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Does New Study Seal the Deal for Fiduciary Standard – or Just Warn Plan Sponsors?

January 19
01:14 2011

Will a new study, part of the National Bureau of Economic Research (NBER) Working Paper Series, be the final straw that forces regulators to adopt a universal fiduciary standard? The research, reaffirming a 2009 study published Helping hand shakes another in an agreementin The Review of Financial Studies, appears to provide empirical evidence showing broker-sold mutual funds significantly underperform direct-sold mutual funds. Most importantly, this underperformance exceeds the cost of broker’s fees, meaning the underlying performance of broker-sold funds – before one even takes fees into account – substantially underperforms their direct-sold competitors. The implications for plan sponsors, however, may outweigh whatever the regulators determine.

Could this be the Holy Grail of all studies? Not only does it suggest a monetary advantage for the fiduciary standard over the suitability standard, but it also may explain the common (and widely reported) misperception regarding active versus passive forms of management.

Kerry Pechter first broke this story in his article “Are Direct-Sold Funds a Better Value?” (Retirement Income Journal, January 13, 2011). Fiduciary News contacted Mr. Pechter and he suggested we speak directly to the authors of the study. (Editor’s note: We apologize but all the links in this article go to pay-per-view sites. This happens often in the academic realm.)

The working paper, “Broker Incentives and Mutual Fund Market Segmentation,” (NEBR, August 2010), was written by Diane Del Guercio (Lundquist College of Business), Jonahan Reuter (Carroll School of Management at Boston College) and Paula A. Tkac (Federal Reserve Bank of Atlanta). Fiduciary News spoke with Jon Reuter, Assistant Professor of Finance in the Carroll School of Management at Boston College who explained the primary purpose of the paper was to try to uncover an economic purpose for the use of certain distribution models within the mutual fund industry. The researchers, after using investment return date from 1996-2002 to compare investment returns of broker-sold mutual funds with the returns of direct-sold funds conclude “within the full sample of actively managed domestic equity funds in CRSP, we also find robust evidence that funds distributed through the direct channel outperform comparable funds distributed through other channels by 1% per year.”

Professor Reuter pointed out their paper “extended the analysis (along several dimensions)” of a 2009 study “Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry,” by Daniel Bergstresser (Harvard Business School), John M. R. Chalmers (Lundquist College of Business, University of Oregon) and Peter Tufano (Harvard Business School and NBER) published May 21, 2009 in The Review of Financial Studies. Reuter credits this study as the first to “document before-fee performance differences between direct-sold and broker-sold funds.” The NEBR paper confirms these results and then some.

But before we get into that, we thought you might be interested in this fascinating (and topical) tidbit from the 2009 study: “Financial advisors are fiduciaries, owing clients even higher duties; in theory, they must put their clients’ interest ahead of their own. The extent to which investment professionals can be held to strict fiduciary standards presents complex legal issues, and investors may not appreciate distinctions between brokers and advisors. Nevertheless, if brokers’ self-interested actions were to explain our results, it would call into question the nature of the relationships between consumers and those who serve them.”

The 2009 study, however, did not include institutional funds in its analysis. Reuter’s paper does – and that can have far reaching implications to plan sponsors along with the adoption of a universal fiduciary standard. While the NEBR study barely addresses the fiduciary standard debate, in a nutshell, the paper concludes direct-sold mutual funds (including institutional funds) outperform broker-sold mutual funds by 1%. Professor Reuter agrees “it is reasonable to conclude” 401k plan sponsors – and the participants of their plans – on average will tend to benefit from hiring a fiduciary charging an asset based fee of less than 1% compared to buying funds through a broker.

And, unlike the analysis which proposes the existence of unidentifiable intangible benefits to retail investors using brokers (e.g., “one-on-one personal attention, or broker incentives to recommend certain funds”), no such non-performance benefit accrues to the participants of 401k plans (and might lead to a prohibited transaction if such non-performance benefit accrues to the plan sponsor).

The NEBR paper does a very good job explaining why direct-sold mutual funds outperform broker-sold funds using common sense economic theory. First, it “proves” the dichotomy of the two channels by showing very few funds (3.3%) attempt to market themselves both directly and through brokers. Second, by focusing on the educational pedigree of the portfolio managers from funds in each group, the study finds direct-sold funds are more likely to hire more expensive talent. In general, since performance is a key attribute in the direct-sold distribution channel, those funds tend to invest more in performance enhancing activities. On the other hand, broker-sold funds tend to invest more in marketing and distribution activities.

Oddly and perhaps counter intuitively, although they perform more poorly, broker-sold funds experience less turnover than their direct-sold counterparts. According to the study, “The relative lack of sensitivity to after-fee performance in the broker-sold channels is consistent with other factors driving flows in these channels (e.g., one-on-one personal attention, or broker incentives to recommend certain funds). It is worth noting that, unlike in traditional brokerage accounts where broker compensation depends on the number of trades their clients make, brokers selling mutual funds have less incentive to churn; broker-sold mutual funds compensate brokers for selling their funds and, through the use of trailing loads (12b-1 fees), for keeping clients invested in these same funds.”

The paper concludes, compared to direct-sold funds, with broker-sold funds “there is little to no benefit to being a top performer and relatively little punishment for posting bad performance.” The study ends with this prediction: “If payments to brokers for advice increasingly come directly from investors rather than via mutual fund families, the universe of funds that brokers are willing to recommend will likely expand, and competition is likely to focus more on after-fee returns.”

There you have it. In short, this one paper, perhaps not as well read as it should be, almost accidentally seals the deal for the fiduciary standard, exposes the conflict-of-interest created by 12b-1 fees and, dare we say, touches the forbidden third rail of all investment research: it shows – within the direct-sold fund channel – index funds have no inherent advantage over actively managed funds (and suggests past studies may have reached opposite conclusion by overweighing the impact of broker-sold funds); thus, adding another nail to the coffin in the all-too-often repeated misconception that passive consistently outperforms active.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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