For actively-managed mutual funds, self-directed investors get better returns than those using brokers. Why this is so comes down to a question of motivation, according to Department of Finance head and Gerry and Marilyn Cameron Professor of Finance Diane Del Guercio and associate professor of finance Jonathan Reuter of Boston College.
Their work has garnered the attention of the highest office in the land. In February, Del Guercio and her coauthor were referenced in the White House report “The Effects of Conflicted Investment Advice on Retirement Savings.”
Previous research indicates investors who have someone else choose their actively-managed fund investments on their behalf are doing so because of their “disadvantaged investor” status. In other words, according to Del Guercio and Reuter’s paper, “investors who rely on the advice of their broker report that they are not comfortable making their own allocation decisions.” Yet those who go it alone experience returns 1.12 percent per year better than those who use a broker.
The common conclusion in finance circles has been actively managed funds typically underperform when compared to passive (index) funds. But when Del Guercio and Reuter broke apart the commonly pooled together “actively managed funds” into two distinct groups—those serving self-directed and those serving broker-directed investors—it was the broker-directed actively managed funds that underperformed. This leads the authors to believe the underperformance of the average actively managed fund tells us more about fund manager and broker incentives than it does about market efficiency.
“Several papers have documented that commissions paid to brokers provide powerful incentives to direct flow to those products, suggesting that broker-sold funds can better compete for assets through larger payments to brokers rather than through increased efforts toward improving fund performance,” Del Guercio and Reuter stated in their study. “Thus fund managers in this segment of the industry have weaker incentives to deliver superior performance to their clients.”
So why would someone use a broker when odds are he or she would get better results on their own?
“One possibility is that brokers provide other valuable services to their clients that compensate for the underperformance, for example, by helping them avoid other costly mistakes,” the authors explained.
It’s also possible, they noted, that brokers “direct clients to the funds that offer them the greatest commission payments, and that their inexperienced clients are unable to distinguish good advice from bad.”
A broker may give advice based more on whether or not he will receive a commission on a product, whereas an individual investor savvy enough to make their own investment decisions is more likely to focus only on returns and, thus, earns better ones.
Del Guercio notes brokers working to gain commissions are not necessarily acting unethically, they are responding to incentives.
For someone uncomfortable making their own allocation decisions, she offered the following advice: “If I were talking to a friend or relative, I would recommend using a fee-only based advisor motivated by serving the customer rather than one motivated by commissions on certain funds and products.”
It’s a timely issue, Del Guercio noted, as employers in the United States move away from pensions and into individual retirement plans and more and more lay people take the reins in their long-term financial future or pay someone else to do so.
Along these lines, Abbott Keller Professor of Finance John Chalmers earlier this month participated in the Eugene Mayoral Forum, cohosted with AARP, where topics of discussion included his research on Oregon PERS participants’ investment allocation decisions (PDF), as well as retirees’ decisions regarding the choice between lump sum and life annuity payments (PDF). Their study was also referenced in the White House report.
Read the White House Report