The Misguided Beliefs of Financial Advisors

• DOI: http://doi.org/10.1111/jofi.12995
• Published date: 01 April 2021
• Author: JUHANI T. LINNAINMAA,ALESSANDRO PREVITERO,BRIAN T. MELZER
• Date: 01 April 2021

THE JOURNAL OF FINANCE •VOL. LXXVI, NO. 2 •APRIL 2021

The Misguided Beliefs of Financial Advisors

JUHANI T. LINNAINMAA, BRIAN T. MELZER, and ALESSANDRO PREVITERO*

ABSTRACT

A common view of retail f‌inance is that conf‌licts of interest contribute to the high

cost of advice. Within a large sample of Canadian f‌inancial advisors and their clients,

however, we show that advisors typically invest personally just as they advise their

clients. Advisors trade frequently,chase returns, prefer expensive and actively man-

aged funds, and underdiversify.Advisors’ net returns of −3% per year are similar to

their clients’ net returns. Advisors do not strategically hold expensive portfolios only

to convince clients to do the same; they continue to do so after they leave the industry.

*Juhani Linnainmaa is with Dartmouth College and NBER. Brian Melzer is with Dartmouth

College. Alessandro Previtero is with Indiana University and NBER. We thank Jason Allen, Gadi

Barlevy, John Chalmers, James Choi, Alexander Dyck, Diego Garcia, Chuck Grace, John Grif-

f‌in, Woodrow Johnson, Gregor Matvos, Jonathan Reuter, Andrei Shleifer, Johan Sulaeman, and

Sheridan Titman for valuable comments. We are grateful for feedback given by conference and

seminar participants at American Finance Association 2017 annual meeting, Boston College,

Brigham Young University, CEIBS Shanghai Finance Conference, Dartmouth College, Federal

Reserve Bank of Chicago, FMA 2016 Napa Conference on Financial Markets Research, George-

town University, HEC Montreal, IDC 13th Annual Conference in Financial Economics Research,

Indiana University, NBER Behavioral Economics 2016 spring meeting, Northwestern University,

Notre Dame University, Research Aff‌iliates Advisor Symposium, SFS Cavalcade 2016, Southern

Methodist University,United Kingdom Financial Conduct Authority, United States Securities and

Exchange Commission, University of Arizona, University of Chicago, University of Colorado Boul-

der, University of Maryland, University of Rochester, University of Texas at Austin, and Western

Finance Association 2016 annual meeting. We are especially grateful to Univeris, Fundata, and

two anonymous f‌inancial f‌irms for donating data and giving generously of their time. Alessandro

Previtero received f‌inancial support from Canadian f‌inancial f‌irms for conducting this research.

Disclosure statement of Juhani Linnainmaa: I received f‌inancial support from the PCL Faculty

Research Fund at the University of Chicago Booth School of Business. I did not receive other

f‌inancial support for this research, and have no f‌inancial interest in its outcomes. I am a Pro-

fessor of Finance at Dartmouth College, a Consultant to Citadel, LLC and Research Aff‌iliates,

LLC, and a Partner at Research Aff‌iliates. Citadel and Research Aff‌iliates are global investment

managers. No third party had a right to review the paper prior to publication and there was no

support provided with any nondisclosure obligation and no conf‌lict. Disclosure statement of Brian

T.Melzer: I did not receive f‌inancial support for this research, and I have no f‌inancial interest in its

outcomes. Disclosure statement of Alessandro Previtero: Five f‌inancial institutions provided data

and research-related f‌inancial support in the amount of C$ 55,000 to Western University, subject

to nondisclosure agreements to protect the conf‌identiality of the data. I had access to these funds

for research support purposes through June 2015 while on the faculty at Western University.

Correspondence: Alessandro Previtero, Indiana University, 1275 E. 10th St., Bloomington, IN

47405, USA; e-mail: aleprevi@indiana.edu.

DOI: 10.1111/jof‌i.12995

© 2020 the American Finance Association

587

588 The Journal of Finance®

INDIVIDUAL INVESTORS THROUGHOUT THE world rely on f‌inancial advisors to

guide their investment decisions. According to the 2013 Survey of Consumer

Finances, nearly 40 million American households received advice from a f‌i-

nancial planner or securities broker. A common criticism of the f‌inancial ad-

visory industry is that conf‌licts of interest compromise the quality, and raise

the cost, of advice. Many advisors require no direct payment from clients but

instead draw commissions on the mutual funds they sell. Advisors may there-

fore be tempted to recommend products that maximize commissions instead

of serving the interests of their clients. Policymakers in Australia, the United

Kingdom, and the United States have responded by either banning commis-

sions or mandating that advisors act as f‌iduciaries, placing clients’ interests

ahead of their own.1The Council of Economic Advisors (2015) concluded that

eliminating conf‌licted advice would improve retirement account returns by one

percentage point per year.

In this paper, we f‌ind support for an alternative explanation of costly and

low-quality advice with starkly different policy implications. Many advisors

recommend expensive portfolios because they are misguided rather than con-

f‌licted. In particular, they recommend frequent trading and expensive, actively

managed products because they believe that active management dominates

passive management, despite evidence to the contrary. These advisors, who

we refer to as having misguided beliefs, are willing to hold the investments

they recommend—indeed, they invest very similarly to clients. Yet, they real-

ize net returns substantially below passive benchmarks, both for clients and

themselves. Eliminating conf‌licts of interest may therefore reduce the cost of

advice by less than policymakers hope. While some advisors may respond to

the alignment of interests, those with misguided beliefs already invest simi-

larly both as agents and as principals. Improving their advice would therefore

require changing their beliefs.

Our analysis uses data provided by two large Canadian f‌inancial institu-

tions. Advisors within these f‌irms provide advice on asset allocation and serve

as mutual fund dealers (MFDs), recommending the purchase or sale of unaf-

f‌iliated mutual funds. These advisors are not subject to f‌iduciary duty under

Canadian law (Canadian Securities Administrators (2012)). The data include

comprehensive trading and portfolio information on more than 4,000 advisors

and almost 500,000 clients between 1999 and 2013. Our data also include

the personal trading and account information of the vast majority of advisors

themselves. This unique feature proves fruitful for our analysis—an advisor’s

own trades reveal his beliefs and preferences, which allow us to test whether

client trades that are criticized as self-serving may instead emanate from mis-

guided beliefs.

1In 2012, the Australian government implemented the Future of Financial Advice Reform,

which banned conf‌licted compensation arrangements, including commissions. In 2013, the Finan-

cial Conduct Authority in the United Kingdom banned commissions. In 2016, the U.S.Department

of Labor f‌inalized a rule to impose f‌iduciary duty in retirement accounts.

The Misguided Beliefs of Financial Advisors 589

We begin by characterizing the trading patterns of clients and advisors.

We focus on trading behaviors that may hurt risk-adjusted performance: high

turnover, preference for funds with active management or high expense ra-

tios, return chasing, and underdiversif‌ication.2Both clients and advisors ex-

hibit trading patterns previously documented for self-directed investors. For

example, they purchase funds with better-than-average historical returns and

they overwhelmingly favor expensive, actively managed funds. This similarity

suggests that advisors do not dramatically alter their recommendations when

acting as agents rather than principals.

An analysis of fees and investment returns likewise shows little evidence

that advisors recommend worse-performing funds than they hold themselves.

The average expense ratios of mutual funds in advisors’ and clients’ portfo-

lios are nearly the same, at 2.44% and 2.35%. Advisors earn commissions on

their personal purchases, but even after adjusting for these rebates, the per-

formance difference between advisors and clients is close to zero. Depending

on the model, this difference ranges from −10 to +16 bps per year. Clients and

advisors both earn annual net alphas of −3%.

We trace differences in advisors’ recommendations to their own beliefs and

preferences. We f‌irst show that the common variation among an advisor’s

clients, as measured using advisor f‌ixed effects, dominates variation explained

by observable client traits such as age, income, risk tolerance, and f‌inancial

knowledge. We also estimate a model with client f‌ixed effects to address the

possibility that the advisor effects capture shared, but unobservable, prefer-

ences among co-clients. We study clientdisplacements—events in which clients

have to switch advisors when the old advisor dies or retires—to verify that ad-

visors causally affect client behavior. The client f‌ixed effects also prove impor-

tant in explaining portfolio choices, but they do not meaningfully crowd out the

advisor effects. We next show that an advisor’s own trading behavior strongly

predicts the behavior common among his clients. For example, an advisor who

encourages his clients to chase returns typically also chases returns himself.

The correlation in trading behavior between an advisor and his clients is al-

ways statistically signif‌icant and ranges from 0.12 to 0.31.

We show that the similarity between advisors and clients is not limited to the

specif‌ic trading behaviors we examine. Using detailed transaction data on the

timing of trades and the specif‌ic funds purchased, we illustrate advisors’ im-

pact on client trading. Client purchases coincide frequently with their own ad-

visor’s purchases but rarely with those of other advisors. The similarity in trad-

ing behaviors is therefore a by-product of trade-level coordination. Although

clients’ and advisors’ trades rarely deviate from each other, we show thatt hese

2Barber and Odean (2000) f‌ind that active trading—which can result from chasing returns,

for example—signif‌icantly hurts individual investors’ performance. French (2008) estimates that

the average investor would have improved his performance by 67 bps per year between 1980

and 2006 by switching to a passive market portfolio. Carhart (1997) shows that expenses reduce

performance at least one-for-one and that returns decrease with fund turnover. Calvet, Campbell,

and Sodini (2007) and Goetzmann and Kumar (2008) f‌ind that underdiversif‌ication leads to large

welfare losses for some households.