Sunday, June 25, 2006

Assessing the Costs and Benefits Of Brokers in the Mutual Fund Industry

There are some brokers who do a truly outstanding job. But according to this study, and my own anecdotal experience, purchasing funds through the broker channel provides little tangilbel benefit.

This study in NBER (National Bureau of Economic Research) focuses on five measurable potential benefits to consumers of brokered fund distribution:

(a) Assistance selecting funds that are harder to find or harder to evaluate;
(b) Access to funds with lower costs excluding distribution costs;
(c) Access to funds with better performance;
(d) Superior asset allocation,
(e) Attenuation of behavioral investor biases.

In short, brokerage customers according to this study, generally pay substantially higher fees, and buy funds that have lower riks-adjusted returns than directly-placed funds.

The study does indicate that any benefits that do exist must be found along less tangible  dimensions. It suggests, that perhaps brokers may help investorssave more, better customize their portfolios to risk tolerances, and/or increase overall investor comfort with their investment decisions.

Seeking a benefit suggested in part (e) would be particularly intriguing and beneficial to clients. If brokers are better able to overcome behavioral biases, client portfolios would benefit. As the paper suggests: "From an academic perspective, the past 10 years have seen an explosion in research focusing on how behavioral biases affect investment behavior. While biases like overconfidence, mental accounting, and loss aversion characterize individuals, little research has focused on whether distribution professionals attenuate—or magnify—these biases. For example, while  investors might have bounded rationality—and be unable to process the mountain of information on the thousands of funds available—paid professional  advisors might be able to help them sift through all of this data and make better investment decisions."

Regrettably, the advisors generally demonstrated all the same biases that the rest of us have. Despite the professional standing, they are after all human.

The paper is quite lengthy at 61 pages and will be of particular interest to those with deeper research needs. Bottom line, even when picking actively managed portfolios rather than index funds, invest directly rather than through most brokers. Exceptions to the rule are always there, but they are truly jewels.

Link to document


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