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Commentary

What Conflict of Interest Has Cost Investors

New Morningstar research examines the impact of high-rebate arrangements on investor returns and the positive impact the proposed fiduciary rule has had.

In early February, 11 former SEC chief economists wrote a letter arguing that the SEC produced a deficient economic analysis of its recently proposed "Regulation Best Interest." Principal among the complaints, the former SEC staffers argued that the commission failed to quantify the costs of conflicts of interest to ordinary investors, and therefore the extent to which the proposed rule could ameliorate these conflicts.

Morningstar has conducted such research. It does not address all the ways in which conflicts of interests can cost investors, but it does evaluate the effects of one type of conflict. In such a situation, the Morningstar policy team found, investors paid a clear price for a conflict of interest that brokers face. The paper "Conflicts of Interest in Mutual Fund Sales: What Do the Data Tell Us?" was recently published in The Journal of Retirement.

Conflicts of Interest Do Hurt Investors, but Regulation Can Ameliorate These Harms
Historically, a key conflict of interest that could distort brokers' recommendations has stemmed from load-sharing arrangements. Here's how these arrangements work: When investors buy a share class with a load (usually an A share), they pay a load to the fund, which then rebates some of this load back to the broker. However, funds vary in how much of the load they rebate to the brokers--a conflict that could distort the recommendations brokers make to their clients.

Put simply, if Fund A and Fund B are similar in terms of asset allocation and performance, but Fund B sends a higher payout to brokers, then brokers have a financial incentive to sell Fund B to their clients.

Our analysis demonstrates that this was a problem in the early 2000s. Funds with unusually high load-sharing arrangements had higher-than-expected flows and worse returns. In fact, we found that every additional dollar of unusually high rebates, investors would see a 0.3% reduction in returns from 2000 to 2005. Further, every dollar of rebate drove flows 0.02% higher than expected.

In recent years, brokers and advisors appear to be more rigorously screening funds on performance when making recommendations to their clients. Higher loads have not been associated with worse returns for investors in a statistically significant way since 2009. Morningstar attributes this shift to the passage of the Dodd-Frank legislation, which gave the SEC broad new powers to regulate advice.

It is important to note that although Morningstar did not find that investors were damaged by brokers' conflicts of interest since 2009, those conflicts continued to exist and continued to affect brokers' decisions. Funds with unusually high load-rebate arrangements continued to receive higher-than-expected flows. This anomaly could have harmed investors in ways that Morningstar did not measure. For example, because of the financial incentives, brokers might not have directed investors to funds that most closely matched their investment goals.

The link between high-rebate arrangements and higher-than-expected flows disappears from 2015 onward. In 2015, the Labor Department proposed the second iteration of its fiduciary rule. In Morningstar's view, the correlation is unlikely to have been accidental. The fiduciary rule appears to have spurred industry change. The effect of unusually high loads on flows ends after the Labor Department proposed its rule. This change was statistically significant.

All the Conflicts We Cannot See and Next Steps for the SEC
Morningstar's analysis is limited to one kind of conflict of interest--load-sharing arrangements--because that is the conflict on which data are available. It reveals that brokers respond to financial incentives, causing them on some occasions to make decisions that are not in clients' best interests. However, regulation (or even the threat of regulation) can remedy these distortions.

In Morningstar's view, the SEC should pay special attention to compensation that would give a broker incentive to recommend one fund over another, and that mitigating these conflicts can benefit investors. Regulation Best Interest, in its draft form, is not clear on whether disclosure would mitigate these risks or how brokers would demonstrate they were acting in clients' best interests. Morningstar's research would seem to fill those gaps.