Do mutual and retirement fund managers put their investors’ best interest above their own?
Research By: Sabuhi Sardarli, assistant professor of finance
The world of wealth management and investment advising is naturally prone to agency problems – a conflict of interest in situations where one party is expected to act in another’s best interest after a specific task has been delegated or outsourced. Retail investors often pool their funds with others and direct them to mutual funds, retirement accounts, college savings accounts, etc. The mechanisms of these vehicles make it necessary for an investment firm and its managers to act as agents on behalf of the retail investors.
Although regulatory disclosures and self-governing ethics standards may play an important role in decreasing agency problems in these relationships, all economic agents respond to incentives and act accordingly. The power of those incentives are often stronger than that of regulation or disclosures.
A string of new research published by Dr. Sabuhi Sardarli, assistant professor of finance in the Kansas State University College of Business, and his co-authors, examines agency issues and conflicts of interest in the wealth management industry.
Mutual Funds
First, the authors analyze mutual funds – investment vehicles that have become increasingly more important for savings and diversification purposes. These funds provide significant advantages for small to mid-size investors as they lower the cost of participating in the capital markets.
In the last two decades, assets under management of mutual funds have grown over four times to almost $20 trillion. Today, about 44 percent of all US households and 94 million US individuals own mutual funds in their investment portfolios for purposes of retirement, savings, and education expenses. Hence, ensuring that the incentive structure and the design of these investment vehicles are not prone to conflicts and agency issues is imperative.
Dr. Sardarli and his co-authors examine the incentives of mutual fund managers, especially when a manager is concurrently in charge of a mutual fund and a separately managed fund (SMA). SMAs are similar to mutual funds and offer many of the same advantages. However, they are usually marketed to high net worth investors as they can be customized according to their individual preferences. SMAs, therefore, usually have higher management fees and require a higher investment minimum for its qualified investors. From the fund manager’s perspective, those higher balances and management fees translate to higher compensation for the manager.
Dr. Sardarli’s research indicates that when a fund manager is concurrently managing a mutual fund and an SMA, performance of the SMA is significantly better. That outperformance is attributed to manager’s preferential treatment of SMAs over mutual funds. By using an event-study analysis, the authors found that managers consistently invest in best performing stocks in SMA portfolios, while they invest poorly performing stocks in their mutual fund portfolios. These findings indicate that investors need to be more cautious of managers controlling several funds, especially in cases where other concurrently managed products offer better incentives.
Retirement Investing
A second line of research by Dr. Sardarli analyzes 401(k) plans. These plans have become the main avenue of retirement investing for millions of Americans as increasingly more employers have shifted from defined benefits plans (e.g. pension plans) to defined contribution plans (e.g. 401(k), 403(b) plans) during the last few decades. Assets under management of these defined contribution plans are currently valued around $7 trillion.
An average investor in these retirement plans does not necessarily possess sophisticated financial knowledge, or might not be willing to spend the time to study the details of the investment options in the plan. Most investors make very infrequent adjustments to their retirement plan and automatically invest into their accounts directly from their wages. Therefore, any agency issues or conflicts of interest are particularly important in this setting, as they are likely to be overlooked and the agent is likely to take advantage of the passive nature of investors.
By analyzing nearly 7,000 retirement plans, Dr. Sardarli and his co-authors find that retirement plan administrators (i.e. the financial institution hired by the employer to design and manage the plan) have significant incentives to offer their own mutual fund products in the retirement plans. Although this fact alone is not an evidence of conflict of interest, the authors find that often these proprietary funds have significantly higher fees and lower performance. In other words, these financial institutions are using their own funds in the plans that they manage while better quality funds exist in the mutual fund industry. The plan administrators have a direct incentive to use their own proprietary funds because they collect management fees from those investments.
Dr. Sardarli finds that plan administrators enjoy both plan administrative fees and management fees from retirement plans when their own proprietary funds are used in the retirement accounts as opposed to outside funds that belong to other financial institutions. Findings further indicate that this conflict is particularly pronounced for plans that are managed by asset management advisor firms, commercial banks, and insurance companies.
Takeaways
In all, it is important that all capital market participants, including mutual fund and 401(k) plan investors, become more aware of conflicts of interest and agency issues that exist in these industries. Some agents may take advantage of passive nature of small retail investors that adversely affect the unsuspecting investor’s wealth. Because average retail investors often lack the sufficient investment knowledge or resources to fully understand the impact on their savings, government agencies, employers, and financial advisors all have a role to play in protecting investors from detrimental effects of agency issues. Regulators must actively monitor these issues and eliminate opportunities where incentives can lead to undesired outcomes. Unfortunately, the wealth management industry is often several steps ahead of government actions as regulation usually tends to be reactive rather than proactive. Therefore, much of the burden falls on to the investors themselves and their diligence.
Further reading:
“Tailored versus Mass Produced: Portfolio Managers Concurrently Managing Separately Managed Accounts and Mutual Funds” (with F. Chen, L-W. Chen, H. Johnson), Financial Review, forthcoming.
“An Investigation of Administrative Fees in Defined Contribution Plans” (with T. Doellman), 2016, Financial Analyst Journal, Vol 72 (2), 41-51.
“Investment Fees, Net Returns, and Conflicts of Interest in 401(k) Plans” (with T. Doellman), 2016, Journal of Financial Research, Vol 39 (1), 5-33.
I was puzzled by the findings and conclusion from your research that: “managers consistently invest in best performing stocks in SMA portfolios, while they invest poorly performing stocks in their mutual fund portfolios.”
First of all, a manager does not KNOW which stocks will be the “better” or “poorer” performing stock until after those stocks have been purchased in these respective SMA and Mutual Fund portfolios.
In addition, given that a manager is compensated on the value and performance of both the SMA and Mutual Fund portfolios, wouldn’t it be in the manager’s best financial interests to invest the in the “better” or “best” performing stocks in both portfolios, to the extent that determining that ahead of time is possible at all. There may be other sources of conflict, but I question whether this phenomenon is one of them.
Incidentally, I am the CEO and primary owner of an Independent Trust Company. With respect to our retirement plan portfolios, we have resolved any such conflict issues by building asset allocation portfolios for plan participants that are invested exclusively in non-proprietary, high quality, low-cost, indexed mutual funds (Vanguard).
This is interesting research, but to much left unsaid and undone. For example, the research on managers running SMAs and Mutual Funds simultaneously found the SMAs performed better. The conclusion was that outperformance was due to incentives. Maybe, but there are so many other variables to look at. For example, maybe the expenses in the Mutual Fund are higher than the SMA. Maybe the Mutual Fund has far more total assets in it and hence the manager has to buy a much larger number of stocks due to size/liquidity constraints. Maybe the manager has a more expansive investment mandate or strategy than the SMA. Maybe the manager is able to get better pricing on stock buys and sells in the SMA simply because he doesn’t have to move as much volume. Maybe the manager doesn’t have to deal with flows in the SMA as he might in the mutual fund.
It would be interesting to see identical strategies with identical holdings/transactions in an SMA side by side with a Mutual Fund…and then look at the net performance at the end of long enough time period.
With respect to the Retirement Plans research mentioned, I’d like to know what the author means by “retirement plan administrators offering their own mutual fund products”. By retirement plan administrators, are we talking about companies who are exclusively in the business of administering retirement plans or are we talking about Investment Companies who also administer retirement plans as a side business?
And what exactly is meant by “mutual fund products”? Are we talking about investment companies who have their own mutual funds who offer them in retirement plans? (i.e. American Funds offering a 401k plan full of American Funds) Or are we talking about retirement plan administrators who put together portfolios of mutual funds (from various companies) and offer that to participants?
There are definitely conflicts that exist when an investment company is also a retirement plan administrator and wants to offer retirement plans full of their own investment products. Ultimately, the question is what do those conflicts look like and how do they compare to every other plan option. They could be good or bad. More research to do there.
At the end of the day, the investment result has so many factors at play. Manager incentives is one of those, but many more to examine. Interesting article, but I’d love to see expanded research here. I see correlation, but only a small piece of causation.