A trio of finance and economics professors from the Massachusetts Institute of Technology, Harvard University and the University of Hamburg concluded in a paper published in 2012 that retail investors really do need fiduciaries to shield them from poor financial advice. They finally got some protection in the Department of Labor’s so-called fiduciary rule, set to take effect in April 2017 — but the future of that rule now hangs in the balance, just as these researchers have produced fresh findings reinforcing their original conclusions.
The rule was created to protect retirement plan participants from the kinds of conflicts of interest that arise when high-commission financial products are sold to investors by stockbrokers and insurance salespeople. With the election of Donald Trump as president of the United States, the rule is in danger, as various senior advisers to Trump’s campaign have vowed to block its implementation.
That is an alarming prospect for Antoinette Schoar, professor of finance at the MIT Sloan School of Management. Schoar — along with her co-authors, finance and economics professors Sendhil Mullainathan of Harvard University and Markus Nöth at the University of Hamburg — published “The Market for Financial Advice: An Audit Study” in 2012. Their conclusion: the less informed that clients seemed, the worse the advice they got from their financial advisers, who adjusted the recommendations they gave to clients based on their own self-interest. The passage of time has not changed their original conclusions: Their results were supported by a second round of research, conducted in 2014 and 2015 and slated to be published early next year, Schoar tells Institutional Investor.
The original study took shape after Schoar had read a report from the Investment Company Institute, a trade association of investment firms, estimating that more than 70 percent of Americans rely on financial advisers to help them make retirement asset allocation decisions. Schoar and her co-authors, with the help of Ph.D. graduate students, set out to discover the effects of this advice on retail consumers’ investment outcomes.
For the study, the professors targeted a representative cross-section of financial institutions in Boston and New York City, from the largest banks and broker-dealers to small, registered investment advisers (RIAs) and independent broker-dealers. To ensure professional staffing for the field research, the professors engaged a financial audit firm that specializes in identifying and training auditors — a high-level version of the “mystery shopper.” Schoar’s team trained the auditors to present themselves to advisers as investors seeking advice on their portfolios.
The researchers purposely constructed these portfolios with a variety of flaws, such as return-chasing or having too much of an employer’s stock, to see if the financial advisers would catch these problems and offer advice on how to fix them. After some 680 separate visits for the original study — followed by an additional 450 visits in 2014 and 2015 — Schoar and her team concluded that advisers provide different advice to different individuals, even when presented with a similar portfolio.
Instead of giving a client “textbook advice,” says Schoar, advisers adjusted to the biases presented by each client. The variation in the advice depended to a large extent on the type of bias and level of financial literacy the faux investor had. The evidence suggested that adviser self-interest played an important role in generating advice that was not in the best interest of the clients.
“We found that advisers were much more likely to recommend actively managed funds with high fees versus index funds,” says Schoar. They were also likely to encourage clients’ behavioral biases — such as chasing past returns —that help brokers sell products. “It is a good bias for brokers, because they can continue to sell and churn a portfolio and make fees,” Schoar adds.
Not all client biases were encouraged by the advisers. Biases were aligned, for example, when an auditor posing as a client presented a portfolio heavy with an employer’s company stock. In those cases the broker would move them toward diversification, since company stock doesn’t pay a commission to the broker. “It is not that brokers are malicious,” observes Schoar. “It’s just that they are motivated to give advice in their own best interest.”
Significantly, the professors also found that fiduciary advisers — RIAs and others — engaged much less in this behavior than did stockbrokers, leading Schoar and her team to conclude that something like the Department of Labor fiduciary standard would be beneficial to investors.
“It would be very unhelpful if this fiduciary rule is rolled back,” says Schoar.
