In an attempt to weed out conflicts of interest, regulators in various jurisdictions have banned commissions and adopted fiduciary duties. Both options are being considered in Canada.
A recent paper from a group of U.S.-based academics is worth reviewing in this context. For “The Misguided Beliefs of Financial Advisors,” Juhani Linnainmaa from the University of Southern California, Brian Melzer from the Federal Reserve Bank of Chicago, and Indiana University’s Alessandro Previtero reviewed 14 years of Canadian trading and portfolio information. The good news is they found most advisors co-invest with their clients; the bad news is many were underperforming.
The paper used data from 1999 to 2013, provided by two unnamed MFDA dealers, where advisors had a broad shelf from which to recommend mutual funds. The data included trading and portfolio information on more than 4,000 advisors and nearly 500,000 clients, as well as personal trading and account information for 74% of those advisors. This allowed the researchers to compare advisors’ own behaviour with what they recommended to clients.
The analysis revealed that advisors “overwhelmingly favour expensive, actively managed funds” for their clients, and that they invest the same way—despite delivering net returns “substantially below passive benchmarks.” Both clients and advisors in the sample underperformed the benchmark by 3%. The paper also found that advisors’ trading behaviour after leaving the industry was mostly unchanged.
“Collectively, our results suggest that advisors’ own beliefs and preferences drive their recommendations,” the authors write. “We examine and rule out an alternative explanation, namely that advisors invest in expensive funds only to convince their clients to do the same. If anything, advisors invest even more similarly to clients when the cost is highest, that is, when their personal portfolios are large.”
The finding has policy implications, the authors say. Reducing conflicts by banning commissions or introducing fiduciary duty won’t change behaviour if the problem is advisors’ beliefs. They suggest “improved education or screening of advisors,” but acknowledge that “regulators would have to specify what constitutes ‘good advice,’ thereby limiting investor choice. Regulation-based barriers to entry could [also] increase the cost of advice.”