Broker-Dealers vs. Investment Advisors

Broker-dealers and investment advisors can both play a crucial role in their clients' financial lives by serving specific needs and goals.

However, though many confuse these two types of financial professionals (or firms), they operate under different rules and for different reasons. Retail investors should understand the difference between broker-dealers and investment advisors, as well as several related terms, so they can decide with confidence which is best suited to handle their portfolios and broader financial affairs.

A broker-dealer is a person or firm that can buy and sell securities in their own account as well as on behalf of clients. Technically, a broker is in the business of buying and selling securities on behalf of clients, while a dealer buys and sells securities for their own account. A broker-dealer simply combines these positions. Their main role is to act as a market intermediary, facilitating trades by connecting buyers and sellers. However, they can also provide investment advice and recommend investment products or trades that net them a commission, as long as their client approves each transaction. Broker-dealers typically earn money by collecting commissions from securities transactions. They may appeal to more knowledgeable, independent investors who want to be more proactive in managing their own portfolios.

In contrast, an investment advisor, sometimes known as a wealth manager, is a person or firm that provides personalized financial advice, makes investment recommendations, offers analyses on securities, or helps with financial planning in exchange for compensation. The compensation is generally in the form of an advisory fee assessed as a percentage of the assets under management.

For example, investment advisors work with clients to pursue their financial goals by developing investment strategies and allocating assets within portfolios. Investment advisors may be ideal for investors who want someone to manage their full range of investments, or for those who want assistance with tax, retirement, mortgage, or estate planning. However, it's important to note that not all investment advisors offer these services. Finding an investment advisor who is qualified and licensed to perform the specific services required is critical.

Both investment advisors and broker-dealers must be registered with the appropriate regulatory bodies at both the state and federal level. However, they abide by different legal standards.

Broker-dealers have historically followed a "suitability standard" that has since been supplemented by the "best interest standard," while investment advisors follow a "fiduciary standard."

Suitability/best interest standard. Broker-dealers are required to put client interests before their own under the best interest standard. However, the main difference between the standards that govern broker-dealers and the fiduciary standard that governs investment advisors is the "scope of duty." This means broker-dealers are required to act in the best interest of their clients—putting client interests before their own—only at the point an investment recommendation is made. This is contrary to investment advisors, whose fiduciary standard obligation applies on a continuous, ongoing basis. In addition, the suitability standard requires broker-dealer recommendations to be "suitable" for their clients. For example, they must ensure their recommendations fit clients' financial needs and goals and that the transaction costs are not excessive.

Fiduciary standard. Investment advisors must continuously put their clients' interests above their own, offer their clients undivided loyalty, and actively avoid or fully disclose any conflicts of interest. As a fiduciary, investment advisors also have what's called a "duty of care" that requires them to act with skill, diligence, and professional judgement while providing advice in the best interest of the client over the course of their relationship. The Securities and Exchange Commission (SEC), or state securities regulators, monitor this standard. However, the Department of Labor (DOL) also regulates the fiduciary standard when retirement accounts are involved.

The following terms relate to these standards and may be important for investors to understand:

• Conflict of interest. When a financial professional may benefit from recommending a particular product or trade, it is considered a conflict of interest. While the phrase may seem to have a negative connotation, it's not necessarily a bad thing when a financial professional has a conflict of interest, but it is something to be aware of so investors can form their own opinions. Both broker-dealers and investment advisors must disclose conflicts of interest to investors.
• Recommendation. This is when a financial professional suggests, or recommends, a client buys, sells, or holds a security. Both broker-dealers and investment advisors can make recommendations, but recommending investments is one of the primary functions of investment advisors. Broker-dealers, on the other hand, primarily execute securities transactions. Broker-dealers and investment advisors generally cannot offer blanket recommendations to all clients and instead must provide personalized recommendations suited to clients' unique risk tolerance, goals, and investment profile. Broker-dealers may also be required to provide background information about themselves, such as accreditations and certifications, when making a recommendation. Investment advisors, meanwhile, are required to provide this background information at or prior to the beginning of an advisory relationship.
• Customer relationship summary. Whenever an investor begins a relationship with a broker-dealer or investment advisor, they will receive a customer relationship summary. This document describes the services, fees, standards of conduct, conflicts of interest, and other relevant information that investors need to understand about the relationship they're about to enter. It acts as a quick reference guide for investors, and it's crucial to review it thoroughly. 

The SEC continues to significantly overhaul the code of conduct for broker-dealers, most recently through the Regulation Best Interest (Reg BI) rule.

Since June 30, 2020, brokers have been required to comply with the requirements of Reg BI when making recommendations to retail investors. This means a broker-dealer must act in the best interest of the investor when making a recommendation of any securities transaction or investment strategy involving securities. In other words, they cannot put their interests—financial or otherwise—ahead of a retail customer's. However, as previously mentioned, broker-dealers are only subject to this fiduciary duty at the time a recommendation is made. They are not subject to the same continuous and ongoing fiduciary duty as investment advisors.

It's important to note that broker-dealers are only considered to be acting in the best interest of their clients if they comply with four specific component obligations: the disclosure obligation, the care obligation, the conflict of interest obligation, and the compliance obligation. These require broker-dealers to disclose required information about recommendations and relationships; to act with diligence and care; to establish and maintain policies designed to address conflicts of interest; and to establish and maintain policies that ensure compliance with Reg BI standards.

In addition to adopting Reg BI, the SEC also clarified regulations on the conduct of investment advisors to "help retail investors better understand and compare the services offered and make an informed choice of the relationship best suited to their needs and circumstances." Essentially, the goal of the SEC was to add protection for clients who are receiving recommendations.

Investors may prefer to work with a broker-dealer over an investment advisor, or vice versa, depending on their specific needs and financial experience.

No matter which type of financial professional an investor selects, it's good to be aware of how they work and the rules they must follow. That way, investors can understand any potential risks and benefits involved with the relationship and make an informed decision.