What's the difference between a broker and an investment advisor ?

Earlier this year, the U.S. Court of Appeals for the District of Columbia Circuit vacated a controversial SEC rule which exempted fee-based brokerage programs from the Investment Advisers Act of 1940.

The "Merrill Rule" or exemption, allowed broker-dealers especially brokerage firms and wirehouses to offer their clients fee-based brokerage accounts without first registering those accounts with the SEC under the Investment Advisor Act of 1940.

Investment advisors offer similar fee-based accounts—termed ‘advisory accounts—and are held to the fiduciary standards stipulated in the 1940 legislation. Brokerages are governed by an earlier Act that ensures that what they recommend is suitable for the client and does not require them to act in the client's best interest.

The real problem is a need to completely separate "brokerage" from "advice".

Brokerage is a sales function and not an advisory function. And I don't mean simply execution of buy and sell transactions for securities. The primary function of a broker is to sell products and services that are created or managed by the investment banking and execution services side of the brokerage.

Earlier that meant encouraging lots of stock transactions and peddling offerings of stocks and bonds. In the bad old days it meant peddling mutual funds that offered the firm a kickback of some form. These days, it means offering the service of managing your money for an annual percentage fee. But in all cases, the brokerage firm is still in the business of selling products and services that the investment banking and execution services portions of the business profit from. Selling advice may sound like a service, but at a brokerage firm it is really more of a collateral activity to induce demand for the actual products and services that benefit the investment banking and execution services sides of the brokerage firm.

That is the key difference of an independent advisor : they don't have investment banking and execution services interests to peddle.

Another related issue is that brokerages are earning increasing profits from their in-house proprietary trading desks. In other words, the firm is trading for its own account. Your assets are on the books as belonging to you, but once you hand them over to the brokerage firm to manage, they can utilize them to fuel the in-house trading operation. For example, your stock can be borrowed to permit a short sale.

Part III - Is the stock market a better long term investment than real estate?

What about the tax benefits of owning real estate?

Real estate, especially if you own your own home offers a number of tax benefits; you can deduct mortgage interest (up to $1m) as well as property taxes. Furthermore when you sell, provided that you've lived in your home for 2 years, the first $500,000 in capital gains are tax free.

Rental property also comes with the very same breaks in addition to the deductibility of maintenance costs, advertising and depreciation. The only difference is that there is no $500,000 capital gains exclusion.

Stocks on the other hand are subject to capital gains tax and provided a stock is held for more than a year, a 15% federal tax rate applies. Moreover any investment losses can be offset against gains.

Part II - Is the stock market a better long term investment than real estate?

"What about the obvious advantage of leverage?" "Doesn't a mortgage magnify the return?".

You know, buy a condo in Miami for $500,000 with a 5% down payment of $25,000 and the condo appreciates 10% in two years. Voila ! Assuming no transaction costs we have a spectacular 200% return!

You can also leverage stocks by buying on margin although only up to 50% of the stock price. You could do even better in options but risk losing everything.

Remember there's a flip side to leverage; take today's condo glut in Miami. In the scenario above the same condo today is worth $450,000, that's if you're lucky enough to find a buyer. Ouch ! now you find yourself owing the bank $25,000; something a lot of people in formerly "hot' markets are experiencing first hand.

Despite this wrinkle, nothing beats the leverage one can get in real estate in taking a small amount of money to make great gains in a rising market.