Why do so many clients of financial advisers lag the stock market’s return?
Advisers’ conflicts of interest are not the only reason, and perhaps not even the major reason. What really harms investors is that many advisers actually are convinced that frequent trading and expensive, actively managed funds are the key to investment success. What’s more, these advisers treat their own portfolios exactly the same.
Those are the surprising findings of a recently released academic study entitled “The Misguided Beliefs of Financial Advisers.” Its authors are Juhani Linnainmaa, a finance professor at the University of Southern California, Brian Melzer, a senior economist at the Chicago Federal Reserve, and Alessandro Preyitero, a finance professor at Indiana University.
In addition, this new research suggests that regulatory changes designed to eliminate conflicts of interest— such as the Fiduciary Rule — are unlikely to have as big an impact as hoped.
The researchers reached these provocative conclusions upon analyzing the portfolio histories of more than 500,000 investors who were clients of 4,000 advisors at either of two major Canadian financial institutions between 1999 and 2013. The database also contained these advisers’ own trading histories. This unique database enabled the researchers to compare the compositions of advisers’ portfolios and those of their clients.
To put this in perspective, investment advice in Canada generally carries higher fees than in the U.S., Preyitero told me in an interview. Accordingly, as a general rule, Canadian investment advisers face greater conflicts of interest than their U.S. counterparts. So if those conflicts of interest did play a large role in advisers’ bad advice, we’d expect them to be particularly evident in the database the researchers studied.
They were not. On the contrary, the researchers found that advisers were guilty of the same value-destructive behaviors as the clients. Consider the average expense ratios of the mutual funds the advisers recommended to their clients, for example: a sky-high 2.36%. If that was the only data point we had, we’d immediately suspect that the advisers were recommending these high-fee funds in order to earn more commission income.
But the researchers found that the average expense ratio of the funds that these advisers held in their own portfolios was even higher, at 2.43%. This certainly implies that the advisers must really believe that these expensive mutual funds are superior, even though the nearly universal conclusion of decades of research is that they are not.
One comeback to this tentative conclusion might be that the advisers are investing in these mutual funds in order to convince their clients to do the same. The researchers rule that out possibility, since they find that these advisers continue to invest in expensive mutual funds even after they have left the industry.
The researchers reached the same conclusions when analyzing high portfolio turnover, which skeptics previously have associated with adviser conflicts of interest since higher transaction frequency generates more commission income. But the advisers’ own portfolio turnover is just as high as that of their clients, and remains high even after the advisers have left the industry.
The bottom line is performance, of course. The researchers found that both advisers and clients had almost identical returns, on average, about 3% below that of a buy-and-hold strategy.
It would certainly appear from these results that one of the bigger challenges the advisory industry faces is education. It’s not that conflicts of interest aren’t important, Preyitero emphasized. It’s just that they aren’t the only, or necessarily the biggest, source of unprofitable advice.
Unfortunately, if you thought overcoming conflicts of interest is difficult — and it is — addressing educational deficits will be even more so, if not impossible.
This research should nevertheless lead investors to recommit to be as educated as possible about what really works in the investment arena. We need to be rigorously empirical as well, subjecting all our beliefs and assumptions to statistical scrutiny. Given that advisers perform just as poorly as their clients, advisers owe this not just to their clients, but to themselves.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com .
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