“I eat my own cooking,” financial advisors and fund managers sometimes boast, perhaps to persuade potential clients they’re putting their own money where their mouths are.
Turns out, that can be a recipe for food poisoning.
A study by Poets&Quants’ Professor of the Week, Brian T. Melzer of the Tuck School of Business at Dartmouth, pored over a massive dataset of hundreds of thousands of Canadian investors and advisors and found that advisors’ poor judgment hurts them as much as it does their clients. Both underperform passive investments by substantial margins, the paper, “The Misguided Beliefs of Financial Advisers,” found.
Co-authored by Tuck School colleague Juhani T. Linnaninmaa and Alessandro Previtero of the Kelley School of Business at Indiana University, it will appear in the prestigious Journal of Finance.
Melzer and the other researchers were trying to ascertain whether advisors’ financial incentives (maximizing commissions rather that boosting clients’ returns) resulted in high costs and underperformance for their clients. But instead of conflicts of interest, they found sincere mismanagement: Many advisors made the same basic errors in their own portfolios as they did in their clients’ accounts.
They included too-frequent trading, performance chasing, favoring expensive, actively managed funds over low-cost index funds, and lack of diversification. These all would seem to be rookie mistakes, yet the researchers found that experienced financial advisors made them, too—and appeared woefully uninformed about the most fundamental financial concepts.
“They recommend frequent trading and expensive, actively managed products because they believe active management dominates passive management, despite evidence to the contrary,” the researchers write. “These advisors…are willing to hold the investments they recommend—indeed, they invest very similarly to clients. Yet, they deliver net returns substantially below passive benchmarks, both for clients and themselves.”
How much lower? Melzer and his co-authors calculated the advisors produced net alpha—the excess return over the performance of low-cost index funds—of -3% annually. That means the investments of the clients and the advisers underperformed passive investing by 3% each year, net of fees.
Compounded over time, that represents a substantial shortfall from the amount they could accumulate simply by owning low-cost index funds. ”The performance difference between advisors and clients is close to zero,” the authors write. In this case, that’s not a good thing.
Melzer and the other researchers found that the expense ratios of mutual funds held in advisors’ and clients’ portfolios were nearly identical and shockingly high–around 2.4%. (Stock index funds’ expense ratios are typically below 0.1%.) And both advisors and clients held around the same weighting of passive funds—1.2% to 1.5%–as the Canadian mutual fund market did in 2012. (It was 9% in the U.S. that year.)
Their findings echo those of landmark studies of active traders and investors by Brad Barber of UC Davis Graduate School of Management and Terrance Odean of Berkeley Haas, who found that the more people trade, the worse they do. “Both clients and advisors exhibit trading patterns previously documented for self-directed investors,” Melzer and his co-authors note.
The study examined more than 4,000 advisors of almost half a million clients of two Canadian investment firms with assets of $18.9 billion from 1999 to 2013. Men and women were equally represented, and their ages ranged from 32 to 67. The advisors, however, were overwhelmingly male and had accounts on average twice as big as their clients’. Tellingly, advisors’ investing behavior didn’t change materially after they left the industry.
Melzer and his co-authors’ findings show human behavior, not perverse incentives, leads to underperformance, which implies policy changes may not be effective. “Regulations that reduce conflicts of interest—by imposing fiduciary duty or banning commissions—do not address misguided beliefs,” they conclude.
Melzer, 41, who has just completed his first year at Tuck as associate professor of business administration, studies financial advice, household finance, and housing investments. He teaches classes in corporate finance and real estate, which includes in-depth looks at complex projects and interactions with industry leaders.
He earned his BA in philosophy from Princeton and a master’s degree in the same subject from the University of St. Andrews in Scotland. He got his Ph.D. from Chicago Booth and immediately joined the faculty of crosstown rival, the Kellogg School of Management at Northwestern, where he taught until 2018. Named L.G. Lavengood Outstanding Professor of the Year, he spoke at Kellogg’s 2018 graduation on the topic of perseverance and grit.
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