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The Misguided Beliefs of Financial Advisors

Critics of the investment industry, me included, often point to conflicts of interest that lead to higher costs and poorer outcomes for investors. Indeed, a 2015 study on mutual fund fees conducted by the Brondesbury Group determined that financial advisors who receive commissions from selling mutual funds are often biased in selecting funds that offer more compensation for the advisor. This is a problem because funds that pay commission underperform.

While there are certainly a few bad apples in the financial advisory bunch, the industry is to blame for designing a compensation model that is prone to conflicted advice and the mis-selling of financial products. Commission-based advice coupled with an inferior ‘suitability’ standard (instead of a fiduciary duty to act in a client’s best interest) causes serious harm to investors.

That’s why lawmakers in the U.K., Australia, and the United States, have either banned commissions or mandated that advisors act as fiduciaries, placing clients’ interests ahead of their own.

Misguided Beliefs of Financial Advisors

But what if there was an alternative explanation for why investors receive expensive and low quality advice? Remember the famous quote by Upton Sinclair:

“It is difficult to get a man to understand something when his salary depends upon his not understanding it.”

Maybe the majority of commission-based financial advisors aren’t evil and conflicted at all. Maybe they just don’t get it.

A shocking report titled, ‘The Misguided Beliefs of Financial Advisors“, suggests that many advisors offer well-meaning, but misguided, recommendations rather than self-serving ones.

The authors go on to say that advisors give poor advice precisely because they have misguided beliefs. They recommend frequent trading and expensive, actively managed products because they believe active management, even after commissions, dominates passive management. Indeed, they hold the same investments that they recommend.

Wow. So when you hear all the sh*t your advisor says about active vs. passive, and mutual funds vs. ETFs, he isn’t just giving you a sales pitch – no, he truly believes it. He’s drank the Kool-Aid.

The study used data provided by two large Canadian financial institutions, using comprehensive trading and portfolio information on more than 4,000 advisors and almost 500,000 clients between 1999 – 2013.

Interestingly, the data also included the personal trading and account information of the vast majority of advisors themselves. The study showed that advisors pursue similar strategies in their own portfolios even after they stop advising clients, which rules out the possibility that advisors hold expensive portfolios merely to convince clients to do the same.

“The advisor’s own trades reveal his beliefs and preferences, which allow us to test whether client trades that are criticized as self-serving emanate from misguided beliefs rather than misaligned incentives.”

The study questions the efficacy of policies aimed at resolving conflicts of interest – either by imposing fiduciary duty or banning commissions – because they do not address these misguided beliefs.

Final thoughts

Hat-tip to Larry Bates for pointing out this study in what he calls the mutual fund mystery. The mystery being, who are these two Canadian financial institutions, and will they take action to educate their 4,000 advisors?

I’ve spent considerable time railing against the mutual fund and investment industry over high fees and conflicted advice. Perhaps it’s time to turn my attention towards the army of blissfully ignorant and misguided advisors who are unknowingly giving bad advice.

The study concludes by taking aim at that very problem, saying it would require improved education or screening of advisors, perhaps enforced with professional licensing requirements.

Changing advisors’ views about active investment strategies may also be difficult:

“Advisors are not random draws from the population, and they may pursue their vocation in part because of their misguided belief that active management adds value. In fact, advisory firms may hire precisely those advisors who will deliver sincere, but expensive, advice.”

Finally, it probably goes without saying but the advisors in the study recommended funds that underperformed the market by 3 percent annually. Shocking, indeed.

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28 Comments

  1. Lorraine Tee on March 12, 2018 at 8:50 am

    How can we find out who these two companies are? Just wondering…..

    • Echo on March 12, 2018 at 10:09 am

      Hi Lorraine, unfortunately the companies in the study are ‘anonymous’ but there are some clues such as the 4,000 advisors, 500,000 clients, and more than $20B in assets under management. I’ll certainly update this if I find out which companies were studied.

  2. Grant White on March 12, 2018 at 10:31 am

    I completely agree with the point of view that compensation and standards for advice need to change in the financial services industry. Compensation should be investment solution agnostic and remove any sort of temptation to anything but what is in the best interest of the clients. I would love to see the industry move towards a fee for service model where a retainer is charged rather than commission or percentage of assets under management. The current compensation model does not accurately describe the value that wealth managers should provide and worse is complicated for investors to understand. The industry needs to simplify and move towards what I call radical transparency. I agree that most advisors are not trying to provide bad advice but with low barriers to entry they simply do not know better and are influenced by the marketing machine that are fund companies. The active versus passive argument however is a completely different topic. Firstly, how do you define active management? Many would argue that Warren Buffett is an active manager (some would not as well) and the Berkshire Hathaway track record speaks for itself. He isn’t the only one, there are many examples of people beating the index consistently when they follow a disciplined process, even after fees. The article seems to hint that all mutual funds are bad for investors because their fees are higher than ETF’s, which I simply don’t agree with. Sure, most funds under-perform the markets but that is like saying most doctors under-perform the top 10% of doctors.

    • Echo on March 12, 2018 at 10:58 am

      Hi Grant, thanks for your thoughtful reply. I think we’re in agreement outside of the active vs. passive debate.

      Is Warren Buffett an active manager? Absolutely. Does he recommend others follow his path? Absolutely not. He has said:

      “My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.”

      Of course not all mutual funds are bad. Some will beat the market. But it’s impossible to identify those funds in advance, and the chances of continued outperformance are vanishingly small.

      That’s why the evidence points to fees as the biggest predictor of future returns. The higher the fee, the lower the return.

      • Grant White on March 12, 2018 at 1:12 pm

        Hey Echo,
        I agree that people need to be fee conscious because you’re right, certainly a high fee is a detractor from growth. However, I think that the real issue is not that there is a fee that is too high but rather an absence of value. Many funds charge high fees and do not provide the value to justify it. I think that many would agree that they are ok paying a higher fee if they knew they were getting better value. We simply need to look at other professions to see evidence of this. You referenced Buffett’s quote which I have had brought to my attention many times but I think that quote is only part of what Buffett is actually saying. Here’s another quote of his from his 1993 letter which I think helps to illustrate the full picture:

        “Another situation requiring wide diversification occurs when
        an investor who does not understand the economics of specific
        businesses nevertheless believes it in his interest to be a long-
        term owner of American industry. That investor should both own a
        large number of equities and space out his purchases. By
        periodically investing in an index fund, for example, the know-
        nothing investor can actually out-perform most investment
        professionals. Paradoxically, when “dumb” money acknowledges its
        limitations, it ceases to be dumb.

        On the other hand, if you are a know-something investor, able
        to understand business economics and to find five to ten sensibly-
        priced companies that possess important long-term competitive
        advantages, conventional diversification makes no sense for you.
        It is apt simply to hurt your results and increase your risk. I
        cannot understand why an investor of that sort elects to put money
        into a business that is his 20th favorite rather than simply adding
        that money to his top choices – the businesses he understands best
        and that present the least risk, along with the greatest profit
        potential. In the words of the prophet Mae West: “Too much of a
        good thing can be wonderful.””

        • Echo on March 12, 2018 at 3:02 pm

          Hi Grant, here’s where we disagree. Funds don’t provide value, they’re simply an investment vehicle. Advisors should be providing the value through financial planning, goal setting, tax planning, estate planning, disaster-proofing your life.

          I’d be perfectly happy in a world where investments were commoditized (i.e. index funds and ETFs capturing market returns minus a very small fee) and clients pay for the true cost of advice. Embedding that cost inside of mutual fund fees leads to all kinds of problems, not least of which is investments that underperform.

          • Grant White on March 12, 2018 at 4:22 pm

            Hi Echo,
            We’re not as far off as you think. I agree with you in that true value is created in comprehensive wealth management and that investment advice is just a piece of that puzzle. To say that funds can’t create value is a bit of a stretch I feel however. If a fund manager has a proven track record, disciplined process and strong philosophy then I’m not sure how you can say that there is not value creation. If a manger can consistently outperform an index on a longer term basis then is that not value creation as well over just buying an ETF? I admit, only 10% of managers do this, but that also means that 10% of managers outperform. You don’t need a crystal ball to identify good fundamental processes.



          • Brandt on March 14, 2018 at 10:55 am

            If the majority of people move to index funds, essentially we would have people who will buy or sell without ever asking “what is the price?” Those who do not follow an ETF/index approach would and will be the ones setting the price and will be able to take advantage of those blindly buying assets. Managing the emotions, though tougher to measure, is far more important than this fee debate. I think it’s inaccurate to make it seem that an ETF approach is a silver bullet to investing. It will work well for those who don’t know what to look for in a money manager (most people) and at the same time have complete control over their emotions with regards to their money (not most people). These people are few and far between. I’m not against nor am I for passive investing or active. I think many strategies will work as long as proper discipline is in place.



          • Ben Felix on March 14, 2018 at 11:47 am

            @Brandt the notion that markets will cease to be efficient due to people investing in index funds is a fallacy. There is no silver bullet to anything, but index funds are the most sensible way for most people to invest. http://csinvesting.ca/blog/2018/1/17/are-too-many-people-investing-in-index-funds



    • Grant on March 12, 2018 at 2:59 pm

      Grant, the active vs passive issue is not a different topic at all. The article states that advisors recommend expensive actively managed products because they believe that active management adds value, when it is well established in their own literature that it does not. You only have to look at the SPIVA reports to see that more than 90% of actively managed funds underperform their benchmarks over the last 15 years. It is also well known that the best predictor of a funds performance is it’s fees – the lower the fee the better the performance. Mutual funds almost always have higher fees than passively managed ETFs, because most mutual funds are actively managed, so that is why the article suggests that mutual funds are bad for investors. Given that the vast majority of actively managed funds fail to beat their benchmark, and that it’s impossible to predict in advance who those few outperformers will be, surely the rational course is not to use actively managed funds.

      • Grant White on March 12, 2018 at 4:37 pm

        Hi Grant,
        Let me just start by saying that I would agree that most advisors charge too much and do not provide enough value to justify the cost, of which most are using funds with high management costs. You will get no argument from me there. To say that the only rational course has to be passive ETF’s with low costs is a stretch in my mind. You are correct, as I have pointed out above, that most active managers fail to outperform passive indexes, however, there is also significant evidence which shows that active managers who have defined and disciplined processes can and consistently do outperform indexes. In particular if you look at the Superinvestors of Graham and Doddsville you will see that with a disciplined approach these investors, including Warren Buffett among others, have consistently outperformed. I think the point I would make is that I agree with you in that if people are not going to take an educated and active approach with their money than the far safer route to success would be index funds with low fees. However, if you are a “know something investor” as Warren Buffett suggests and are able to understand business economics so that you can find 5 – 10 companies with competitive advantages, can buy them at a bargain price based on fundamentals in terms of intrinsic value and margin of safety then it is perfectly rational to expect an individual can outperform an index.

        Here is the link to the article in case you haven’t read it. https://www8.gsb.columbia.edu/rtfiles/cbs/hermes/Buffett1984.pdf

        • Grant on March 13, 2018 at 6:04 am

          Grant, of course an investor can outperform the market, but it’s about probabilities. If the data shows that only a tiny minority of active investors outperform (including the Super Investors of Graham and Doddsville), and it’s not possible to pick them in advance, surely the prudent course of action is not to try. Would you rather have the certainty of market performance (less a small fee), or the remote possibility of outperformance combined with the near certainty of underperformance? The latter sounds like gambling to me.

          • Grant White on March 13, 2018 at 12:29 pm

            I think that is the point… the probabilities increase significantly if you know what to look for and cut out the noise of the media or the fortune tellers. The letter points out commonalities between a group of people that have all significantly outperformed the market and their success can be drawn back to common traits and experience. There are many more examples out there as well. Again, I would go back to the quote I shared above,
            “On the other hand, if you are a know-something investor, able
            to understand business economics and to find five to ten sensibly-
            priced companies that possess important long-term competitive
            advantages, conventional diversification makes no sense for you.
            It is apt simply to hurt your results and increase your risk. I
            cannot understand why an investor of that sort elects to put money
            into a business that is his 20th favorite rather than simply adding
            that money to his top choices – the businesses he understands best
            and that present the least risk, along with the greatest profit
            potential. In the words of the prophet Mae West: “Too much of a
            good thing can be wonderful.””
            Gambling is playing on probabilities, I am suggesting an approach based on fundamentals and facts.



          • Grant on March 13, 2018 at 1:10 pm

            Actually, I disagree. The point is that because there is no evidence that you can identify in advance who those very few outperformers will be, the probablities do not increase by screening for various characteristics. If that did work it would be easy to pick the winners in advance. But that is not the case, even it may seem logical to be able to do so. It’s easy to spin a good story that sounds perfectly reasonable but is not supported by the evidence. Therefore, the probability of being successful in this endeavor is very low, which is why it’s not prudent/rational to try.



          • Grant White on March 14, 2018 at 7:20 am

            Well I guess we will agree to disagree. There is plenty of evidence out there showing that skilled managers with disciplined processes will outperform ETF’s on a long term basis. The students of Benjamin Graham is just one example. Quoting that the average active manager doesn’t does nothing to disprove the fact that there are disciplined managers out there who do. The average will always under-perform the highest performers in anything.



          • Grant on March 14, 2018 at 8:27 am

            Grant, I agree there are a very few active managers that can outperform. The issue is that there is no evidence that you can identify them in advance. So that information is of no use to anyone. Do you have any peer reviewed evidence (not marketing pieces) that the very few active managers that will outperform in the future (around 2-5%) can be identified in advance?



    • Pedro Diaz on March 12, 2018 at 10:19 pm

      Please, mention these companies.

      I am a financial advisor. How can you say, or what evidence do you have to support the fact that there is a commission paid to us?

      We get paid as a percentage of assets under management as stated in the Fund Facts which we are LEGALLY required to give to a client BEFORE we conduct any trades.

      So, as far as compensation, I could care less if the client wants funds from company A, B, C, D all the way to Z. It’s the same percentage.

      There’s only two CAPTIVE agencies that I know FORCE their advisors (not through extra compensation, but by withholding other companies compensation) to sell their own in house products.

      Other that that, you’re painting the whole industry with the same biased advice of a few.

      There’s also plenty of actively managed funds that beat the market and I can list many.
      However, actively managing is not about beating the market. It’s about downside protection.
      Would you rather get 100% of the upside and the downside, or 95% and 60% of the downside?
      Let’s see what happens to all these do-it-yourself investors when the next market crash comes.

  3. M on March 12, 2018 at 11:16 am

    Active Financial Advisors who actually know what they are doing, may outperform the market by 13% just like mine did in 2017 . I think it is about finding a good advisor, highly qualified, experienced and with the right set of values. On top of that it is a flat fee , whixh is a percentage. The more He makes money for me, the more he gets paid and vice-versa, which is perfectly fine for me.

    • Grant on March 12, 2018 at 3:02 pm

      M, many active managers can outperform over short periods of time like 1-5 years. But it’s the long term that matters. Over the long term (20 years plus), the vast majority underperform, and it’s not possible to pick those few winners in advance. Who knew, in 1964, that Warren Buffett was going to be one of the very few?

  4. David McGruer on March 12, 2018 at 12:02 pm

    There is much that could be said about this article, but I will provide just one thought. Anyone leaning hard on the Brondesbury article for support has either not read it thoroughly or has given it much more credibility than it deserves. It is a review of literature, provided no original research, was paid for by regulators and draws some conclusions that look biased towards those who paid for it. I note that it does have some merits but people usually draw out only the poorest quality statements from it and omit the rest.

  5. Grant on March 12, 2018 at 3:17 pm

    Rob, interesting that it is not avarice, but ignorance. But not surprising considering the lack of requirement for proper credentialing in the industry. On a slightly different note, it’s not just commission based products that cause conflicts of interest. It’s also the widely used assets under management fee model. How can a client get objective advice about how to invest when an advisor is incentivized to gather assets? What if paying down debt, or purchasing an annuity would be in the clients interest? A flat fee based on work needed to be done is a much better model for combined portfolio management and financial planning. Such a model can be found in the US, but unfortunately not yet in Canada.

    • Grant White on March 12, 2018 at 4:41 pm

      Agree with you on this completely. The fee based on assets under management is also flawed. Compensation and costs should be tied to services being provided. You are completely right in that the current model encourages more sales people rather than advisers.

  6. JV on March 12, 2018 at 5:35 pm

    Once again a one sided recycled article vilifying fund companies and the advisors that sell their products. Why not try something original and see what the risk level of just staying passively invested is and whether or not the average client has the courage to ride the market. Or you might try to explain how bank trading revenues have skyrocketed since the adoption of passive investing in ETFs….hmm wonder who’s making that spread??
    Do your homework and you will find plenty of products that offer superior returns to the market on a risk adjusted basis. And since when is everything supposed to be free? Why not check out how expenses actually work. How much tax makes a part of that expense. What other product other than gasoline has had to disclose the breakdown of their cost structure. The misguided beliefs are this written by the author.

    • Grant on March 13, 2018 at 5:20 pm

      JV, are you suggesting that the cost of financial advice should be hidden from the client?

  7. Ben Felix on March 13, 2018 at 8:05 am

    Great article. This research is fascinating and has substantial policy implications. A best interest standard means very little if the people giving financial advice do not understand the evidence around active management and fees. I recorded a video about the same paper last week, to be released in a few weeks.

  8. Ryan on March 13, 2018 at 10:08 am

    Robb. Thanks for the article. I can appreciate the discussion on MF’s but I wonder what your thoughts are on Martijn Cremers and Antti Petajisto’s study showing that high active share funds do outperform after fees. I agree with a fiduciary responsibility, but that does not exclude the use of MF’s

    • Ben Felix on March 13, 2018 at 10:42 am

      The research on Active Share has been debunked. It is not basis to say that active management is a sensible way to invest.

      Abstract from Deactivating Active Share (https://www.aqr.com/~/media/files/papers/aqr-deactivating-active-share.pdf)

      We investigate Active Share, a measure meant to determine the level of active management in investment portfolios. Using the same sample as Cremers and Petajisto (2009) and Petajisto (2013) we test the hypothesis that Active Share predicts investment performance. We find that the empirical support for the measure is not very robust and the difference in outperformance between high and low Active Share funds is driven by the strong correlation between Active Share and benchmark type. Active Share correlates with benchmark returns, but does not predict actual fund returns; within individual benchmarks, Active Share is as likely to correlate positively with performance as it is to correlate negatively. Overall, our conclusions do not support an emphasis on Active Share as a tool for selecting managers or as an appropriate guideline for institutional portfolios.

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