ARLINGTON, VA. -- As SEC examiners make their rounds at advisor practices this year, they will be taking a hard look at dually registered firms and the use of non-traditional mutual funds, according to the head of the commission's compliance unit.

The focus on practitioners who are registered as both investment advisors and broker-dealers grows out of concern that the different compensation structures of the two business lines can create conflicts of interest and potentially harm investors, Andrew Bowden, director of the SEC's Office of Compliance Inspections and Examinations, said in a keynote address here at the Investment Adviser Association's compliance summit on Thursday.


"One of the areas where we're actively looking for undisclosed and unmitigated conflicts is the trend among dually registered firms to move their clients from commission-based brokerage accounts to fee-based wrap accounts that offer advice and no commission trading for one bundled, asset-based fee," Bowden said.

He acknowledged that expanding into an advisory practice can hold great benefits for brokers, who have been seeing commission rates fall as trading volumes decrease. The fee-based model also enables brokers to "transform choppy transaction-based compensation into a steadier and more reliable and predictable revenue stream," Bowden explained. "They no longer have to make a sale to collect a fee."

The SEC is also mindful of the upsides of the RIA model for investors, and Bowden allowed that "there are many compelling and legitimate reasons why the move to fee-based advisory accounts is in the best interest of the client."

For instance, advisory clients can benefit from the ability to initiate trades without paying a commission. And many receive additional financial planning services from an advisor, such as estate planning or cash-flow analysis. Portfolios managed by advisors have historically outperformed accounts that investors manage on their own, Bowden said, and noted that in the advisory model, "the incentive to recommend unsuitable transactions to generate a fee is removed."

"But we see instances where the value proposition to clients is not clear," he cautioned.

SEC examiners have become alarmed at the tendency of some dual registrants to shift accounts from one wing of the practice to the other because they stand to profit by the move, not because it is in the best interest of their clients.


In their reviews of dual registrants, SEC examiners will look closely for evidence of portfolios that were constructed through active trading in a brokerage account, racking up hefty commissions in the process, and then shifted over to fee-based wrap accounts, Bowden said.

Likewise, the commission will be on the lookout for cash or cash equivalents that advisors park in wrap accounts, as well as fee-based accounts that sit idle for years, save for an occasional trade to cover the cost of the management fee.

"I could go on, but suffice it to say that the move into fee-based wrap accounts is a widespread practice," Bowden said. "A lot of people have jumped into the pot, and we fear that the rationalization that everyone is doing it may be adversely affecting people's thinking about how some of these arrangements are in the best interest of their clients."


In addition to the growing concerns about conflicts associated with the dually registered model, Bowden's team at the SEC is wary of the rise of alternative mutual funds, what he calls the latest "bright shiny object."

The SEC's research has found that assets under management in alternative funds soared 63% over the 12 months ending Oct. 31, 2013, increasing from $158 billion to $258 billion. The commission identified at least 60 new alternative funds launched in 2013, following the rollout of 64 new ones in in 2012, making more than 400 such products available to investors.

“One of the areas where we're beginning to conduct exams to assess the existence and effectiveness of controls is in the alternative mutual fund space. Increasingly, advisors to mutual funds are establishing and marketing funds that are labeled alternative and hold non-traditional investments or engage in complex trading strategies," Bowden said.

"There's certainly nothing wrong with alternative investments, or alternative investment strategies per se. Many investors have benefited from their inclusion in portfolios. But -- and it's a big 'but' -- the use of hard-to-value or liquid securities in an open-end mutual fund, which requires daily valuation and offers daily liquidity, is fraught with risk."

Those characteristics of alternative funds -- daily valuation and liquidity -- "require a tremendous amount of control and discipline," Bowden said.

"If you -- any of you -- have launched or are considering launching a mutual fund that uses alternative investments or strategies," Bowden cautioned the audience, "I implore you to evaluate the reasonableness and effectiveness of your controls."

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