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If you're enrolled in one of the popular investment advisory services offered by brokers, such as Merrill Lynch (MER
) Personal Advisor, Smith Barney Advisor (C
), or Schwab Private Client (SCHW
), your brokerage firm will soon make a special request of you. You'll be asked to agree in writing to allow the brokerage house to engage in "principal trading" with your account. That means buying stocks and bonds from the firm's own inventory, rather than having your adviser search for the best price on the open market.
Although principal trading is often employed in traditional commission-based brokerage accounts, it had been effectively off-limits in fast-growing advisory accounts, which number some 400,000 and provide unlimited transactions and a more comprehensive level of advice for an annual fee that averages about 1% of assets.
Known as nondiscretionary advisory accounts, these are governed by a more stringent set of regulations aimed at preventing conflicts of interest than are brokerage accounts. But in September, the Securities & Exchange Commission granted temporary permission for principal trades in the accounts, in part to give investors better access to hard-to-find securities.
Brokerage firms say such trades are especially advantageous if you want to buy individual bonds or shares in recently completed initial public offerings. Even consumer advocates concede such trades may result in more competitive prices. That's in part because when brokerages have a large block of a particular security—say, a municipal bond—in inventory, they can combine individuals' small orders with the bigger ones that come in from institutional investors. That allows them to pass along more attractive prices, says Jeff Strange, a senior analyst at Cerulli Associates, a research firm specializing in the financial services industry.
On the flip side, consumer advocates warn that brokerage firms may have incentives to push securities in their inventories. For instance, when Charles Schwab sells newly issued bonds as a principal, the firm pockets a distribution fee from less than 0.01% to 2% of the bond's face amount. In the disclosure brochure for its Schwab Private Client advisory account, the firm concedes that there's an inherent conflict of interest in those transactions.
If you think you can benefit from principal trades, give your consent but keep a watchful eye. Since your broker/adviser must seek permission for each trade as well as your approval to do a principal transaction, that's a good time to question a price. You also need to keep an eye on how your principal trades perform as a group. It's difficult to prove a broker failed to give you the best price available at the time on a particular transaction. That said, a red flag might be raised if you see a pattern of price declines in securities your firm recommends and sells you on principal that can't be explained by a fall in a stock's sector or in the overall market. If you have concerns, you can revoke your consent at any time.
When the rule that permits principal trades in these advisory accounts expires in 2009, the SEC will weigh whether they're working in investors' favor. If you're diligent in watching the transactions, you might even have some informed comment to offer the regulators. By Anne Tergesen