Financial advisors often work against the interests of their clients if it means the advisor can earn more in fees, according to a new study by the National Bureau of Economic Research.
"Advisors encourage returns-chasing behavior and push for actively managed funds that have higher fees, even if the client starts with a well-diversified, low-fee portfolio," according to the NBER, which is based in Cambridge, Mass.
The conclusion was reached based on the results of NBER auditors, pretending to be clients, making 284 visits to financial advisors in the Boston and Cambridge areas.
The advisors "tended to move shoppers away from existing strategy regardless of the initial portfolio, that is, even when they looked at a low-fee diversified portfolio," the study said. "So they were willing to make the client effectively worse off."
The study, "The Market for Financial Advice: An Audit Study," was written by Sendhil Mullainathan of the Department of Economics at Harvard University; Antoinette Schoar of MIT Sloan School of Management; and Markus Noeth of LS Banking & Behavioral Finance at the University of Hamburg in Germany.
It was based on the premise that investors may be bad at choosing portfolios on their own, but that many factors tend to influence the investor, including input from financial advisors. The advisors who were visited were those who an average citizen would have access to through a bank, independent brokerage or investment advisory firm. The advisors were usually paid through fees they generate rather than assets under management or portfolio performance. The auditors had investments between $45,000 and $55,000 or between $95,000 and $105,000.
The auditors presented the advisors with various portfolios and asked for advice for future investments. The study showed that the advisor recognized the situation as a sales situation, so the advisor praised the investor's portfolio choices, but then proceeded to change them.
"Overall, advisors had a significant bias towards active management," the study found. In nearly 50% of the visits by auditors, the adviser encouraged investing in an actively managed fund, while only 7.5% of the advisors encouraged investing an index fund.
When the advisors mentioned fees they did so in a way that downplayed their importance. The advisor was more likely to mention fees without being asked when the auditor was older, suggesting the advisor may believe an older person was more astute and would know more about fees, the authors said.
"These results suggest that the market for financial advice ... exaggerates biases that are in the advisor's financial interest while leaning against those that do not generate fees," the authors said.
When presented with a low fee index fund, the advisors still advocated a change to a high-fee, actively managed fund that would make the client worse off than the allocation he started with, according to the study.
Advisors recommended investing in stocks and domestic assets more as the auditor's income increased, "a fact that may be explained by an assumed higher risk or loss tolerance for the well-off," the study said. The advisors also did not seem to tailor the mix of stocks and bonds to the age of the client.
"Overall, our findings suggest that the market for advice works very imperfectly," the authors said. "Our evidence suggests that advisors' self interest plays an important role in providing advice that is not in the best interests of their clients."
The report acknowledged that advisors provide other worthwhile services such as giving clients more confidence to invest, protecting them from fraud or reducing transaction costs.