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Financial advisors governed by fiduciary duty are bound by law to act in the best interests of their clients at all times. This is very important because it protects individual investors from having an advisor take advantage of them.

What Is Fiduciary Duty?

Fiduciary duty is considered the highest legal obligation. It requires the fiduciary to act only in the best interest of her client, the principal. Fiduciary duty applies to a number of professionals, including lawyers and corporate directors. These individuals have a fiduciary duty to their clients and shareholders, respectively.

Fiduciaries are also required to avoid conflicts of interest that may prevent them from seeking the best outcome for the principal. This means avoiding situations in which the principal's interests clash with the fiduciary's personal gain.

For example, a lawyer should not represent a client who is suing the company where the lawyer's husband works. To preserve her husband's career, the attorney may be tempted to do less than her best work in prosecuting his employer, putting her in breach of her fiduciary duty to her client.

Fiduciary Duty in Finance

Fiduciary duty in the world of finance and investment is incredibly important because there so many situations in which an advisor might unfairly gain at the expense of her client's interests. However, not all financial advisors are subject to the constraints of fiduciary duty. In fact, only advisors registered with the Securities and Exchange Commission (SEC) or similar state securities regulators have a fiduciary duty to their clients. Since this type of registration is not required, there are many advisors who are only bound by a suitability standard, by which they are required only to recommend investments suitable for their clients based on the clients' goals and finances.

Example

Assume you want to invest in mutual funds but need some help deciding where to put your money. You have specific investment goals in mind but need a financial advisor to point you in the right direction and help you achieve those goals. After much research, you narrow it down to Advisor Jim and Advisor Jane. While Jim is registered with the SEC and bound by fiduciary duty, Jane is not.

Both advisors agree there are three mutual funds that suit your needs and have identical returns. One is offered by Jim's firm, one by Jane's and one by a third firm. Both Jim and Jane receive a commission on any investment you make in products offered by their respective firms.

If all three funds are identical in every way, there is no potential conflict of interest because choosing a fund that pays a commission to one of the advisors does not impact your investment or returns in any way. However, in reality, the three funds have varying expense ratios of 3%, 2% and 1.5%. An expense ratio is the percentage of the fund's value that a firm retains each year to pay for operating and administrative costs, which can add up quickly if you make a sizable investment.

If you employ Jim, he is required by his fiduciary duty to recommend the mutual fund with the lowest expense ratio, since all other factors are equal. Even though he does not receive a commission, he is legally obligated to ensure you are directed to the most profitable option.

However, since Jane is not constrained by fiduciary duty, she is well within her rights to recommend the fund offered by her firm, despite its higher expense ratio. Because it meets your investment goals, the fund that pays her commission is technically suitable despite being more expensive for you.

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