It’s not conflicts of interest that lead advisors to put clients into high-cost, high-turnover, actively managed mutual funds. Advisors personally invest the exact same way and in the same funds for their own portfolios and experience similar drags on investment performance, according to a recent research paper.
The researchers found that advisors were as prone to performance chasing, high-cost active management investment funds and ill-timed trades in their own accounts as they were for their clients; they often make investments in the same mutual funds and at the same time. The findings suggest a focus on fiduciary regulations for advisors may not be as effective as increased screening and education for the profession.
“Advisors are willing to hold the investments they recommend. Indeed, they invest very similarly to clients, but they have misguided beliefs,” according to the research paper published by Indiana University's Kelley School of Business, authored by Juhani Linnainmaa from the University of Southern California and Alessandro Previtero from Indiana University, both associated with the National Bureau of Economic Research, and Brian Melzer from the Federal Reserve Bank of Chicago.
“Both clients and advisors exhibit trading patterns previously documented for self-directed investors. For example, they purchase funds with better-than-average historical returns and they overwhelmingly favor expensive, actively managed funds. This similarity suggests that advisors do not dramatically alter their recommendations when acting as agents rather than principals,” they found.
The average expense ratios of mutual funds in both advisors’ and clients’ portfolios were also nearly the same, at 2.43 percent and 2.36 percent. After adjusting for fees and rebates, the researchers found the “net alpha” for both advisors and clients were similar, around -3 percent.
The results held true even after adjusting for “fixed effects” on portfolios, like age, risk tolerance and time horizons. “The client fixed effects also prove important in explaining portfolio choices, but they do not meaningfully crowd out the advisor effects ... an advisor’s own trading behavior strongly predicts the behavior common among his clients.”
A caveat: These advisors and clients were Canadian, and not fiduciaries. The researchers used comprehensive trading and portfolio information on more than 4,000 advisors and close to 500,000 clients between the years 1999 and 2013, provided by two large Canadian financial institutions whose advisors provide advice on asset allocation and the purchase of mutual funds. The advisors aren’t providing captive distribution of funds, rather, they are free to recommend any mutual fund. The data also included the personal trading and account information of the advisors themselves.
When advisors do invest differently than their clients, they actually favor funds that have even stronger prior performance, higher expense ratios and more “idiosyncratic risk.”
The conclusions for policy makers? A focus on fiduciary rules for advisors may be less beneficial than previously believed; instead, the focus should shift to assuring a higher bar of competency.
“Regulations that reduce conflicts of interest—by imposing fiduciary duty or banning commissions—do not address misguided beliefs,” the researchers write. “When advisors recommend strategies that underperform, they act as an agent exactly as they would as a principal, so aligning their interests would not change their behavior. Solving the problem of misguided beliefs would instead require improved education or screening of advisors.”
