The Financial Advisor’s Hypocritical Oath
Imagine a world in which there was a distinction between “doctors” and “physicians,” and imagine further that doctors were bound by the Hippocratic Oath to “keep the good of the patient as the highest priority” while physicians simply had to do whatever was expedient. To top it off, it was your responsibility to distinguish the doctors from the physicians.
That’s the very situation that exists today in the world of investment advice. Financial advisors come in two basic varieties. The first and most common variety work for broker-dealers like Merrill Lynch, Smith Barney or scores of smaller investment firms affiliated with banks and insurance companies. These brokers tend to be compensated by commissions generated by the products they sell to their clients. Brokers are regulated by the Financial Industry Regulatory Authority (more commonly known as FINRA). FINRA, which is funded by the very brokerage firms it regulates, requires that brokers recommend products that are “suitable” for their clients. The other type of financial advisor is a Registered Investment Advisor or RIA. The Securities and Exchange Commission (SEC) regulates RIAs and requires that they serve in a fiduciary capacity for their clients — in other words, they must focus on recommendations that are in the client’s best interests. RIAs do not receive commissions; instead they are compensated directly by their clients, usually in the form of an agreed-upon flat fee or a fee based on assets under management.
The operative words in the preceding paragraph are “suitable” and “fiduciary,” and investors need to understand the difference and determine which is better for their needs. Here’s a simple way to think about it. Let’s say you needssome broad exposure to large-cap U.S. equities. You don’t believe in active management and want a simple index fund benchmarked to the S&P 500. A broker is likely to offer you an index fund, often managed by his own firm, that pays an upfront commission and/or annual trail commissions. In order to pay those commissions the fund has to boost its expenses — thereby reducing the return you get on your investment. Nonetheless, it is a suitable investment, and the broker is under no obligation to inform you that there are less expensive alternatives or that his actions may represent a conflict of interest. An RIA, on the other hand, would have a fiduciary obligation to recommend a low-cost index mutual fund or exchange traded fund. Doing otherwise would be grounds to lose his or her license.
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