If we’re honest, most (if not all) of us are greatly influenced by financial incentives. Behavioural economists have observed what they call incentive-based bias in a range of different sectors, particularly financial services. As Charlie Munger liked to say, ”Show me the incentive and I will show you the outcome.”
Numerous academic studies over the last 20 years have shown the impact of commissions and other inducements on the advice that financial advice firms give their clients. The findings have been broadly similar for every country researchers have looked at, including the US, Canada, Switzerland and India. In short, if advisers are paid to recommend high-fee, actively managed funds, that’s generally what they do, despite the fact that the vast majority of active funds have underperformed low-cost index trackers.
Transparency is not enough
Interestingly, another finding some of these studies have in common is that, on its own, greater transparency doesn’t necessarily result in clients investing in cheaper funds. For example, a 2005 paper, The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest, by Cain, Loewenstein and Moore, examined the unintended consequences of disclosing conflicts of interest. (1) The researchers found that although disclosure is meant to mitigate bias, it can sometimes have the opposite effect. Advisers, they suggested, might feel morally licensed to give more biased advice because they have disclosed their conflict, while clients may discount the disclosed bias less than is warranted.
In other words, it’s not enough for regulators to make advisers disclose potential conflicts of interest; they need to remove financial inducements to give biased advice altogether. So far, only two European countries — the UK and the Netherlands — have taken that step.
The sad reality is that financial advisers in the UK were paid commissions by fund management companies to put their clients in active funds for decades. Only a small proportion of advisers recommended index funds.
2014 proved a turning point
Then, in 2013, the Financial Conduct Authority banned the payment of commissions. Initially, the ban appeared to have little impact on fund flows. A new white paper from the fintech consultancy Broadridge Financial Services shows that, in 2014, the proportion of new money going into active funds was still 72%. But since then that figure has sharply declined. Over the last decade, the Broadridge data show, an extraordinary 92% of new money invested has gone into index funds.
In most of continental Europe, however, commissions are still very much the order of the day. Also, it’s still very common in most European countries for banks and insurance companies to deal with retail investors directly, and they mostly sell their own, often very expensive, active funds.
Right across the continent, the Broadridge paper shows, active funds continue to reign supreme. In Luxembourg, for example, Europe’s largest fund industry hub, 89% of the new money invested in the last ten years has gone into active funds.
Devin McCune, vice president of governance, risk and compliance services for Broadridge’s Distribution Insights business told the FT: “Luxembourg products are sold across Europe, across the world in reality, and in many of these markets they are sold through intermediaries and these intermediaries are still moving money into actively managed funds.”
The link between RDR and passive inflows
Kenneth Lamont, a senior fund analyst at Morningstar, believes there is a direct connection between the move away from active funds in the UK and the Retail Distribution Review, which included the ban on commissions to advisers.
“RDR was an extremely positive move,” Lamont said. “There are fewer corners for intermediaries to tuck away fees and kickbacks, which clearly favour higher margin products. (The Broadridge research) shows that the regulation is working.”
Yes, we still have some way to go on the road to a fairer and more transparent UK investing industry. For example, vertically integrated advice firms are still using targets and bonuses to incentivise advisers to recommend in-house active funds, which are charging higher fees.
As Andy Agathaneglou and Gina and Alan Miller warned in the latest episode of The Investing Show, there are worrying signs that both the financial industry and Labour and Conservative politicians want the FCA to focus less on consumer protection and more on promoting UK financial services.
However, for all the criticism levelled at the FCA, our regulator does deserve some credit for the progress made in tackling biased advice. It’s high time other European regulators followed the UK’s lead.
This article is produced by us for Financial Advisers who may choose to share it with their clients. Timeline Planning and Timeline Portfolios do not offer direct-to-consumer products.
ROBIN POWELL is a freelance journalist and Editor of The Evidence-Based Investor.
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