New 401k Plan Sponsor Fiduciary Worry: Study Reveals Previously Unpublicized Conflict of Interest Can Harm Mutual Fund Performance
The calendar may say today is April Fools’ Day, but this is no joke. In fact, if you’re a 401k plan sponsor, it should scare you. A study by University of Iowa Professor Ashish Tiwari and Lorenzo Casavecchia at the University of Technology Sydney (as in Australia) has discovered a previously underreported hidden conflict-of-interest in many mutual funds that can cost investors significantly in terms of performance. Unlike other conflicts-of-interest (like 12b-1 fees and revenue sharing), this particular conflict-of-interest is not disclosed in the mutual fund prospectus. It’s almost impossible for a retail investor to find and uncovering it in specific situations can tax even the most ardent professional adviser.
Yet, in the worst case, its impact can be the difference between a comfortable retirement at a reasonable age and working longer than desired to accumulate sufficient assets to retire. Tiwari and Casavecchia write the impact can be as much as 1% a year in terms of investment performance. How significant is 1%? For every ten years, it will take an addition year to make up an average annual shortfall of 1%. So, for example, after ten years you’ll need another year to catch up. After 20 years, you’ll another two years to catch up. After 30 year, you’ll need another three years to catch up.
What is this heretofore ignored conflict-of-interest. FiduciaryNews spoke with co-author Ashish Tiwari about it. Tiwari, an Associate Professor of Finance and Tippie Research Fellow at the Henry B. Tippie College of Business, University of Iowa, Iowa City, Iowa, identifies this culprit as “cross trading” (here’s a link to the paper, titled “Cross Trading by Investment Advisers: Implications for Mutual Fund Performance”).
“A cross trade is a transaction between two accounts that are managed by the same investment adviser,” says Tiwari. “Cross trades may be conducted by an adviser on an agency or a principal basis. In a principal cross trade, an adviser (or its affiliated broker), acting for its own account, buys a security from, or sells a security to, a client – for example, a mutual fund. In an agency transaction, the adviser (or its broker), arranges a transaction between different advisory clients, or between a brokerage customer and an advisory client. In general, cross trades are permitted as long as they are disclosed and consent is obtained from the client, prior to the completion of the transaction.”
Please note that cross trades are perfectly legal and not always against the interest of the client. Tiwari says, “It should be emphasized that cross trades could in fact benefit the client funds – for example, by reducing or eliminating commission costs. However, cross trades present some inherent risks. For example, based on past administrative actions that the SEC has initiated against certain investment advisers, the practice of cross trading creates the potential for one party to be favored over another client. This may happen, for example, when an adviser, acting as an agent, causes an illiquid security to be sold by one client fund to another client fund at an inflated price, thereby benefitting the shareholders of the first fund at the expense of the latter. Another example could be a case in which the incentive to earn additional compensation, in the form of trading commissions, may create a conflict of interest when facilitating agency transactions among client funds. Such conflicts would be reflected in relatively high commission costs borne by the client funds. In fact, our findings suggest that the substantially higher commissions paid by client funds of advisers that rank high on our measures of cross trading intensity (high-TCT advisers), are a major source of the underperformance such funds.”
The challenge, of course, is trying to some metric for cross trading. It’s certainly not available in the mutual fund prospectus. In fact, the authors had to create a metric based on answers provided in the fund adviser’s Form ADV. “The source of the data on investments advisers is the Form ADV (UNIFORM APPLICATION FOR INVESTMENT ADVISER REGISTRATION) that investment advisers are required to file with the SEC,” says Tiwari. This is not a form many 401k plan sponsors are familiar with. Still, says Tiwari, “Form ADV data are available through the Investment Adviser Public Disclosure (IAPD) website maintained by the SEC (http://www.sec.gov/answers/iapd.htm). Along with other information, under Item 8 (Parts A and B) of Form ADV, fund advisers are required to disclose their “Participation or Interest in Client Transactions.” This disclosure takes the form of a “Yes” or “No” response to a set of 6 questions about the fund adviser’s participation and interest in the client (fund’s) transactions. Three of these questions are designed to assess interest in principal transactions and the other three questions assess the adviser’s interest in agency transactions. For example, one of the questions is:”
Do you or any related person:
(1) buy securities for yourself from advisory clients, or sell securities you own to advisory clients (principal transactions)?
(2) buy or sell for yourself securities (other than shares of mutual funds) that you also recommend to advisory clients?
(3) recommend securities (or other investment products) to advisory clients in which you or any related person has some other proprietary (ownership) interest (other than those mentioned in Items 8.A(1) or (2))?”
“You may see an example of such a filing at: http://www.adviserinfo.sec.gov/iapd/content/viewform/adv112010/Sections/iapd_AdvClientTransSection.aspx?ORG_PK=17507&RGLTR_PK=&STATE_CD=&FLNG_PK=0495456C00080155056DEC5003194145056C8CC0”
Tiwari and Casavecchia created a simple measure of cross trading intensity for each fund advisor by computing the percentage of affirmative (‘Yes’) answers to the six questions that are designed to assess the fund adviser’s participation and interest in the client (fund’s) transactions. Tiwari says, “This gives us a measure of Total Cross Trading (TCT) intensity for each fund adviser. Thus, a fund adviser that responded ‘Yes’ to all six questions would be deemed to have the highest intensity of cross trading, with a TCT measure of 100% or 1.0. Similarly, we construct measures of Principal Cross Trading (PCT), and Agency Cross Trading (ACT) intensity based on the proportion of affirmative (‘Yes’) responses to the two subsets of 3 questions, each of which is designed to assess interest in Principal and Agency cross trades, respectively.”
While expense ratios seem to get all the press, the far greater toll of conflicts-of-interest like 12b-1 fees, revenue sharing fees and, now, cross trading remains relatively uncovered. Tiwari blames this on the greater accessibility of mutual fund expense ratios and the prevailing view that high fees are bad. (Although, as we’ve seen before in “A 401k Must Read: Mutual Fund Expense Ratio Myth Busted,” FiduciaryNews, October 9, 2012, high expenses ratio do not always mean lower performance.) He says, “potential conflicts-of-interest, and more importantly, their impact on performance, is an issue that is much harder to assess. As pointed out above, it is hard for investors to assess potential conflicts of interest, etc. as these items are not disclosed directly to investors in say, the fund prospectus. While public disclosure is required via the Form ADV filings with the SEC, this information is a little harder to access for the average investor. Furthermore, the link between the intensity of cross trading related conflicts of interest and fund performance, is more subtle. To our knowledge, ours is one of the first studies that formally examines this link and provides evidence on the magnitude of the performance penalty imposed by the potential conflicts of interest related to cross trades. Our hope is that the findings of the study will lead to increased attention on these issues among investors as well as the media.”
And it doesn’t take a fool to see the light shining through on that one.
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