Why, when the evidence overwhelmingly shows most investors are better off using low-cost index funds, do most financial advisers around the world continue to recommend more expensive active funds?
The question is addressed in a paper by Juhani Linnainmaa, Brian Melzer and Alessandro Previtero in a research paper for Indiana University’s Kelley School of Business, called The Misguided Beliefs of Financial Advisors.
The research team looked at 14 years of data on client investments and advisory relationships provided by two mutual fund dealers in Canada.
They specifically compared the returns achieved by the 488,263 clients they analysed to those achieved by the firms’ 3,276 advisers with their own private portfolios.
Clients outperformed advisers
Astonishingly, they found that, on a gross basis, the clients significantly and positively outperformed the advisers. It was only after accounting for fees the client paid and rebates the adviser received from mutual funds that the adviser actually performed as well as, but not better than, their clients. The advisers’ inferior performance continued beyond retirement.
Four causes of underperformance
The advisers underperformed in four critical categories. They were more likely than their clients to:
— be influenced by short-term past performance
— lean towards active funds;
— under-diversify; and
— turn over their portfolios frequently.
The researchers also concluded that the evidence showed that it wasn’t any incentives but rather advisers’ own belief structures that drove the advice they gave.
You can read the research paper here:
The study is also featured in the first a new series of videos for financial advisers, called #OneMinuteAdviser. The series is produced for our sister blog Adviser 2.0 by our colleagues at Regis Media. Please share this video if you find it interesting. We would welcome any opinions on the study and its findings.
There’s overwhelming evidence that the vast majority of actively managed funds underperform the market and that most investors are better off in low-cost index funds.
Yet most financial advisers around the world continue to recommend active funds.
It’s often assumed they do so because they’re conflicted; in other words, they’re financially incentivised to promote funds with higher fees. But is it true?
Researchers from the University of Southern California, Indiana University and the Federal Reserve Bank of Chicago analysed 14 years of data on more than 3,000 advisers in Canada.
They looked at what the advisers recommended for their clients, and also what they did with their own portfolios.
They actually found that it wasn’t incentives but advisers’ own belief structures that governed their recommendations.
Indeed, advisers were more likely than their clients to be influenced by short-term past performance; to lean towards active funds; to under-diversify; and to turn over their portfolios frequently.
As a result, the advisers underperformed the market by even more than their clients.. and that inferior performance continued into retirement.
So, in short, this study suggests that advisers who advocate high-turnover active investing aren’t so much conflicted as misguided.
Either way, the findings aren’t exactly comforting for their clients.