Morningstar - Q3 2021 - 16

Dispatches
Does Compensation
Affect Advisors'
Advice on Funds?
New evidence
suggests it does.
Aron Szapiro
POLICY
In recent years, regulators have become interested
in a complex issue with deep implications
for policy: Do financial advisors respond to certain
kinds of conflicted payments by recommending
mutual funds or other financial products for
which they receive additional compensation, and
if they do, is this bad for retail investors?
In this article, we present new evidence from a
unique data set that demonstrates that
commission-based advisors do not consider
the full range of relevant data as regularly as
fee-based advisors.1
How advisors respond to compensation has
profound implications, given the massive
shift in retirement savings from traditional
pensions to defined-contribution plans. With this
shift, Americans have found themselves largely
responsible for selecting and managing
their investments to achieve a secure retirement.
If some advisors are giving conflicted advice
and selecting subpar funds, it could be harmful
to many retirees.
The Obama administration concluded that these
conflicts were real, that they hurt investors,
and that the government should respond with
more regulation. The Council of Economic Advisers
estimated in 2015 that conflicts of interest
cost investors $17 billion annually. In part because
of this finding, the U.S. Department of Labor
promulgated its fiduciary rule, although
the department estimated the annual harm
to investors was less.
Even the Trump administration, which generally
favored deregulation, agreed that investors
deserved financial professionals who mitigated
their conflicts of interest. Once the Labor
Department's fiduciary rule was vacated by the 5th
U.S. Circuit Court of Appeals in 2018, the
SEC issued a draft version of Regulation Best
Interest, which it finalized a year later and has
been in effect since June 2020.
Regulation Best Interest is not as strong
a standard as the Labor Department's original
package. It does not hold broker/dealers
to a fiduciary standard, but it does emphasize that
to comply with the rule, broker/dealers need
to emphasize costs and take steps to mitigate
conflicts of interest.
At the end of the Trump administration, the
department again finalized a prohibitedtransactions
exemption aimed at raising standards
for advisors serving retirement savers.
It also added new requirements for rollovers.
Fund Costs Not a Priority for All
The literature on advisor compensation generally
shows-not surprisingly-that advisors
respond to incentives and that these incentives
do not always align with investors' interests.
The most influential article addressing this issue
demonstrates that variation in payments to
independent brokers from mutual funds influenced
brokers' recommendations to the detriment of
ordinary investors.2
Specifically, the authors
examined the practice of load-sharing-in which
payments flow from asset managers to
intermediaries that sell funds, creating a conflict
by giving intermediaries an incentive to sell
products for which they collect a higher
payment rather than products that are in the
best interests of an investor.
These findings, which Morningstar researchers
replicated and extended,3
make three key
observations to support the conclusion
that conflicts of interest hurt investors. First,
fund flows can be largely predicted by
examining the fund and fund family size, lagged
returns, and the expense ratio. Second,
funds that offer unusually high load-sharing
payments to broker/dealers get stronger
flows than would otherwise be expected. And
third, this conflict hurts investors by reducing
their future returns.
When Morningstar researchers extended this
analysis, they found that after the Department of
Labor released its draft fiduciary rule, conflicted
payments still influenced flows but were
no longer associated with lower future returns.
The authors concluded that this evidence
suggests the fiduciary rule caused broker/dealers
to restructure their businesses and to put
more scrutiny on recommendations, a sign that
such regulation benefited investors.
This literature raises two questions. First, given
the SEC's emphasis on cost in Regulation
Best Interest, how much do broker/dealers or
others paid on commission pay attention
to fund fees? Second, what about financial
professionals who are not paid on commission?
In other words, is the form of compensation
responsible for emphasizing different factors in
recommending funds to clients?
Using data from 811 responses to a survey we
emailed to advisors registered with
Morningstar.com in September 2020 (after
Regulation Best Interest went into effect), we
found that commission-based advisors
were less likely than level-fee advisors to indicate
they considered fund costs one of their three
top priorities when making recommendations
to clients. We ran regressions in a variety
of ways and found similar results regardless of the
functional form. We will report these findings
in depth in our white paper.
1 We will release a complete white paper on these findings later this year.
2 Christoffersen, S.E.K., Evans, R., & Musto, D.K. 2013. " What Do Consumers' Fund Flows Maximize? Evidence From Their Brokers' Incentives. " Journal of Finance., Vol. 68, No. 1, PP. 201-235.
3 Sethi, J., Spiegel, J., & Szapiro, A. 2019. " Conflicts of Interest in Mutual Fund Sales: What Do the Data Tell Us? " The Journal of Retirement., Vol. 6, No. 3, PP. 46-59.
16
Morningstar Q3 2021
https://www.morningstar.com/authors/2015/aron-szapiro http://www.Morningstar.com https://www.morningstar.com/research/trending https://afajof.org/journal-of-finance/ https://jor.pm-research.com/content/6/3/46

Morningstar - Q3 2021

Table of Contents for the Digital Edition of Morningstar - Q3 2021

Contents
Morningstar - Q3 2021 - Cover1
Morningstar - Q3 2021 - Cover2
Morningstar - Q3 2021 - 1
Morningstar - Q3 2021 - 2
Morningstar - Q3 2021 - Contents
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