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Beware of financial advisers

By Sheyna Steiner · Bankrate.com
Friday, April 6, 2012
Posted: 8 am ET

I know nothing about cars. Short of becoming educated about modern fuel-injection engines, I walk into service stations like a willfully ignorant lamb. It's all a vast mystery, and I'm surprisingly OK with that. Thus far, it's worked out well -- my car runs. Case closed.

It's much more difficult to gauge service on products that are more abstract than cars. Things such as 401(k)s, individual retirement accounts, taxable brokerage accounts and the universe of investment options therein can be confusing. Not only that, the people paid to service these accounts, financial advisers, may benefit from the confusion.

Many financial advisers encourage investors to chase returns and to invest in expensive actively managed funds, according to a working paper from researchers Sendhil Mullainathan, professor of economics at Harvard University, Markus Noeth, professor of banking and behavioral finance at the University of Hamburg, and Antoinette Schoar, professor of entrepreneurial finance at MIT.

The researchers set up auditors with fake portfolios and sent them to speak with financial advisers.

Auditors were assigned 1 of 4 portfolios.

There were two biased portfolios -- one bent toward chasing returns with nearly a third of the portfolio devoted to a sector-specific exchange-traded fund that had performed well the previous year and a portfolio in which 30 percent was invested in company stock.

The study also featured two unbiased portfolios. One held only certificates of deposit, or bonds, and cash; the other reflected a diversified assortment of low-fee index funds.

One group of auditors in their 30s had $50,000 to invest, and a group in their 40s had $100,000. The study spanned 284 visits to advisers.

Active versus index

As it turned out, advisers were much more likely to recommend actively managed mutual funds. Index funds were recommended in 7.5 percent of the visits as opposed to active funds, recommended in 50 percent of visits.

The frequency of recommendations for actively managed funds combined with recurrent downplaying of fees lead researchers to conclude that advisers recommend the more expensive funds because it puts more money in their own pockets.

Additionally, the study found that advisers were not very likely to change investors' biases towards chasing returns and overinvesting in company stock.

Finally, the researchers also note that individual investors visiting commission-based advisers are at a significant disadvantage when it comes to choosing competent counsel. Eighty-four of the auditor visits revealed that advisers refused to give out specific recommendations until the client had transferred their account to the advisers company.

That makes sense given that advisers don't want to give away their expertise for free, but it makes it much more difficult for investors to shop around and compare advice.

That's not all: Men and women didn't receive that kind of treatment equally. Advisers were 40 percent more likely to tell female prospects to pony up their money before receiving advice.

Know the F-word: Fiduciary

The bottom line for investors: Know how your adviser gets paid and find out why the more expensive products just happen to be better. Keep in mind that returns only matter net of fees.

Most financial advisers are ethical people, but they, just like everyone else, have bills to pay. Unless they are acting as a fiduciary, they have no professional obligation to put their clients' best interests ahead of their own financial well-being.

To read more about the differences between actively managed mutual funds and index funds, and some situations where active-management does actually make sense, check out the Bankrate feature, "Index funds vs. actively managed funds."

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3 Comments
Sheyna Steiner
April 08, 2012 at 6:47 am

I spelled adviser correctly and chose not to use advisor. I think the former was more appropriate than the latter.

wilson1
April 07, 2012 at 10:35 am

I cant exactly take advise from someone who spells ADVISOR incorrectly....

Brian Solik, CRPC
April 06, 2012 at 10:20 am

Great article! How can I email Sheyna with some interesting story ideas?