The Misguided Faith in the Fiduciary Standard

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.