client for providing advice about or conducting analysis on financial securities. For example, an investment adviser may review someone's investments for an hourly fee. An investment adviser is a fiduciary and is required by law to consider and act in the best interest of their clients at all times. Questions following this educational section tested to see if the subjects answers to the first group of questions had changed. In other words, we tested to see if the subjects understanding of financial workers and how their jobs work had improved. This group of

17 TRANSPARENCY IN THE INVESTMENT INDUSTRY 15 questions included, Which of the following receives a fee or commission for buying or selling an investment for a client? Check all that apply. The answers here were limited to Broker and Investment Adviser. We also asked subjects to indicate which of the list of titles from the first section reflected a financial worker s position as either a broker or investment adviser. The third section of the paper asked about how much formal education the subjects believed was required for a person to be hired as or to hold themselves out as a broker or investment adviser. We also asked about how much education these workers should have to give advice about important investment decisions. The survey was delivered through Qualtrics panel to US adults in the early spring of The survey set quotas for age and for gender; otherwise subjects were self-selected and given a small reward for completing the entire survey. The survey contained an item which read This is an attention check. If you read this question please leave it blank. Respondents who checked an answer for this question were deleted from the final sample. When all the quotas were met we had 994 people log on to the survey and 534 were removed because of being too young, failing the attention screener, finishing the survey in too little time or being over quota. The final sample included 460 subjects. Of these, men and women were each 50% of the sample. Ages ranged from 18 to 84 with an average of 45.7 years. 4. Results 4.1 Titles Used by Investment Professionals Results for the first two hypotheses relating to investor confusion over titles used by brokers and investment advisors are found in Tables 1 through 4. The terms 'investment

18 TRANSPARENCY IN THE INVESTMENT INDUSTRY 16 adviser' and 'investment adviser representative' were both used as response options in these survey items. Although the SEC states, "An investment adviser is an individual or a firm that is in the business of giving advice about securities to clients, 17 " some state-level regulatory bodies prohibit individuals from calling themselves "investment adviser." For instance, in Kentucky the title "investment adviser" can only be used for a firm and the term "investment adviser representative" is reserved for an individual. So, if John Doe opened a Registered Investment Advisory firm called Doe Wealth Management, the state of Kentucky would require that the term "investment adviser" be used to describe the firm as a whole. John Doe would be permitted to call himself an "investment adviser representative" but not an "investment adviser." Consistent with the first hypothesis, the results in Tables 1 4 show that the participants in this study were confused by common titles used by brokers such as financial advisor, financial planner, and wealth manager. In the first question, participants were asked, "Which of the following is held to a fiduciary standard by law meaning they are expected to behave with the highest standard of care and in the best interests of their customers? Check all that apply." This question has only two correct answers: an Investment Adviser and Investment Adviser Representative. A Certified Financial Planner (CFP) is held to a fiduciary role only under limited circumstances. The Certified Financial Planner Rules of Conduct Section 1.4 states, "A certificant shall at all times place the interest of the client ahead of his or her own. When the certificant provides financial planning or material elements of financial planning, the certificant owes to the client the duty of care of a fiduciary as defined by the CFP Board." For instance, if a 17 See "Investment Advisers: What you Need to Know Before Choosing One" available at

19 TRANSPARENCY IN THE INVESTMENT INDUSTRY 17 Certified Financial Planner is registered as a broker, that individual is not held to a fiduciary duty when selling investments. 18 ***Insert Table 1 About Here*** Certified Financial Planner was the top response to the first question. While 59 percent of participants selected Certified Financial Planner, the second highest response was financial advisor, which was selected by 55 percent of participants. Interestingly, broker was the third highest response with 51 percent of participants selecting this option. Forty-seven percent of participants chose financial planner, a higher percentage than those who correctly identified that an investment adviser is held to a fiduciary duty (44 percent). Oddly, investment adviser representative was the second to least popular response, with only 34 percent of participants correctly identifying that an investment adviser representative is held to a fiduciary obligation. The only title chosen less than investment adviser representative was investment sales representative, which was chosen by 29 percent of participants. The Table 2 results are for the question "Which of the following is in the business of providing financial advice? Check all that apply." Financial advisor was the top response at 77 percent, but this could have been due to the use of the phrase "financial advice." Consistent with our second hypothesis, the terms broker and investment sales representative were the bottom two responses. In fact, consumers were less likely to identify an investment sales representative (26 percent of respondents) as someone who provides financial advice relative to a broker (35 percent of respondents). Interestingly, a financial planner (64 percent) was 18 To get an idea of the percentage of CFP certificants registered as brokers, we analyzed all Certified Financial Planners within a 25-mile radius of Mississippi's state capital in Jackson. This search yielding 44 practitioners, 34 of whom were registered as brokers.

20 TRANSPARENCY IN THE INVESTMENT INDUSTRY 18 perceived to be more likely to provide financial advice than a Certified Financial Planner (58 percent) by the participants. ***Insert Table 2 About Here*** Responses to question three further support H1 and H2. Sixty-two percent of respondents correctly identified brokers when asked, "Which of the following is in the business of selling investments or financial products? Check all that apply." The term investment sales representative was a close second with 58 percent of respondents selecting this option. Surprisingly, the term investment adviser was the third most-selected option, albeit a distant third with 36 percent of participants selecting this option. The term financial advisor was seen as less likely to be in the business of selling financial products relative to investment advisers and investment adviser representatives, even though the term financial advisor is an unregulated term typically used by brokers. In other words, a broker who correctly selfidentifies is more than twice as likely to be correctly labeled as someone in the business of selling products than a broker who uses the generic term financial advisor. Table 3 shows that allowing a broker to use the terms financial advisor, wealth manager, or financial planner only serves to increase confusion among American investors. It is likely this confusion is intentional since, as we will show in Section 4.2, we find that consumers have a strong preference towards investment advisers relative to brokers with investors preferring to work with an investment adviser relative to a broker to a margin of 4 to 1 before learning the differences between the two, and a margin of nearly 8 to 1 after learning the differences. ***Insert Table 3 About Here***

21 TRANSPARENCY IN THE INVESTMENT INDUSTRY 19 Next, participants were asked "Which of the following is paid to provide advice regarding investments? Check all that apply." Again, perhaps due to the presence of the words "advice" and "investments" the top choice was investment adviser at 65 percent. Financial advisor, a term commonly used by brokers who are prohibited from offering investment advice unless it is solely incidental to the business of effecting transactions, was a very close second at 62 percent. Half of the participants believed that brokers are in the business of providing investment advice. However, participants were clearer about the title investment sales representative, with only 34 percent of respondents selecting this incorrect answer. ***Insert Table 4 About Here*** Anecdotal evidence suggests that financial advisor is one of the most commonly used terms for brokers. Additionally, when piloting the survey used in this study, financial advisors were viewed as most likely to be held to a fiduciary standard. Therefore, participants were asked to identify the primary job function of a financial advisor. As shown in Table 5, more than half (54 percent) of the respondents in the study identified investment advice as the primary function of a financial advisor, consistent with the third hypothesis (H3). In addition, 17 percent responded that retirement planning is the primary function of a financial advisor. Therefore, while the Investment Advisors Act of 1940 provides an exemption to brokers as long as their investment advice is solely incidental to their position as brokers, a broker s reference to himself or herself as a financial advisor sends a misleading signal to the public according to our survey results where more than half of the respondents believed that investment advice is the primary function of a financial advisor, not something that is solely incidental. ***Insert Table 5 About Here***

22 TRANSPARENCY IN THE INVESTMENT INDUSTRY Differences between Investment Advisers and Brokers As shown in Section 4.1, there is confusion regarding the different titles used by investment professionals. The next section of the survey provided respondents with the following information about the differences between brokers and investment advisers: A broker is a person who is paid a fee for making financial securities transactions on behalf of their clients. For example, a broker may receive a commission to purchase a mutual fund for a client's account. A broker is generally not held to a fiduciary standard which means that they are free to act in their own interest and not the best interest of their clients. For instance, a broker can recommend an investment which pays a high commission even if there are investments that are nearly identical which pay a lower commission or no commission at all. An investment adviser is a person who is paid a fee by a client for providing advice about or conducting analysis on financial securities. For example, an investment adviser may review someone's investments for an hourly fee. An investment adviser is a fiduciary and is required by law to consider and act in the best interest of their clients at all times. After providing participants with the above information, (henceforth, educational paragraph ), we asked a series of follow-up questions. The first, shown in Table 6, was Given what you have just learned, which you would rather choose to manage your investments?

23 TRANSPARENCY IN THE INVESTMENT INDUSTRY 21 with three response categories Investment adviser, Broker, and It makes no difference to me. This was a repeat of the same question asked at the beginning of the survey. The repetition was to gauge the extent to which subjects learned from the educational paragraph. After reading the educational paragraph, 78 percent of participants chose investment adviser, only 10 percent chose broker, and the remaining 11 percent responded It makes no difference to me. Before reading the educational paragraph, only 54 percent had a preference for investment advisers, and 13 percent had a preference for brokers, while the remaining 33 percent had no preference. Consumer preference towards an investment adviser relative to a broker appears to increase after the consumer is educated on the job responsibilities of brokers and investment advisers. ***Insert Table 6 About Here*** After the educational paragraph, participants were once again asked the questions from Tables 1 through 4, but this time, they were only given the options broker and investment adviser. As shown in Table 7, after reading the educational paragraph, 85 percent of participants correctly identified that an investment adviser is held to a fiduciary standard, up from 55 percent before the educational paragraph. Only 20 percent identified brokers as fiduciaries after the educational paragraph, a decrease from the 51 percent who identified brokers as fiduciaries before reading the educational paragraph. ***Insert Table 7 About Here*** Results for the next question, found in Table 8, repeats the question from Table 2, with the narrowed response set and asks participants to identify who is in the business of providing financial advice. After reading the educational paragraph and with only two response choices,

24 TRANSPARENCY IN THE INVESTMENT INDUSTRY 22 the percent of respondents who choose investment adviser increased from 58 percent to 91 percent. The percent of participants who chose broker dropped from 35 percent to 28 percent. The educational paragraph also helped consumers identify financial professionals who are in the business of selling investments or financial products, as shown in Table 9. Before the educational paragraph, only 62 percent believed that brokers were in the business of buying or selling financial or investment products, but this number increased to 86 percent after the educational paragraph. Interestingly, there was only a small decline in the proportion who believed investment advisers buy and sell investment products after the educational paragraph with a decline from 36 percent to 33 percent. ***Insert Table 8 About Here*** ***Insert Table 9 About Here*** Finally, Table 10 replicates the results of Table 4 and shows how the educational paragraph increased participants understanding of who is in the business of providing advice regarding investments. Sixty-five percent correctly identified an investment adviser as someone who is paid to provide advice regarding securities. After the educational paragraph, this number increased to 87 percent. Likewise, 50 percent incorrectly believed that brokers are paid to provide advice regarding investments before reading the educational paragraph. After the educational paragraph, only 31 percent still incorrectly believed that brokers are paid to provide advice regarding investments. Tables 7 through 10 show that although investor education can help to mitigate misunderstanding that investors have regarding the different job functions and responsibilities of investment professionals, the confusion is not completely eliminated through education.

25 TRANSPARENCY IN THE INVESTMENT INDUSTRY 23 ***Insert Table 10 About Here*** 4.3 Education of Investment Advisers and Brokers Respondents in our study were also asked about the levels of education required of brokers and investment advisers. Table 11 reports the results of the question asking respondents what level of education is required to become a broker. Fifty-three percent of respondents believed a broker must be a college graduate or have a graduate education. When asked the same question regarding Investment Advisers, this number jumped to 68 percent, as shown in Table 12. Table 11 (Table 12) shows that only 5 percent (2 percent) correctly identified the actual level of formal education required to become a broker (investment adviser) by choosing the option less than high school graduate. These results are consistent with fourth hypothesis (H4) since most of the participants overstated the requirements needed to become a broker or an Investment Adviser. Although most states require that a broker or an investment adviser pass the Series 7 exam, typically no formal education requirement is needed to sit for this exam. These results are also consistent with our fifth hypothesis (H5) since respondents characterized the amount of education needed to become an investment adviser as higher than the education needed to become a broker. ***Insert Table 11 About Here*** ***Insert Table 12 About Here*** Table 13 shows the response results where participants were asked In your opinion, what is the minimum level of education that someone should have in order to be a broker? Consistent with our sixth hypothesis (H6) 74 percent responded that they believed a broker

26 TRANSPARENCY IN THE INVESTMENT INDUSTRY 24 should have a college or graduate degree and 82 percent thought the same of investment advisers (as shown in Table 14.) These results are also consistent with H4 and H5. ***Insert Table 13 About Here*** ***Insert Table 14 About Here*** Participants were asked to compare the education requirements of brokers and investment advisers to those of a Certified Public Accountant (CPA). Those results are reported in Tables 15 and 16. The CPA license was chosen for comparison to brokers and investment advisers because all deal with financial issues and because the CPA license is widely recognized. According to a study by Ipsos commissioned by the Certified Financial Planner Board of Standards, Inc., the CPA license was recognized by 94 percent of study participants. 19 The licensure requirements needed to become a CPA vary from state to state but most states require work beyond a baccalaureate degree with 150 college credit hours, and 12 to 27 credit hours in accounting. For example, according to This Way to CPA sponsored by the American Institute of Certified Public Accountants, in Kentucky, a candidate needs 120 credit hours and a bachelor s degree to sit for the exam, and 150 credit hours, including 27 semester hours in accounting, to obtain the CPA license. 20 As shown in Tables 15 and 16, participants in our study thought that the education requirements of brokers and investment advisers are similar to those of CPAs. Table 15 (Table 16) shows that 61 (76) percent of participants believe the education needed to become a broker (Investment Adviser) is the same or higher than to become a CPA, consistent with H7. 19 See

27 TRANSPARENCY IN THE INVESTMENT INDUSTRY 25 Only 16 (7) percent responded that the education needed to become a broker (investment adviser) is much lower than a Certified Public Accountant. ***Insert Table 15 About Here*** ***Insert Table 16 About Here*** 4.4 Comparison Tests In Table 17, participants are asked "Which of the following best describes your experience working in the investments industry?" Three percent of the participants in our study currently work in the industry while five percent (four percent) do not currently work in the investments industry, but have done so in the last five years (ten years). An additional three percent reported that they do not currently work in the investments industry, but worked in the industry more than ten years ago. In total, approximately 14 percent of participants had experience in the investments industry while the remaining 86 percent have no investment industry experience. ***Insert Table 17 About Here*** Table 18 presents the results of an F-test comparing the responses of people with industry experience to those without industry experience. Table 18 takes the results presented in Tables 1 and 4 and breaks the responses down by industry experience. Participants were assigned a score to each question: they received one point for each correct answer and the lost one point for each incorrect answer. For the questions presented in Tables 1 and 4, there are only two correct answers: Investment Adviser and Investment Adviser Representative. Certified Financial Planner was not accepted as a correct answer because, as explained in Section 4.1,

28 TRANSPARENCY IN THE INVESTMENT INDUSTRY 26 Certified Financial Planners are not required to act as a fiduciary unless they are providing comprehensive financial planning advice. Therefore, a broker who holds the CFP credential is not held to a fiduciary standard. In addition, only an Investment Adviser and Investment Adviser Representative are legally permitted to provide investment advice for compensation. Panel A of Table 18 shows the average score for the question " Which of the following is held to a "fiduciary standard" by law meaning they are expected to behave with the highest standard of care and in the best interests of their customers? Check all that apply." The average score for all participants was , meaning that on average, the number of incorrect responses chosen by each participant exceeded the number of incorrect responses by , which shows that the participants in our study had difficulty identifying who is held to a fiduciary standard and who is not. While those with industry experience scored slightly higher than those without industry experience ( versus ), the number of incorrect responses from participants with industry experience exceeded the number of incorrect responses by Even more disturbing is that respondents with industry experience did not outperform those without industry experience by a statistically significant margin. ***Insert Table 18 About Here*** Panel B of Table 18 shows the average scores to the question " Which of the following is paid to provide advice regarding investments? Check all that apply." Again, under the Investment Advisers Act of 1940, only an Investment Adviser or an Investment Adviser Representative is permitted to receive compensation for providing investment advice. The remaining possible answers given in Table 4 are incorrect since they may be used by brokers. Similar to Panel A, the average score for all participants was negative, meaning the number of