The financial journey to retirement may feel more like a labyrinth than a well-marked path. Is paying into your employer’s 401k plan enough? How do you pick the perfect mutual fund? Will you be able to retire young enough to enjoy time with the grandkids?
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Overwhelmed by these questions, many of us turn our investments over to the experts. We trust financial advisors to keep our best interests, and our unique retirement goals, in mind. In fact, more than half of the U.S. households that own mutual funds make their purchases through a financial advisor.
But researchers and policymakers have begun to question the value that advisors create for their clients.
One concern is what seems like a conflict of interest. Because advisors generally earn commissions from the funds that they sell, they have a financial incentive to recommend frequent trading and to push their clients toward pricy, actively managed funds that pay higher commissions. Yet many experts believe that the majority of retirees would earn more money in low-cost, passive index funds. This potential conflict led the Department of Labor to rule in April 2016 that people providing advice to retirement savers must act as “fiduciaries,” putting the interests of savers over their own.
Will the new rule actually improve retirees’ investment performance? New research by Brian Melzer, an assistant professor of finance, indicates that, unfortunately, it may not help much.
Instead, the research shows that the problem behind advisors’ choices for their clients is not a potential conflict of interest—it is that they actually believe that active trading and fund management provide value. In fact advisors are so convinced about the soundness of their advice that they put their own money into the same investments. Furthermore, despite the allure of personalized portfolios, Melzer found that advisors generally use a one-size-fits-all strategy with clients.
There is growing consensus among researchers that retirees do not always receive the best investment advice.
“There’s little evidence, for example, that active management adds value,” says Melzer. Generally speaking, to the extent that a given actively managed portfolio outperforms the market, any gains over time are offset—or more than offset—by high management fees.
Yet active management is incredibly popular.
“Advisors acting as a principal for themselves hold the same types of funds, display the same trading patterns, as their clients do.” - Melzer
“The idea has been raised that advisors have the wrong incentives, that they’re pushed by their personal interest to put clients into funds that pay higher commissions,” says Melzer.
But are advisors truly—and intentionally—putting their own interests first? Melzer, along with coauthors Juhani Linnainmaa of University of Chicago and Alessandro Previtero of University of Texas at Austin and Western University, decided to find out.
If advisors knew that active management served their clients poorly, the researchers reasoned, “you wouldn’t expect advisors to hold the same funds in their own portfolios,” says Melzer. That is because, even assuming advisors receive a slight break in fees (as they receive the sales commission on their own purchase), these funds are still considerably more expensive to hold than index funds. So the researchers decided to compare the portfolios that financial advisors build for themselves with the ones that they recommend to clients.
They analyzed data from three Canadian financial institutions. The data, spanning from 1999 to 2013, included comprehensive information about the trades and portfolios of more than 500,000 clients overseen by 5,000 advisors. Critically, the data also included information about advisors’ personal portfolios.
Sure enough, the researchers found a surprising degree of overlap between an advisor’s portfolio and the portfolios of his or her clients. “Advisors acting as a principal for themselves hold the same types of funds, display the same trading patterns, as their clients do,” says Melzer. In fact, financial advisors’ personal portfolios actually performed worse over the same period than the portfolios of their clients.
And it is not the case that the advisors are simply putting on a show by keeping a small portfolio of expensive, actively managed funds to convince clients to do the same. The researchers found that even when advisors leave the business, “they continue to hold the same types of portfolios,” says Melzer. “And any new investments they buy typically look like they did before they left the business.”
Self-selection, rather than conflicts of interest, might be driving poor financial advice, the researchers suggest. After all, people who believe strongly that the market can be beaten may be disproportionately likely to become financial advisors.
“There is some cognitive dissonance there, if you’re going into an actively advisory role, and then what you say to your clients is that you ought to do passive investing,” says Melzer.
The powerful resemblance between the portfolios of advisors and clients has another unexpected implication: most advisors favor a one-size-fits-all approach to investment.
In a second study, Melzer, Linnainmaa, Previtero, and an additional colleague—Stephen Foerster of University of Western Ontario—find that, despite wide differences in personal traits, clients who share a financial advisor end up with quite similar-looking portfolios.
“To me that was counterintuitive,” Melzer says. “Advisors often hang their hat and market their services based on being in tune with client circumstances. They propose that their role is to understand these circumstances and then tailor a portfolio.” In fact the importance of customization is perhaps the biggest argument against a newly popular FinTech invention: robo-advising, which replaces human advisors with lower-cost algorithms.
Though portfolios managed by a financial advisor had a larger share of risky assets than other portfolios, this seems to reflect the advisor’s appetite for risk, not necessarily the investor’s. Clients paired with a financial advisor who took on substantial risk in his or her own personal portfolio held nearly 15 percentage points more in equities than clients paired with an advisor who personally took on low risk. This pattern held even among clients with low risk tolerance.
“If I could tell you just one thing about somebody and you had to give your best guess as to how much risk they take, what our data shows is that the identity of the financial advisor says much than does the investor’s risk tolerance, their income, and their point in the life cycle,” Melzer says. “It’s pretty striking that the identity of the advisor is so predictive.”
Might clients be attracted to financial advisors whose investment beliefs and attitudes mirror their own? Is that why advisors appear to leave such a clear fingerprint on their client’s portfolios?
The researchers eliminated this possibility by tracing the outcomes of clients’ portfolios when they were forced to choose a new advisor after their original advisor either retired, passed away, or left the profession. In these cases, where clients did not initiate an advisement change, the researchers found that their portfolios morphed in ways that are most likely explained by the new advisor’s input. For example, when clients moved from a financial advisor who took on moderate risk to one who took on greater risk, the client moved in tandem.
If financial advisors tend to offer advice that is poor, expensive, and one-size-fits-all, what value do they really bring their clients?
Melzer cautions against the assumption that financial advisors have no role to play in retirement planning. They can offer clients a big benefit by simply giving them confidence to invest in the first place.
“Equities on average earn higher returns,” he says. “There’s risk associated with that, but long term, your money will compound at a much lower rate if you just leave it in a bank account.”
Melzer speculates that there may be other reasons for people to use financial advisors as well. Perhaps the clients are taking advantage of other services offered by the advisor’s firm such as financial planning and budgeting, advice on saving for college or retirement, or estate planning. Advisement may also offer a psychological value. “This is an area that is very difficult to measure and observe, this notion of people being quite anxious about holding risky assets without someone to talk to and check in with if the market return has been low lately,” Melzer says. “I take that very seriously: that people feel they are buying psychological security when they have an advisor.”
But he also offers that, ideally, there would be a way for clients to find emotional security without paying such high fees.
Advice for Advisors and Clients
Melzer hopes his research will convince advisors that their own beliefs and biases often bleed heavily into their client’s portfolios, even when they should not. For example, it might not be appropriate for an older client to hold a high proportion of equities, even if the advisor feels the market is perfectly positioned to devote a large part of the portfolio to them. And the majority of clients are unlikely to benefit from frequent, expensive trades, no matter how tempting they seem.
Instead, says Melzer, investment firms should focus on where they can truly add value.
“If they’re spending a lot of time encouraging their advisors to do research on individual funds to try to pick winners, that looks like it could be time that’s wasted. Those energies might be better devoted to understanding taxes in detail, understanding the importance and role of diversification in the portfolio, or focusing in on retirement planning and thinking about household budgets.”
And for savers, Melzer has this advice: “Do your due diligence to screen the advisor up front. And make sure that you’re being cognizant of how much the advisor’s own preferences may be reflected in your portfolio. Check in with benchmarks for how much risk you are taking.” Ideally, investors would not fully turn over a portfolio to an advisor, no matter how much psychological relief they may anticipate from letting someone else deal with it.
Foerster, Stephen, Juhani T. Linnainmaa, Brian T. Melzer, and Alessandro Previtero. Forthcoming. Retail financial advice: Does one size fit all? Journal of Finance.
Linnainmaa, Juhani T., Brian T. Melzer, and Alessandro Previtero. 2016. The misguided beliefs of financial advisors. Working paper.
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