Have you ever wondered how much value brokers add? In my nearly 25 years in this business, I've asked that question many times, so you can imagine how my interest was piqued when an academic study called "Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry" showed up in my inbox. It was written by by professors Daniel Bergstresser and Peter Tufano (Harvard Business School) and John Chalmers (University of Oregon) and published in the October 2009 edition of the Review of Financial Studies. (Click here for a working paper version of this article. The published version is under copyright restrictions.)
Bergstresser and his companions examined detailed data on mutual fund returns, distribution activity and the flows in and out of funds during the time period 1996 to 2004. They compared the data for funds that were sold by brokers with the data for funds that were sold directly to investors. The study found the following:
As a group, funds sold by brokers perform worse than those sold directly to investors, even before subtracting any brokerage fees, sales loads, or other distribution charges. This finding holds even when the differences between actively managed funds and index funds are considered.
Funds sold by brokers have higher non-distribution expenses.
Clients who work with brokers do not make better investment decisions. They still chase performance (i.e., buying yesterday's winners and selling yesterday's losers) leading to the overall result of "buying high and selling low."
These empirical facts beg the question: why do people work with brokers? The authors of the study explored three possible reasons.
Perhaps brokers give their clients access to products that the clients would not otherwise be able to access. In their research, the authors found some differences between the products sold by brokers and those purchased directly by investors. For example, on average, broker-sold funds tended to be:
- Newer - broker sold funds were more likely to be less than three years old.
- Managed by managers with less tenure.
- Not covered by Morningstar.
- Have fewer assets under management.
- Actively managed.
Taken as a whole, these traits indicate that brokers may, in fact, help clients buy mutual funds they would not likely buy on their own. But since these funds don't deliver better returns, why should clients want to buy them?
Perhaps brokers save clients money in other, more subtle, ways? The authors looked in the detailed data for other possible savings. Unfortunately, they found none. In every category of funds, except foreign equity funds, the non-distribution expenses of broker-sold funds exceeded those of directly-purchased funds.
Is it possible that investors working with brokers are fundamentally different from investors who buy directlY? To answer this questions, the authors combed through demographic data compiled by the Investment Company Insititute, the trade association for the mutual fund industry. They found that customers of brokers tend to have:
- Slightly lower incomes (median income of $93,800 vs $101,300)
- Lower financial assets ($363,700 vs. $447,900),
- Less education (57% have a college degree vs. 65%),
- Slightly more aversion to risk.
- Less experience with investing.
Despite these differences both groups of investors share some striking similarities. For example, both groups express similar attitudes about fees and expenses (they are important in their decision about which funds to buy) and investment horizon (they are not concerned with short-term fluctuations in mutual fund investments). These similarities again beg the question, why use a broker?
The crux of the matter
After wrestling with the implications of their analysis, the authors ask a very important question: "Do brokers merely sell what they are paid to sell?" Their answer is sobering:
A less charitable interpretation of our results is that financial intermediaries may not always act in their clients' interest, but rather put clients' interests behind their own interests and the interests of the fund companies that pay them.
To me, this is the crux of the matter. Financial products are often "sold," meaning the person buying them lacks the knowledge or information to make a fully informed decision. They trust their broker and their broker uses that trust to sell them products that may be "suitable" from a regulatory point of view, but are less attractive than the other alternatives a more informed investor would choose. And why don't they recommend the superior product? Because the broker makes more money hawking the inferior one. The conflict of interest is so obvious, it is hard to imagine why anyone accepts it.
Instead of working with an advisor or broker caught in the conflicts of interest that come with earning commissions, consider working with a financial advisor who works for you. I wrote about this in a blog post last summer, but here are the highlights:
- Find an advisor who works on a "fee-only" basis, meaning the only payment she receives comes from fees paid by the client. Direct payment is vital if you want to avoid conflicts of interest and it is the only way I operate.
- Find one that has true expertise. The financial services world tends to attract sharp operator who are great at form but light on substance. Insist on working with someone who had demontrated expertise.
- Interview your prospective advisors to find out the kinds of clients they deal with and the kinds of situations they have experience handling.
- Check advisor qualifications with professional referrals. Don't ask for a list of satisfied clients because you won't get a good view of the advisor's capabilities. Instead ask to talk with CPA's, attorneys or other professionals who know the advisor's work and can give you a sense of their true expertise.
- Finally, once you have established the technical and professional capabilities, make sure your advisor has the service ethic to really provide you the support you need. The most valuable benefit you will get from working with an advisor is their ability to keep you on track with your financial goals.