Before forking over your money to an investment adviser, who could potentially have the authority to make trades for your account, you may want to go over the adviser's investment advisory agreement with a fine-tooth comb. It may seem tedious to wade through the entire document, but by squaring away key points, you will have that much more confidence about the person to whom you are entrusting your investments.
Description of Services
Look for a summary of the services provided by your investment adviser. This should go beyond stating that he has authority to trade your account. You should look for details such as the kinds of investments being managed by the adviser, and how often the adviser reviews your portfolio. As for trading authority, check for what this authority encompasses -- and what it does not include. For instance, under trading authority, ascertain if the adviser is the one who trades, or whether he chooses or recommends a broker who does so. Further, determine what specifically the adviser does for your portfolio, such as rebalancing it according to a given asset allocation.
Discretionary or Nondiscretionary Authority
The investment advisory contract should clearly state whether the adviser has discretionary or nondiscretionary authority. In the first case, Advisor One suggests that the agreement might go as follows: "Adviser shall have discretion to trade in securities and to execute transactions without any obligation on its part to notify the Client or Custodian." For a nondiscretionary account, the agreement would state, for example, that the manager will "supervise and direct the investments of the account on a nondiscretionary basis, thus the Adviser will obtain Client approval before placing any orders for the account."
Fees and Compensation
You should look at an investment advisory agreement for its fee structure and billing practices. Any authorization to deduct fees does not constitute custody by the adviser and the agreement should state this. The U.S. Securities and Exchange Commission checks these agreements for consistency, and when errors arise, such as when a client is billed higher than at the rates stated in the agreement, or if the client is billed in advance when in the agreement it says that fees will be charged in arrears, these could be red flags about the firm you have chosen. It is possible that the statement is simply outdated rather than being intentionally misleading, but any inconsistencies should be addressed immediately before or during doing business with the firm.
Restrictions on Agreements
The North American Securities Administrators Association offers guidance as to what investment advisers are not allowed to do in their advisory agreements. They may not enter into or renew an advisory agreement if it is not in writing. They must also not coerce clients to waive compliance with the Investment Advisers Act of 1940 or any other rule prohibiting unethical behavior by investment advisers. RIA Central says that ongoing agreements are not appropriate for financial planning due to legal liability, and updates should be made under a new agreement each year.
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