Proponents of the fiduciary standard claim that it will lead to better financial outcomes for clients. But a new study of Canadian advisors, who resemble U.S.-based RIAs but do not adhere to a fiduciary standard, casts doubt on this assertion.
Individual investors throughout the world rely on financial advisors to guide their investment decisions. A common criticism of the financial service industry is that conflicts of interest compromise the quality and raise the cost of advice. For example, in the U.S., many brokers require no direct payment from clients; instead, they draw commissions on the products they sell. Brokers may therefore be tempted to recommend products that maximize commissions instead of serving the interests of their clients. Such conflicted advice leads to higher costs and lower investor returns. Thus, banning commissions and requiring a fiduciary standard of care would improve investor outcomes.
At least in theory.
Juhani T. Linnainmaa, Brian Melzer and Alessandro Previtero, authors of the study, “The Misguided Beliefs of Financial Advisors,” published in the April 2021 issue of The Journal of Finance, considered another hypothesis for the sale of high-cost funds: “Advisors [1] recommend expensive portfolios because they are misguided rather than conflicted. They recommend frequent trading and expensive, actively managed products because they believe active management dominates passive management, despite evidence to the contrary.” If that is the case, then banning commissions and requiring a fiduciary standard of care would not improve results as much as might be expected – a change in their misguided beliefs would also be required.
To test their hypothesis, the authors analyzed data provided by two large Canadian financial institutions. Advisors within those firms provided advice on asset allocation and served as mutual fund dealers. They made recommendations and executed trades on clients’ behalf but could not engage in discretionary trading. And they did not provide captive distribution for particular mutual fund families – they were free to recommend all mutual funds (investing in more than 3,000). These advisors were not subject to fiduciary duty under Canadian law.
The data sample included comprehensive trading and portfolio information on more than 4,000 advisors and almost 500,000 clients between 1999 and 2013. It also included the personal trading and account information of the vast majority of the advisors themselves. The two firms in their sample advised just under $20 billion of assets. The authors focused their analysis on trading behaviors that may hurt risk-adjusted performance: high turnover, preference for funds with active management or high expense ratios, return chasing, and under-diversification. They noted that these patterns have been documented in studies on self-directed investors.
Following is a summary of their findings:
- Advisors invest very similarly to their clients, trading frequently, chasing returns (buying funds with better than average recent returns), preferring expensive (average expense ratio of about 2.4%), actively managed funds, and under-diversifying (7-8% greater idiosyncratic risk than a market-like portfolio).
- The average client invests almost exclusively in actively managed mutual funds (only 1.5% were allocated to passive funds in the study). Advisors allocate even less (just 1.2%) to passive funds.
- An advisor’s own trading behavior strongly predicts the behavior common among his clients. For example, an advisor who encourages his clients to chase returns typically also chases returns himself.
- The connection between advisor and client trading goes beyond similarity in strategy; clients often invest in the same funds at the same time as the advisor.
- Although clients’ and advisors’ trades rarely deviate from each other, differences are systematic – when an advisor deviates from his clients, he favors funds with even stronger prior performance, higher expense ratios and more idiosyncratic risk. Advisors also trade more frequently than their clients.
- Advisors’ and their clients’ net alphas (performance versus passive benchmarks) were negative, averaging -3.1% for clients (t-stat = 3.4) and an even worse -3.7% (t-stat = 3.8) for advisors. The average advisor would earn higher returns if he copied his clients’ portfolios.
- The sales and trailing commissions paid back to advisors on their personal portfolios, net of other fees, raised their net alpha by 66 basis points per year. Therefore, net of all fees and rebates, the total performance of advisors and clients is similar.
- Advisors who pay high fees underperform those who pay low fees, and so do their clients.
- Advisors do not strategically hold expensive portfolios only to convince clients to do the same; they continue to do so after they leave the industry. Post-career advisors continue to favor actively managed funds and under-diversified portfolios, with allocations similar, but slightly more diversified, than they held while active. And nearly 90% of them continued to hold a personal portfolio at their old firm.
Their findings led the authors to conclude: “Our results suggest that advisors’ own beliefs and preferences drive their recommendations.” This is bad news for policymakers, as the evidence demonstrates that requiring a fiduciary standard of care would not result in improved outcomes unless those advisors changed their misguided beliefs and began recommending lower-cost, passively managed funds and greater diversification.
The takeaway for investors is that while choosing an advisor who acts as a fiduciary should be a necessary condition for hiring, it is not a sufficient condition. The sufficient condition should be that the advisor follows the evidence and has a preference for lower cost, passive (systematic or indexed) funds that are also broadly diversified, minimizing idiosyncratic risks.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
Important Disclosure: This article is for educational and informational purposes only and should not be construed as specific investment, accounting, legal or tax advice. The analysis contained herein is based upon third party data and information and may become outdated or otherwise superseded at any time without notice. Third-party data and information is deemed to be reliable but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Wealth Partners, collectively Buckingham Strategic Wealth® and Buckingham Strategic Partners®. R-20-1531
[1] Advisor Perspectives uses the term “advisor” to refer to SEC-registered advisors who adhere to a fiduciary standard. It uses the term “broker” to refer to those licensed to sell securities but not required to adhere to a fiduciary standard. This distinction cannot be applied to Canadian professionals in this study, so we use the term “advisors” for those referenced in this study.
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Proponents of the fiduciary standard claim that it will lead to better financial outcomes for clients. But a new study of Canadian advisors, who resemble U.S.-based RIAs but do not adhere to a fiduciary standard, casts doubt on this assertion.
