To determine if incentives drive investor decisions when choosing mutual funds, Diane Del Guerico and Jonathan Reuter, authors of the study, “Mutual Fund Performance and the Incentive to Generate Alpha,” came up with a unique take on the performance of mutual funds. They divided the fund marketplace into two very distinct segments — funds that are marketed directly to retail investors and funds that are sold through brokers. They found several important differences.
Blame the brokers for poor performance
First, they found that while it’s well documented that actively managed funds underperform, once the funds where segmented, the underperformance is basically explained by the poor performance of the funds sold through brokers. They found that the actively managed funds marketed directly to the public perform similarly to index funds The difference was 1.8 basis points per month, or about 0.22 percent a year. Funds sold through brokers underperform by 9.3 basis points per month or 1.12 percent per year.
Avoid the raw returns
risk-adjusted performance impacts the cash flows of the funds that are sold
directly to retail investors (investors increase flows to funds with superior
risk-adjusted returns). However, this is not the case for the actively managed
funds sold through brokers. Investors in funds sold through brokers have fund
flows that follow raw returns — not returns adjusted for risk.
This naive behavior can be explained by the results from a study on defined contribution plans which found that participants who choose to invest through a broker are younger, less highly educated, and less highly paid than self-directed investors, suggesting that they are less experienced investors. Brokers are able to exploit the lack of knowledge and inexperience and recommend funds that provide them with greater compensation.
Check the scores
Third, they found that funds sold directly to the public are more likely to hire portfolio managers from undergraduate institutions with higher average math SAT scores than families with broker-sold funds.
Fourth, direct-sold fund families are about half as likely to hire sub-advisors as broker-sold families — approximately 22 percent of broker-sold funds have a sub-advisor versus roughly 12 percent of direct-sold funds. This is important because it has been found that funds run by sub-advisors underperform the sub-advisor’s own brand of in-house funds by about 1 percent a year. The study authors drew this conclusion: “Direct-sold funds are less willing to sacrifice performance in order to meet other family objectives, such as expanding fund offerings to include investment styles outside of the family’s current expertise.”
Conflict of interest
The authors concluded: “The fact that the vast majority of the assets in the broker-sold segment are invested in underperforming actively managed funds is likely to reflect an agency conflict (conflict of interest) between brokers and their clients. The brokers tend to recommend funds that compensate them the most, and these funds have higher expenses because of the need to compensate the fund managers as well as the brokers selling the product. The higher expenses create the higher hurdle which active managers have not been able to overcome. This conflict of interest is easily overcome by insisting on a fiduciary standard of care and by requiring that any compensation an advisor receives should come solely from the client in the form of fees, not commissions."