Aug 27, 2019
My mother instructed me never to patronize restaurants that featured “home cooking.” If given a choice between them and fast food, she said, go with the fast food. Whatever the chain. As with most mothers, she offered considerable advice, and, like most sons, I initially ignored her counsel. My mistake.
Mom would have appreciated “The Misguided Beliefs of Financial Advisors.” (Juhani Linnainmaa, Dartmouth College, Tuck School of Business; Brian Melzer, Federal Reserve Bank of Chicago; Alessandro Previtero, Indiana University.) The paper examined the investment habits of both Canadian financial advisors and their customers, and it concludes that the advisors heartily dined on their own cooking. Their mistake: They would have been better off at McDonald’s.
At this point, American readers may wonder about this column’s relevance. After all, Canadian financial advisors operate differently from their American compatriots, and much has changed in the U.S. marketplace since 2013, which was the final year evaluated in the author’s study. Bear with me. The paper, I believe, is neither provincial nor dated. It carries broad implications for all delivery of financial advice, the American version included.
Somehow, the authors persuaded “two large Canadian financial institutions” to provide “comprehensive trading and portfolio information” for 3,276 financial advisors and almost 500,000 of their clients, from 1999 through 2013. (To paraphrase a Nobel Laureate, “The best way to write a great paper is to have a great database.”) It is difficult enough to obtain the latter; even when authors promise strict anonymity, companies are reluctant to provide customer lists.
It is harder yet to receive the former. Publishing advisor performance is … unprecedented. Where can one learn about an advisor’s personal portfolio? Nowhere, to answer the rhetorical question. (The same generally holds for columnists, although a couple of years back I did divulge most of my holdings.) The “Misguided Beliefs” paper partially fills the gap. It doesn’t indicate how any single advisor fared, but it does illustrate the group’s general behavior. Which was, to summarize, honest but unsuccessful.
The biggest problem is that Canadian mutual funds are expensive, and advisors did not work around that disadvantage. When Morningstar last checked, the average asset-weighted expense ratio for Canada’s equity funds was 2.23%. One might speculate that Canadian advisors put their customers into costly funds, thereby pocketing higher commissions while investing their own assets in cheaper fare.
Not so. The authors calculated the average expense ratio for client portfolios as 2.36%. (That seems steep given that clients owned bond funds as well as equity funds and that Canada’s bond funds are much cheaper than its stock funds. However, Canadian expense ratios were even higher back in the day.) However, the advisors’ portfolios were even higher, at 2.43%!
Walking the Walk
The country’s financial advisors ate what they cooked. When they placed their clients into expensive funds, claiming that the results would justify the extra cost, they sold their own beliefs. They invested in that fashion themselves–including after they retired from the business, when their average expense ratios declined only slightly and solely because they became more conservative with time, swapping some of their equities for bond funds.
Besides holding costly funds, the authors identify: 1) high turnover, 2) return chasing, and 3) underdiversification as investment errors. Such tactics can be helpful–return chasing, for example, is required for momentum strategies–but there’s no question that retail fund investors have not profited from them. Once again, neither did advisors. If anything, they churned their own portfolios more rapidly, chased their tails more eagerly, and held even less-diversified portfolios.
The overall result was awful. The authors estimated that both customers and advisors trailed their passive benchmark (as defined by a Canada-specific, six-factor model) by roughly 300 basis points per year. The good news, in a sense, was that most of the damage came from costs. Investors (and advisors) weren’t greatly harmed by their investment errors. What really hurt them were expenses.
This paper has changed my thinking about mutual fund regulations. Heretofore, I have enthusiastically supported the Department of Labor’s now-defunct Conflict of Interest rule, which would have required that U.S. financial advisors subject to ERISA regulations act solely in their clients’ best interests, as opposed to the lesser standard that their recommendations must be “suitable.” I continue to advocate for such legislation. Investment professionals–any professionals–should work solely for their customers and should legally stand behind that principle.
However, “Misguided Beliefs” makes clear that, however well-drafted and well-intended, legislation misses the central problem. When financial advisors serve their customers poorly, that is rarely because they sell them funds that they wouldn’t touch themselves–on the contrary, the trouble comes because they like those funds. Advisors’ judgment is primarily to blame, not their intent.
(At this stage, one could argue that Canadian advisors aren’t representative of the global breed, being more honorable. That strikes me as highly unlikely. Canadian advisors, by and large, are employed by large banks. To put the matter gently, I have yet to encounter an argument that bank employees are abnormally ethical. I doubt that I ever will.)
Unlike Canadian advisors, most U.S. financial professionals now understand the math of fund expenses. At 0.67%, the asset-weighted U.S. equity-fund average is less than one third that of Canada’s. (This gap is somewhat less than it seems, because Canadian advisors are usually paid by embedded mutual fund fees, while these days U.S. advisors typically charge separately. Still, there’s no denying the discrepancy.)
Given how large the U.S. industry has become and the dominance of index funds, that 67-basis-point cost could easily be halved. In addition, American financial advisors trade their clients’ portfolios more rapidly than do Canadians, and they chase returns just as often. Thus, while U.S. advisors can justifiably take pride in bettering their practices, thereby bringing better results to their clients, the battle is not over. Further improvement remains.
What I now understand is that most of those gains will come from within the marketplace–by advisors continuing to learn from history and (one hopes) by stronger educational programs from both their employers and the fund companies that solicit their business. Regulation can and should do its part, but advisors’ personal beliefs will lead the charge.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own