Yield of Dreams

New Study Says You Are Biased, But Are You Really?

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A new study says you're in it for the money, but I have some issues with their argument.

It has long been debated in this industry whether commission-based advisors are doing what’s in the best interest of their clients, or simply piling them into the investments that gives them the most fees. Now the debate has gone national, with a new paper published by the National Bureau of Economic Research (NBER) on an audit by Consumer Financial Protection Bureau (CFPB).

The paper concludes that retail financial advisors tend to choose investments that will maximize their fees, particularly actively managed investments with higher expected fees. But there are several holes in this study, and in my opinion, it’s plain subjective and wrong.

The study was conducted by sending undercover auditors into financial advisors’ offices at banks, independent brokerages, and investment advisory firms. The paper argued that these advisors are usually paid on the fees they generate, not on AUM or the performance of the portfolio.

But is that even a safe assumption to begin with? Afterall, Registered Rep.’s 2012 Independent Broker/Dealer Report Card, a survey of these very independent brokers, found that asset-based fees account for 44 percent of their business, compared with 49 percent coming from commissions. Further, they expect asset-based fees to grow to 55 percent of their business in three years.

So, it’s not a valid argument that the majority of retail advisors are paid by commissions. The industry’s changing, and shifting towards a fee-based model more every day. RIAs and hybrids (mix of commissions and fees) are the fastest-growing segments of the advisor market. Even some Wall Street firms are ramping up their fiduciary training programs, although these firms are keeping it on the down low.

Even if we’re having a discussion about those advisors who are primarily paid by commissions, you’re walking a fine line if you assume that their decisions are predominantly motivated by fees. That’s extremely subjective. Nobody knows what makes an individual advisor tick.

Granted, there are always the bad apples out there—those who will put their clients in unsuitable, inappropriate, and risky investments for their own gain. (There are also those who will flat-out steal from clients.) But there are bad apples in any industry, and one bad apple doesn’t spoil the whole bunch.

In the NBER study, each undercover auditor went through one of four scenarios with the financial advisor:

In the first scenario (“chasing fund returns”), the auditor holds a portfolio in which 30% is invested in one sector exchange traded fund that performed well in the previous year, and he expresses an interest in identifying more industries that had done well recently. In this case, the incentives of the adviser and of the client are not aligned: the adviser benefits from the bias of the client since it allows him to churn the portfolio more often and generate more fees, whereas the client would profit from a better diversified portfolio.

In the second scenario (“employer stocks”), an auditor holds 30% of his portfolio in the company stock of his assigned employer. Thus, incentives of the adviser and of the client are aligned: it is in the best interest of the adviser to reduce or eliminate the client’s bias since holding company stock also reduces the adviser’s ability to generate fees.

In the third scenario, the auditor holds a diversified, low‐fee portfolio consisting of index funds and bonds‐‐in effect, an efficient US portfolio. We introduce this scenario to test if advisers are willing to move clients out of this portfolio which would be closest to an allocation recommended in most finance textbook.

Finally we have a control group (“cash scenario”) in which the advisee simply holds certificates of deposits and does not espouse a particular view beyond a general willingness to increase risk for higher returns. This variation in treatment groups will allow us to test how responsive advisers are to the needs of their prospective clients.

Broadly, advisors supported the trend-chasing portfolio, while they were less supportive of the company stock portfolio, the paper said. They did not support the index portfolio and instead suggested a shift to active management.

But there was a huge problem with its methodology in coming to this conclusion. The paper said only about half of the advisors pushed auditors towards active funds, versus 7.5 percent who pushed index funds. First, the paper called this 50 percent “a significant bias towards active management.” That’s not even a majority! Second, what happened to the other 42.5 percent?

Now, that said, I’ve seen the evidence myself for passive investing. Many great investing minds say active management’s a zero sum game. But why does active management have to be synonymous with bias? It does have its place in certain portfolios, depending on what the investor wants and what their risk tolerance is. Even the NBER study said that most advisors asked clients about their demographic characteristics, time horizons, and risk tolerances.

And these days clients are demanding some sort of active management! I’m with Josh Brown, financial advisor and the blogger behind ReformedBroker.com, on this: “I don’t think that people’s entire portfolio should be actively managed. But I also don’t think in this day and age with a potential crisis around every corner that you can just say, ‘Buy it and let the market take care of it.’ Clients are counting on me not to do that.”

I’m not sure Brown would agree with me here on my arguments about commission-based reps, as he’s a fee-only advisor. But I understand what he’s saying here about active management:

“Anyone who says every dollar should be passively or every dollar should be actively managed is an ideologue. There are some instances where a managed solution makes sense, and some instances where passive is the way to go. I feel bad for the client whose advisor is so doctrinaire that they won’t even consider one of the other.”

Also, I don’t think their sample size was large enough to paint such a broad streak across the industry. According to the paper, there were 284 total audit visits—not a complete snapshot by any means.

Further, this paper makes no attempt to show how each portfolio would’ve performed, had the auditors taken the advisors’ advice. Isn’t this what their whole argument is based on? So their fees were higher, but did the portfolios make up for that in performance? We don’t know.

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Casting a gimlet-eye on asset management issues.

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