An academic's take on financial advisor conflicts that can leave investors saddled with costly, underperforming funds. We also touch on hedge fund activism, financial contagion, and female portfolio managers.
Our guest this week is Nicole Boyson. Boyson is the Patrick F. and Helen C. Walsh Research Professor at Northeastern University's D’Amore-McKim School of Business, where she teaches and conducts research in the areas of investments and corporate finance. Professor Boyson has authored numerous publications and referee journals, with a focus on regulatory arbitrage, hedge fund management, and hedge fund activism. She also recently published a provocative working paper on financial advisor conflicts of interest entitled, "The Worst of Both Worlds? Dual-Registered Investment Advisers." A certified public accountant, Professor Boyson serves on the Editorial Board of the Financial Analysts Journal. She received her bachelor's degree from Kent State University, her MBA from Case Western Reserve University, and her Ph.D. in Finance from Ohio State University. Professor Boyson is active on social media, where she can be found on Twitter at @nikir1.
Background and Influences
Nicole Boyson’s Twitter profile @nikir1
Josh Brown’s Twitter profile @reformedbroker
Wes Gray’s Twitter profile @alphaarchitect
Max Schatzow’s Twitter profile @advisercounsel
Investment Company Institute (ICI) Fact Books
Published Research: Hedge Fund Activism
Published Research: Female Hedge Fund Managers
Published Research: Hedge Funds and Contagion
Financial Advisor Conflicts
Working Paper: “The Worst of Both Worlds? Dual-Registered Investment Advisers” by Nicole Boyson
“Report of the Committee on Compensation Practices” dated April 10, 1995
SEC Final Rule “Certain Broker-Dealers Deemed Not to Be Investment Advisers”
“Ferri: There are No Average Investors,” The Long View podcast, July 3, 2019
SEC Investment Adviser Public Disclosure (IAPD) website
Financial Planning Association v. Securities and Exchange Commission
SEC Final Rule: “Regulation Best Interest: The Broker-Dealer Standard of Conduct”
SEC Share Class Selection Disclosure Initiative
“SEC Share Class Initiative Returning More Than $125 Million to Investors”
Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, head of manager research for Morningstar Research Services.
Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar, Inc.
Ptak: Our guest this week is Nicole Boyson. Boyson is the Patrick F. and Helen C. Walsh Research Professor at Northeastern University's D’Amore-McKim School of Business, where she teaches and conducts research in the areas of investments and corporate finance. Professor Boyson has authored numerous publications and referee journals, with a focus on regulatory arbitrage, hedge fund management, and hedge fund activism. She also recently published a provocative working paper on financial advisor conflicts of interest entitled, "The Worst of Both Worlds? Dual-Registered Investment Advisers." A certified public accountant, Professor Boyson serves on the Editorial Board of the Financial Analysts Journal. She received her bachelor's degree from Kent State University, her MBA from Case Western Reserve University, and her Ph.D. in Finance from Ohio State University. Professor Boyson is active on social media, where she can be found on Twitter at @nikir1.
Professor Boyson, welcome to The Long View.
Nicole Boyson: Thanks, Jeff. Thanks, Christine.
Ptak: You're an active contributor to financial Twitter. That's how we found you and I suppose how you found us. What's drawn you there? And what have you taken away from that experience?
Boyson: Yes, financial Twitter has actually been kind of amazing for me. I joined initially because I was working on this project that we'll talk about in a bit, about financial advisors and conflicts of interest. And I really thought that trying to go to Twitter and see if I could find some people that were interested in it or were thoughtful about it might give me a chance to get a little bit of feedback. So I joined, and I was posting here and there. And then, I got really lucky; a couple people sort of found me. One was Josh Brown, who kind of goes without introduction, and he kind of picked up on my work and helped promote me. So, that was a great way just to get some numbers and get some followers. And then, Wes Gray, who I knew, had known before from his previous life as a professor. Wes is at Alpha Architect, runs an ETF, and a wonderful guy. And so, he kind of also was really involved in promoting what I was doing and kind of highlighting my work. And then it just went from there. I estimate I've met probably close to a couple hundred people in person now that are my Twitter followers, and have gotten just exceptional health and feedback. And the community has been really wonderful in--you know, I've gotten speaking engagements, I've gotten opportunities to serve on panels. I've met people across all different parts of the spectrum. And it's been just really wonderful for me, who often is kind of stuck in my ivory tower and really wishing to get out and talk to people. So, it's been a great conduit for that.
Ptak: I was amused to see that one of the folks that you acknowledged in your most recent paper, "The Worst of Both Worlds? Dual-Registered Investment Advisers," is actually someone who I think follows you on Twitter and had replied to some of your tweets. I think that his name is Max Schatzow, if I'm not mistaken. He's an attorney.
Boyson: Yes.
Ptak: And it looks like you had an exchange on Twitter and that actually found its way into the paper itself. Is that correct?
Boyson: Yeah, that's correct. And it's funny because he and I disagree on just about everything. And so, even though it's sort of a very friendly and cordial disagreement, and so he and I sort of giggle when we actually agree on things. But I had been tweeting about something in particular, and I sent him a direct message to ask him for specifics because I knew his expertise would be helpful. And then, I asked him, you know, can I cite you? And he's like, Oh, of course, that'd be great. So, yeah, he's Twitter and in the acknowledgments, I sort of thank a bunch of anonymous people and those are online Twitter people as well. So, it's been really interesting.
Ptak: Can you describe your teaching and research focus at Northeastern and how you came to focus on those areas?
Boyson: Sure. I've been at Northeastern about 16 years, and my focus has always been kind of directly or indirectly on investors, and more specifically on institutional side. So, a lot of work, my early work, is in hedge funds, really just trying to understand them since like the late ‘90s, early 2000s. And then, as my work progressed and as the research and hedge funds became more rich and deep, I started to focus on hedge fund activism. And so, I was really interested--kind of at the end of the day, I'm really interested in managers and if they have skill, and it's not high technical looking for alpha, but in a way it's trying to understand sort of the value-add from active management. And so, because I was working in that space in hedge funds and mutual funds as well, I started to think a little bit about mutual funds and mutual fund flows. And I saw a report from the ICI, the Investment Company Institute, and they have these gorgeous annual reports every year with lots of great data. And there was one graph that just stood out to me, and the graph was showing mutual fund flows. That was showing that on the distribution side, a lot of flows were coming out of the traditional broker-sold mutual fund share classes. So, you can think of these as load funds, A, B, C shares. Money is flying out of those classes and strongly going into the institutional share classes. And I knew just enough to be dangerous. So I knew that institutional share classes weren't really institutions, but I didn't know a lot about who was in there. And so, my first thought was, this graph itself is a paper. And if I can figure out what's happening and where these flows are coming from, why they're leaving and where they're going, then I've got something really interesting to tell. I had no idea that it would lead me into becoming sort of an expert on the fiduciary role and understanding conflicts, but that's where it took me. So, that's where I followed it.
Benz: Going back to hedge fund activism, that was a specific focus of yours. And activism is in vogue given the increasing interest in ESG--environmental, social, governance--investing. What recommendations would you have for an investor trying to take a fund's measure as an activist, how good it is at activism?
Boyson: It's a really interesting question. And hedge fund activism generally is not focusing on the environmental or the social, although some are, but a big chunk of hedge fund activism is focusing on governance. And so, a lot of hedge fund activists will target firms. So, I take a step back to sort of even figure out what an activist is. We look at ownership--and the SEC requires that hedge funds or anyone who buys more than 5% of a company stock has to file this form--and talk a little bit about what they're doing, in addition to disclosing some of the data about how much they're buying and when they bought it, and those sorts of things. And so, as researchers, we have this really nice data set where we can take a look at these forms and see what these activists are trying to do.
What we mostly found is that initially when activists are coming in, they're usually targeting kind of small to midsize firms, partly out of necessity, right? It's hard to buy 5% of Apple or something like that. And so, they're targeting these small, mid-cap firms, and typically going after management for being inefficient. So, you know, the classic--you're buying a jet and we don't like that, or you're flying on your jet. So, without it being environmental, per se, there's definitely a huge aspect of governance there. And many, many activists, probably more than half of the campaigns have some component of governance. The CEO isn't doing a great job, or the firm is making too many acquisitions, or the firm has too many takeover defenses, or isn't fair to shareholders. And so, a lot of that activism was sort of directly targeting governance to sort of indirectly get at financial metrics and trying to improve all the things that hedge funds care about, right? So, improve ROA, improve the stock price, try to reduce expenses, and that sort of thing.
Benz: So, how would you recommend if investors are looking at some sort of a fund that engages in these activist behaviors? How do they decide whether they're any good at it? How do they assess--I know that that can be costly, right, relative to just being sort of like a passive owner of some of the stuff. So, how should investors think about that?
Boyson: Yeah. So, I think the way that I think about activism, and it's a very good question, there are a lot of hedge funds out there that are presumably engaging in activism. But it turns out, there's only kind of a small number that do it consistently and frequently. And I have a recent paper that's a working paper not yet published. And we actually look at the backgrounds of these managers. And we find that the ones that have background experience in things like private equity, venture capital, turnaround funds, distress, tend to be better activists in terms of the long-term outcomes for the firm. Those firms that are targeted by these guys, they tend to have a much longer-term approach. They're much more likely to get on the board of directors and try to make some more fundamental changes to the firm. And the probability of those firms going bankrupt down the road is lower than the firms that are targeted by just kind of the run-of-the-mill activists.
But the other really kind of not-great part of all of it is that it's hard to identify all that. We can think of like Bill Ackman, who was a wizard activist for many years, and then had two years in a row where he was like the worst performer of all hedge fund managers--I'm exaggerating, but he had a couple really terrible years. And so, again, like any kind of investment manager, persistence is really hard to find. The one thing we do know for sure about activists that I can say with confidence with all the literature, is that when activists get into firms, the stock price responds positively. So, we take that as the market thinking that this is a good thing. But it's harder to find a longer-term performance there.
The second thing we know is that when activists get involved, there's a much higher chance that the firm will be merged. We don't know for sure, and we don't know when, but they really do seem to come in and agitate for the kind of changes that lead to firms being bought. And I guess there's one more thing that happens when an activist comes in, which makes the firms not happy, is that CEOs and upper management are far more likely to step down or be removed from their positions. And so, it's a really interesting push and pull. I think that on average, most activists are adding value on the hedge fund side. But there are definitely cases where activists go after firms that probably don't really need them there. And there may be some downside, certainly, for employees, and often sometimes even for bondholders. So, it's not a perfect thing. But again, on the ESG side, it is very clear that when activists come in, there's almost, if they're targeting governance, which they often are, we usually will see some positive changes.
Ptak: I wanted to talk about financial advisor conflicts, which is a key focus of the paper that you published recently, which we alluded to already. But before we do that, there is another paper of yours that I wanted to touch on. You had examined the investment performance of female hedge fund managers if I'm not mistaken. Maybe you could summarize for our listeners what your key findings were from that study. Again, that's another topic that's been very hot in the investment management industry, sort of looking at the relative performance of funds that are run by females and males and seeing whether there's a difference. What did you find?
Boyson: Yes, that actually was a really fun paper to write. Jane Buchan, who is a hedge fund manager herself, she ran a fund of funds for many years, had commissioned my colleague and I to write this paper--commission sounds like the wrong word--but she provided us a grant to put together the data set. And she said to us, look, you know, there's some work out there that says females are better managers. And she said, frankly, I don't think that's true. She said, but we need a really comprehensive study done by academics to really try to understand what's happening. And so, that was kind of cool. She's a wonderful person. We started to work on this project, and there are a couple of key findings. I'll try to list them in some reasonable order.
So, the first is that a very, very, very tiny fraction of hedge funds have women in management; it’s something like 4%. So, already we're working with a really small sample of managers. So, that's the first kind of very striking finding. In the mutual fund space, I want to say it's 15% to 20%, it may be even a bit higher, still way lower than what you might expect, but incredibly low in hedge funds. So, that's kind of one of the first findings.
The second thing we find is that the performance between men and women is almost exactly the same. There really are no differences, whether we look at raw returns or risk-adjusted performance--and we're academics, so we have like dozens of ways to adjust for risk. And we really don't find that. And so, that goes against the conventional wisdom that, you know, women are going to have worse performance but take less risk. Or maybe women will have the same performance but take less risk, which makes them have better performance. We find none of that. We find that women are just as willing to take risk, and their performance is equally as good.
The third thing we find is that women just have trouble collecting flows. And so, when you think about raising capital, what we show is that the women in our sample, they fail at a much higher rate, their funds go out of business, typically just we think because they can't get to the size that they want. And one of the really kind of fascinating findings is that when we look at surviving funds, because our paper looks at funds that failed and funds that didn't, I mean most hedge funds fail eventually, and we took a look at the surviving funds. And we found that among the survivors, the women actually were better performers. And so, that is why prior research done by nonacademics was probably focusing on the funds that survived and found that result. So, we found effectively that women hedge fund managers have to do better than their male counterparts just to raise enough money to be able to survive.
And so, we thought that was kind of a cool story. We backed it up by looking at just a quick Google search of female hedge fund managers. And we found sort of—disturbingly--things like, you'd look up female hedge fund managers you're trying to get a sense for what the media is saying about them, and most of the articles--first of all, there weren't a lot of articles about them. And then the ones that were, they would talk about what they were wearing, or how their makeup looked, or how they dressed, or whether they were married or not. And so, it was just not--the focus seemed to be not on the important things, like performance. And so, our kind of takeaway from this is just, there aren't a lot of women in the business. Part of the reason is that they just seem to be ignored by investors. And their performance is equally as good no matter how you measure it. And so, it's just a tougher row to hoe, I think, to be a female in that space in terms of raising assets.
Benz: So, another topic that you focused on in your research is financial contagions. And let's talk about what led you to that topic and what were some of the major conclusions from studying that area.
Boyson: Yes, that's probably my best-cited paper. It's written with my dissertation advisor René Stulz, who is an extremely superb economist. And he knew I was working on hedge funds. And my other colleague, Christof Stahel, who interestingly now works at the ICI, although he wasn't there at the time I discovered that chart. We were in grad school together and René's worked a lot on contagion and trying to understand sort of international transmission of shocks. And he called Christof and I and said, Hey, do you want to work on something trying to understand hedge fund contagion? And so it turned out to be a cool project. When we started it, it was pre-financial crisis. And so, we were just thinking about in general, kind of, when things go bad in the hedge fund space, or when things go bad in the broader economy, how does that sort of transmit across? And the reason we think hedge funds are particularly interesting is that they're sold as diversifying tools. They're often sold as alternative assets that are not correlated with the general markets, or if you like, say, with sort of more long-only mutual funds.
And so, the question really is, are they going to hold up to a crisis or to a downturn in the economy? And so, in that paper, we took a look at sort of bad times in the markets, and we define those in a bunch of different ways and saw how hedge funds did. And sort of to our dismay, we found that most hedge funds did poorly when other assets did poorly. So, you'll hear people say things like, “During a downturn all correlations go to 1,” and we found that to be kind of true, right? We sort of found that to be true in the hedge fund space. There were a couple of bright spots that--I haven't looked at that paper in detail for a little while--but the truly market-neutral funds, the ones that really were running beta of close to 0, they kind of did OK, and some of the global macro funds and some of the CTAs that sort of manage futures funds did kind of OK during downturns. But what we found was that, overwhelmingly, hedge funds weren't quite able to provide that buffer during downturns. So, that was kind of cool.
And then, we tried to think about why. And the financial crisis started come along. And there were lots of cool theory papers at the time talking about liquidity and liquidity shocks. And so, we were able to correlate the downturns for those funds to shocks to liquidity. And that comes in a bunch of different ways. But a really simple way to think about it is that if there's a liquidity shock, and it's hard to borrow, and your hedge fund is levered, you're probably more likely to get a margin call just when you don't want to get a margin call. And so, we sort of tried to take a look at that and get a sense for it. Then we found very strong correlations between crises or downturns that were also liquidity-linked, used a bunch of different proxies for liquidity, and tied those to underperformance and hedge funds during that time. And so, those were effectively our essential findings that kind of…be careful what you wish for--the typical hedge fund in our sample wasn't able to provide a tremendous amount of downside protection. On average, hedge funds did better during the crisis, and that was due to a couple of the categories that I mentioned earlier.
Ptak: So, let's shift gears and talk about financial advisor potential conflicts of interest, which has been an area focus for you in recent work. Every industry has its conflicts. The financial advice industry is no exception in that regard. But for the unacquainted, can you briefly describe the types of conflicts you've examined?
Boyson: I sure can. And so, in this paper, I'm focusing on conflicts among investment advisors, not mutual fund managers, not institutional managers, but the investment advisors that you're going to meet with one-on-one as an individual or a family, trying to get some advice and helping with asset allocation at the very least, and overall investment planning. Some advisors do a lot more detailed work than others. So, some it's more just investment-related, and others are going to be involved with your taxes, and your estate planning, and budgeting, and things like that. But in general the investment advisors are working with individuals, often wealthy individuals, but in my sample, there are lots of advisors that are willing to take small individuals as well.
In that world, you can imagine that even an advisor with sort of the purest intentions and the clearest, cleanest sort of moral standing is going to have some conflicts in the way that they advise their clients. And not all conflicts are equal and not all conflicts are terrible. But on average, conflicts can be a problem. And so, some specific conflicts, the very obvious conflicts that come up for financial advisors that are acting as brokers--brokers are typically paid commissions. And so, if I'm going to get a higher commission for selling mutual fund 1 over mutual fund 2, I'm going to have an internal conflict that would make me prefer mutual fund 1, even if maybe mutual fund 2 was better for my client.
Lots of other conflicts as well. Some of them that come up in my paper are conflicts related to the way that investment advisors are paid. So, again, this idea of commissions versus fees. But there are also conflicts that I talk about with respect to selling affiliated funds. So, if I work for JPMorgan as an advisor, I have an incentive to sell JPMorgan funds. It may not be an incentive that puts money directly in my pocket, right? So, I might not be getting a little more money if I sell a JPMorgan fund versus another. But internally, I'm going to know that if I sell JPMorgan funds, that's going to improve JPMorgan's revenues, increases the probability that I keep my job. Those funds are all around me. The managers are nearby. And oftentimes, if I am going to receive a bonus at the end of the year, it may be easier to sell those funds than others. So, the idea of affiliated mutual funds is a conflict. Now, if I can sell other funds, and if those funds that I am selling, the affiliated funds, are objectively good for my client, then that's mitigating that conflict, but the conflict exists, nonetheless.
A couple others that show up in my sample. One is that mutual fund families--so, mutual fund families like T. Rowe Price, or Oppenheimer, or others, are going to be, in many cases, paying money to the advisors through their firm. So, the advisors again are not receiving this money directly. But the firm--say it's Ameriprise. Ameriprise will say, hey, Oppenheimer, if you want to be listed on our platform, if you want to have access to advisors, and if you want to be on our short list, our short preferred list of funds, you need to share revenue with us. It's called revenue-sharing. Revenue-sharing means many things in the business, but in my context, it's what I'm talking about. It's Oppenheimer is now going to pay Ameriprise some money out of their profits, so out of the profits of the firm, not of the individual funds, and that money then goes to the firm like Ameriprise, and now Ameriprise is going to get Oppenheimer in front of the clients. They're going to get Oppenheimer in front of the advisors, they're going to be listed on the preferred list. And so, that revenue-sharing is kind of insidious. The advisors probably don't know about it. This comes from my conversation with people on Twitter. And I believe that's probably true, but the firm knows about it. And if I'm an advisor, and I'm 22 years old, and I am handed a preferred list of funds, it's probably pretty likely that I'm going to start with that list as I work with my clients. So, the conflict is there, but it's at the firm level, trickles down to the client level.
And then, probably the last conflict that I sort of talk about is the ability for advisors to earn both fees and commissions on the same asset. So, the commissions will come through a mutual fund that pays a commission through the funds. It's disclosed to investors, but it's kind of hard to see. And then, that advisor will also charge a fee to their clients as a percentage of assets, say, and so you can call this double-dipping if you like. It's not illegal, but it incentivizes the advisor to sell a fund that's going to pay him both, versus simply the asset-based fee.
Ptak: And so, I think that your research has found that there are certain business models and certain types of advisors where there's a greater propensity for these types of conflicts, and we'll get to that in a minute. But it seems like foundationally we need to draw the distinction between firms that maybe have what's, let's call, sort of a pure fee-based RIA model and then others where it's both advice, and perhaps there's an affiliated broker/dealer. Isn't that a key distinction that sort of laced through the research that you've done?
Boyson: It really is and the way that I think about that is just as you put it, if the firm--again, I'm using Ameriprise, although I'm not picking on them in particular--Edward Jones, Merrill Lynch, Morgan Stanley, Wells Fargo, they all fit in this category. These are all the household names. These are big firms. They are what we call dual-registered, so they have registered investment advisors who are supposed to act as fiduciaries. These advisors are typically paid fees as a percentage of assets. And that same person, that same registered investment advisor, may also be registered as a registered representative or a broker and be permitted to receive commissions as well. So, the firm is dual-registered. It has the affiliated broker. And most of the individuals that work at the firm are dual-registered as well.
Now that can be good. If I come to Ameriprise and really all I want to do is trade stocks all day long, then the broker and that business is going to let me do that. Maybe instead I want a buy-and-hold portfolio, or to monitor an asset allocation, sort of, that's going to change over time as my risks change, that same advisor then could put me in a fee-based account and provide me more monitoring, more personal attention. And so, the idea of dual registration is not in itself a problem. It can have some advantages. But because of that dual registration, these conflicts exist.
So, for example, being able to receive both commissions and fees on the same asset can only exist in a dual-registered firm because those commissions have to come through the brokerage side of the business. In an independent registered investment advisor, who's not also a broker and who's not affiliated with a broker/dealer, he literally can't collect commissions because there's no mechanism for him to do that. So, the conflicts on the dual-registered side that I focus on in my paper are those that really can only exist because of dual registration. And what I want to point out in my paper is that these conflicts can be costly for investors.
Ptak: So, maybe just a hypothetical example, let's suppose that this is an RIA that doesn't have a broker/dealer attached to it. So, it's not a dual-registered investment advisor. Would they be able to do things like revenue-share with fund companies with that setup?
Boyson: They would not as far as I can tell. So, that's one of the questions I asked Max about. And I did my best to try to find a way that revenue-sharing could kind of come through an independent RIA's business, and not in the traditional sense of the fund family paying a percentage of their profits to the advisor. There's not a mechanism for that to happen. And the thing about revenue-sharing that's interesting is that it always was kind of on the fund families who were traditionally broker-sold. So, if you think about a family like MFS or American Funds, those funds from those families were almost solely distributed through brokers for many, many years. And then as times changed and as the independent RIA model became more popular, American Funds was very smart in saying, well, look, you know, we distribute ourselves through brokers, but we also want to make share classes available to our advisors who are registered investment advisors. And so, American Funds has something like 38 different share classes, it’s a crazy number, but they're all geared towards serving different clients. And so, if I work at Ameriprise, what I'll do is, if I'm working with my broker hat on, working with a brokerage client, I'll sell an A share which has a front load, or a C share, which has a backload that comes through the fund family. Or if I put on my RIA hat, I'll sell a different share class that doesn't have those fees or loads to my RIA clients.
And so, the interesting thing is, because the revenue-sharing is at the fund family level, all the assets that American Funds have at Ameriprise, they'll pay Ameriprise--their formula is complicated--but they'll pay them some proportion of those assets. So, they're not distinguishing between the different share classes. But the revenue-sharing model really grew up in the broker side of the business.
Benz: So, you've previously talked about how some key legal and regulatory decisions paved the way for the current climate where financial advisory rather than brokerage has become the dominant model. Can you walk us through that and explain how we got to the place we are today?
Boyson: Yeah, I found the story to be fascinating. And I remember reading it, and suddenly something clicking, and I was probably working in my basement surrounded by a cat or two. And just like cheering because I finally understood how it works. But I remember sitting and reading about this. And so, the short version is that prior to, say, 1990, call it the early 1990s, Merrill Lynch started in their brokerage business. So, forget about the RIA side for the minute, just straight--up brokerage. They had clients who wanted to trade a lot. So, you can imagine a client that wants to trade a lot of stocks and sort of having a good time doing that. These are nondiscretionary accounts. So, the broker may make recommendations, but the client has to sign off on all of them. And recall in 1990 commissions were not cheap. And so, what Merrill was doing was putting together these accounts, and they called them “wrap accounts,” which now, of course, means other things. But at the time, they would say, look, we're going to charge you 1.5% or 1% of your assets, and you can trade as much as you want. And so, that actually was a pretty good deal for some of these clients.
Once Merrill realized that charging a percent of assets was a really nice way to have an annuity and a really steady income stream, versus having to go out and pitch a new stock or a new fund every day, they started making this available to more of their clients, some of whom were probably active traders, and some of whom weren't. They were a little concerned that the SEC would find this problematic because typically, only registered investment advisors were able to charge fees in that manner. So they talked to the SEC. The SEC gave them a no-action letter. And for a while, sort of, everybody was doing it.
The SEC actually commissioned Merrill to do a study in 1995. And their study was to try to see whether this was a problem, whether this would be confusing to investors. And the SEC concluded in 1999, which was eventually called the “Merrill Lynch rule,” that it was OK. That it was OK if you were a broker to charge asset-based fees to your brokerage clients. And they talked about it. I recall at the time reading--they talked about it as sort of amortizing the commissions, so just sort of spreading them out over some period of time. So, that was where they came with that.
In 2004, the Financial Planning Association, which was a group of independent advisors, they were not happy about this. So they sued the SEC, saying, look, this blurs the line. So, one of the clear distinctions between us and brokers is that we can charge asset-based fees and they can't, and now you're letting them charge asset-based fees. They call themselves advisors. Our clients aren't going to be able to understand the difference. And of course, the difference was that RIAs are held to a higher fiduciary standard, brokers held to a suitability standard. And so, they sued the SEC. In 2005, the Merrill Lynch rule became law. So, it has been kind of was like a working rule for several years, and then it became signed into law. In 2007, the FPA actually won their lawsuit.
And so, the outcome of that, which is sort of law of unintended consequences, right? Kind of watch out what you hoped for? The FPA won, so what that meant was that any brokers that were charging asset-based fees in their brokerage accounts had to either, A, start an RIA and move their clients over. Turns out most of them already had RIAs. So what they did was they just shifted their clients from the brokerage side of the business to the RIA side of the business. There was something like $400 billion moved very shortly after that. And if you look at flows and revenues for these guys, you see very clearly that in 2007 or so, the percentage of firm profits that came from commissions, these big dual registrants was about 80%. And now, it's less than 50% coming from commissions. And so, there's been a really big shift from the brokerage side of the business to the RIA side of the business. And I think the financial planners--I'm not sure what they thought would happen. But it turns out that that wasn't great for them, because it didn't seem to be a big deal for firms to sort of do this shift. Now they had some new compliance costs and so forth, but this still has been really profitable for these big dual registrants.
Ptak: And so, it sounds like that brings us full circle back to one of your earlier observations about that original ICI chart where you were seeing these prodigious inflows, the institutional share classes, and outflows from the brokerage share classes, so to speak, isn't that right?
Boyson: That's exactly right. And so, once I understood--when you look at that graph, you can see very strongly those flows starting to sort of trickle out of the A, B, C shares and into the institutional classes right around 2007-2008. And so, my paper is not trying to claim causality. But that certainly was a contributing factor. There were some other factors leading to those changes at that time. One was, we were coming into a financial crisis, and so a lot of people fired their brokers, I'm guessing, during that time. And also during that time, because of the crisis, I think a lot of people realized that when the market goes down, actively managed funds don't do well because they're--whatever--they don't--no one's doing well when the market goes down. And like my contagion paper, it wasn't that these actively managed fund managers were doing better at kind of managing risk. And so, a lot of people at that point started moving into passive. And so, I have a chart in the version of the paper where you can see just flows going out of active and into passive. My paper is about the active side, but I wanted to show that there are a lot of contributing factors to that sort of shift.
Benz: So, if I'm kind of thinking about consumers and thinking about these brokerage commissions versus paying an advisor a percentage of assets on an ongoing basis, it kind of makes me wonder why either of those are better than just paying an hourly fee or some sort of flat dollar amount to an advisor. Do the other models maybe eliminate some of the conflicts of interest that you studied? Do they do that a little better? So, like hourly, for example, am I missing some conflict that might be there?
Boyson: I don't think you're missing a conflict. I do think that hourly can be better. So, here's the thing. When I talk to advisors about hourly, there's one advisor--Rick Ferri, my friend, who loves it, this is what he's doing. He used to be a fee-based guy and now he's moved to hourly. The problem with hourly, it's just like being a broker. You have to go out and continually get new business. And so, the asset-based model has made advisors kind of--I don't want to say lazy because that's not the right word at all--but it allows them to build their base of business kind of once, focus on those clients. And there can be some really nice advantages to these long-term relationships that you develop with people. That said, the hourly model, I think, despite it being difficult, and despite it being sort of a constant, having to go find new clients, I think there's huge demand for it potentially. I have several--this is anecdotal, to be sure--but I have lots of very smart friends in probably the $500,000-$2 million range in assets. They're kind of right in between that DIY, and I need to pay 1% a year for the rest of my life. And so, a lot of them really would benefit from the hourly model. And I do think the hourly model can reduce conflicts. I think it's just a harder sell to the advisors.
Ptak: It seems like one of the key cohorts that your research examined just by virtue of the fact that they are a key market for the dual-registered investment advisors is the mass affluent market, right? And so, perhaps that would be a bit of a barrier also for the hourly model just given the fact that so many of those accounts are, are smaller. Does that seem like a fair statement?
Boyson: I think it would be. And so, to some extent, I feel like there are people out there who maybe have $100,000 in assets, who really would be willing to pay a couple thousand dollars upfront for a good financial plan, a good structure, and then maybe meet with that person every couple years for an hour or so. I think that would certainly be cheaper for that person. And I think in many cases, it might be sufficient if the person is sort of sophisticated on the finance side. But I think you're right. And so, one of the kind of independent advisors that I'm friends with really liked my paper because it says they have fewer conflicts. But the downside is that they don't have the capacity to serve the smaller clients. And so, if I have $50,000 or $100,000, I'm probably not going to be able to use an independent RIA. I just don't have enough assets to justify. But I can certainly go to Ameriprise and they'll put me in one of their models. And my research shows that those tend to not be great models.
The other thing, though, is that they're very expensive. And the models that I see--one of the things that was a huge shock to me, although it's not surprising when you think about it for a minute, is for clients under $100,000, the average fee charged by dual registrants is over 2% per year. And that's before mutual fund expenses and any other kind of trading costs they’re going to throw in there. So, that's super, super expensive. Now, as a percent, as a dollar amount, it's not very big, right? Two percent of $50,000 isn't a huge number for the advisor, but those are the fees that they're charging. And so, I really struggle with that. So, coming full circle to the brokerage model, when I think about the trade-offs, I think about a broker that I used to work for who I don't think was the most ethical guy in the planet, but he would sell you a mutual fund C share. That mutual fund C share is going to pay him about 1% a year for the rest of time. So, that's fine. That's sort of a perpetuity kind of annuity model. If he were in the RIA business and working for one of these dual registrants and had a small client, he may put them in an RIA account, fiduciary account, and charge them 2% a year. And again, the monitoring is different, its suitability on the brokerage side at the time versus the fiduciary model. But for small clients, from my experience, and from talking to lots of people in the business, the service level isn't that different. And so, in many cases, those smaller retail clients really probably were better off in a C share than they are in a 2%-per-year advised account.
There's been pushback by the SEC on this, pretty good pushback and pushback by some class action lawsuits saying you're charging us 2%, you're not really monitoring our accounts very well and there's not a lot of action happening there. And so, you can call this reverse-churning, if you like, you put me in some model portfolio and you never change it. That may actually be best for the client. But I'm not sure it's best for the client at 2% plus the fees. And so, there's been a fair amount of pushback on that as well. So, just charging asset-based fees, in my opinion, does not reduce the conflict. And if those fees are higher than you might have been paying in a brokerage account, then I don't think that that's great either. So, as I say to most people that I talk to, I don't like any of the models, fair question, and I have enemies across the board. But I think that all the models have problems. And I worry a bit about these high fees. And I worry a lot about that kind of mass affluent, or even not quite affluent, group of investors because their only choice really has been for the last several years, do-it-yourself, or go work with one of these advisors that is likely to charge you a pretty high fee.
Ptak: So, I wanted to talk in a bit more detail about how you were able to determine what dual-registrant clients were paying. You alluded to it. But before we do that, maybe seeing it through the investors' eyes, so to speak, can you explain to our audience how they would figure out if the advisor they're working with or they're considering working with, was operating under the dual-registrant model or call it the fiduciary RIA model. Like what would they need to look for? What would they need to ask for?
Boyson: It's a good question. So, right now, I think the easiest way to figure out whether you're an RIA client, or you're a brokerage client, is to look at your statement. If you're being charged a percentage of assets, then you're in the RIA category. If you're paying fees or buying commission-based mutual funds, then you're in the broker category. But other than that, it's not straightforward at all. And so, all these financial advisors call themselves financial advisors, and they frequently aren't going to disclose--whether it's intentional or not--which umbrella you fall under. So, again, if you have an account, look at how fees are being charged. That's your first step. The second thing is to ask your advisor, Am I in a fiduciary account or am I in an independent sort of individual RIA account? And then, the third way is to go look at their Form ADV, which is super-boring. But Form ADVs are found on the SEC's website. You can look up the individuals, or you can look up the firm, and the data is in there.
One of the good things that's coming out of this new regulation, Regulation Best Interest, which is going to be implemented in June of this year, is the advisor has to hand you a form. It's called Form CRS, the Customer Relationship Summary. And that form will tell explicitly which they are. So, if they're an independent advisor, the form is two pages long and it will say nothing about brokerage. If they are a dual registrant, the form is four pages long, and they're going to describe both sides of their business on that form.
Benz: So, you mentioned Regulation BI. Let's talk about that. It's been widely criticized as being pretty toothless. What's your take on it?
Boyson: I think it's kind of toothless. The biggest concern with Regulation BI is that it's very long. It's unclear to me whether it makes any really substantive changes, other than a couple that you can point at. So, one of the good changes that it makes--the Form CRS, I think, is going to be really hard to implement in the way that the SEC is envisioning. They only want it to be two or four pages. And if you look at the instructions, the instructions are like 15 pages long, and they tell them to do a lot of things that I think would be hard to fit into four pages. So, I'm not sure it's going to help clients much, other than hopefully the distinction between RIA and fiduciary maybe will be more clear. So, the Form CRS is one of the things. Another thing that comes out of it is the SEC is putting some pretty strict restrictions on the way that brokers—this is on the broker side of the business--the way that brokers can be paid so they can't have certain types of explicit sales contests, for example, that they used to have.
But otherwise, if you take a look at it--and this is some of this information that I'm repeating comes from talking to people on the brokerage side of the business--in many ways, it's just reiterating the suitability standard on the broker side. And so, effectively, Finra has been pushing brokers to behave in all the ways that are already sort of outlined in Reg BI. So, although it kind of goes further in some of its language, talking about conflicts and so forth, it doesn't set down any strict requirements that I might like to see, things like, you can't charge both commissions and asset-based fees in the same account, things like revenue-sharing should not be permitted. Now, that's huge, right? And I don't know that that could ever change. But there are things that could be done that would effectively eliminate certain conflicts that show up in my paper that don't exist in Reg BI.
And so, I think it was an attempt to please both sides of the business. The dual registrant and brokerage of the business is not unhappy with Reg BI, which implies to me that the changes that they need to make are not tremendously substantive. It's not focusing on the RIA side of the business, so my research doesn't speak directly to it. But again, my views on it from reading it pretty carefully and listening to a lot of people at conferences talking about it, it doesn't strike me as--it's not imposing a strict fiduciary standard on the brokerage side of the business, which I personally frankly think is pretty hard to do as long as commissions exist, and I actually think commissions are OK. So, my Michael Kitces take, who is one of my favorite persons to follow on Twitter, is that if we just keep the two sides of the business more separate, if we make it really explicit and clear that I'm acting as a broker here, and I'm going to sell you something and here's how much money I'm going to make, versus I'm acting as an advisor here, and here are the things that I'm going to do for you as an advisor, and making that line more distinct, even if it's within the same firm, would solve a lot of problems.
But the advisors don't want that. The advisors, on average, seem to prefer that opacity, and not necessarily making it clear which side of the business they're working on. I shouldn't say the advisors--the firms that employ the advisors. The advisors themselves are often just sort of pawns in the system.
Ptak: So, even under BI, there's still this, I guess you would say duality, where you have the advice side, which has a more stringent standard, a higher standard of care, and then you have the broker/dealer side, let's call it, where it's less exacting. And I thought that one of the most interesting observations from your research is that the wall between these two sides, advice and broker/dealer, is porous, right? That the practices and incentives on the brokerage side, they kind of seep through to the RIA side. So, maybe to bring some of these different strands that we've been talking about to this point in the conversation, can you give an example of how this is so, how this plays out in these dual-registrant firms and affects investors?
Boyson: I can. And so, when I think about this idea of problems bleeding over, one of the problems that bleeds over is that if I'm working as a broker for many years and most of my clients are brokerage clients, I've been selling mutual funds that pay me commissions through the fund or a front load from the client kind of through the fund and that's the model I have, I'm going to be really familiar with those fund families. I'm going to know the wholesalers; I'm going to have a relationship with them. These are funds that I've been selling forever. They're on my preferred list, and I know them. So, when I start to become an RIA, effectively the mechanical switch that's happening there is simply taking my old clients, say, I'm going to move a brokerage client to my RIA side, or maybe I just have a new client walking in the door and I choose to put him in the RIA side, I'm going to treat them effectively the same way in terms of my investment advice.
On the fiduciary side, the idea would be that I need to go and look and find the best funds for the client. Now, that's probably impossible even in a perfect world. But it probably means, at least in my view from a fiduciary standpoint, that I might look outside the list of funds that I've been using for a long time on the brokerage side. Totally met the suitability criteria, no problem there. But in terms of its fiduciary criteria, it's hard for me to say whether that meets the spirit of the fiduciary rule. But nonetheless, as a dual registrant, like I said, I'm familiar with these funds, I know these funds. These funds have been revenue-sharing with my firm for years, which I might not even know about, because I'm not directly getting a piece of that. I'm going to move my RIA clients into those same funds. And I'm not necessarily, again, in these large dual-registered firms where I have hundreds of clients per advisor, I'm not necessarily going to treat them much differently than I treated my brokerage clients.
So, if I was good to my brokerage clients, if I explained the fees carefully, and they understood what they were paying, and I gave them the kind of service that made sense for them, I'm probably doing that same thing with my RIA clients, and that's probably OK. But if I were the kind of churn-and-burn kind of advisor, and I see the opportunity, it's not hard to see--I'm getting 1% per year and having to sell a whole bunch for some of these brokerage clients, and I can shift them to the RIA side and suddenly make 2% per year, and pretty much invest them in the same way, there's a huge incentive, in my opinion, to make that shift. And there's lots of conversation about that. So, there's a whistleblower JPMorgan named Johnny Burris, who's arguing this, that that's what they were doing. I've had off-the-record conversations with advisors from various firms who said, absolutely, once the fiduciary kind of fear came in that we're all going to have to comply by the fiduciary rule, it appears that lots of the firms took that as an opportunity to move clients to the RIA side of the business.
If the fees are similar, or the fees are maybe a little higher and there really is a difference in service, that's fine. But what I'm seeing in my research is not an obvious difference in service, twice the fees, same underlying mutual funds. And here's the kicker from my paper: These are mutual funds that underperform their peers that aren't the revenue-sharing funds. So, when I take a look at risk-adjusted performance for the mutual funds that revenue-share, regardless of share class, versus mutual funds that don't, the revenue-sharers are the worst performers. And so, that incentive to kind of keep doing what I was doing, working with the same funds and shifting that over to the RIA side, now what I see is, it's the same funds, the fees are being paid differently, they're not coming through the funds directly from the client, but they're twice as high as they were on the brokerage side. And for me--again, this is on average; I'm an academic; I have a big sample; I look at the averages--that doesn't seem to be particularly fiduciary-like.
Ptak: How did you determine, or I should say, estimate, the fees that dual-registrant clients are paying? You indicated the fact that your research found that they're paying substantially more than if they were just sitting on the brokerage side before they made the switch over to the advice side. So, what were you looking at? Like the data, were you kind of combing through ADVs?
Boyson: I did an answer before, but yes. So, Form ADV Part 2, which is also known as the “brochure.” The SEC required all advisors, so anyone who's a registered advisor, whether they're a dual or independent, to fill out this Form ADV Part 2 starting in 2011. So I can read those, they’re a narrative format, some of them are very long, but I read through them. And when I pull out the fees, what I'm looking for is--particularly the dual registrants still often have a fee schedule. So, under $100,000, here's what we charge; $100,000 to $200,000, here's what we charge. And so, I was focusing very specifically on clients with $100,000 or less and pulling out the fees for that. And so, these come from the firm's own disclosures. Sometimes I'll see fees as high as 2.75% for under $100,000. The median in my sample--the mean or the median, they're very close, just over 2%. And so, these are disclosed.
Now, I talk to lots of advisors in this space, and they'll say, you know, we disclose the maximum fees, we don't always charge that. And that's fine. But, you know, I can only observe what I can observe, and their fee schedules are pretty clear on the fees that they're charging. And typically, these are what they call wrap accounts, where the portfolio that they're going to put the client in is kind of this predetermined, third-party managed portfolio that is often made up of mutual funds from the families that I talk about that revenue-share. And so, these are very kind of plug-and-play portfolios, which can be fine for clients--I'm a big fan of simplicity--but they're expensive.
Ptak: And how prevalent does your research suggest double-dipping, if I can use the term, is in the dual-registrant model, whereby you have an advisor and they're charging an advice fee that wraps around the portfolio, maybe it's a percentage point or more based on the research you've conducted? But then, there's the underlying expenses of the funds, which can include things like 12b-1. And so, does your research find that that's still a fairly prevalent practice, albeit one that's disclosed?
Boyson: Yes. So, the good news is that the SEC did, what they call the share class disclosure initiative in April of 2019. And they effectively knew that this was happening. It's legal, by the way. But they knew that this was happening, and they knew that firms weren't disclosing it adequately in their Form ADV Part 2. And so, in ADV Part 2, firms are required to disclose conflicts, material conflicts. And what firms would often do is, say, you know, we may double-dip. They wouldn't use that language. But they'd say, you know, we may charge commissions and fees on the same account. What the SEC wanted them to say was, we are charging fees and commissions on the same account. And so, the SEC knew that the disclosure was inadequate; they knew this was happening. And this was actually kind of brilliant of them. They went to the firms and said, Hey guys, if you come clean and tell us that you are doing this and give us a dollar estimate of how much that you've kind of presumably overcharged clients over the past several years--I forget how far back they went, but it was several years back--they said, we won't charge you any civil penalties. We will just make you pay back the clients this sort of overcharging, and going forward, you need to better disclose this.
And so, the outcome was pretty substantial. There were about 100 firms that came forward, all dual-registered by definition, that came forward and admitted to this. And so, the total dollars paid something like $125 million, $140 million paid back to clients with no civil penalties on the firms. So, that was one kind of cool thing. They're still going after firms that they kind of know are doing this but didn't disclose. And those firms they're making pay civil penalties, plus pay back the money. And my very unscientific review of some very, very recent Form ADV Part 2 post this--which is not in my sample, but I was curious--I'm finding that most of them are now saying, we do our best to avoid double-dipping; but if it happens, we're going to rebate those fees back to the clients. And so, this is one, like, super positive thing that seems to have come out of this SEC action, is that by shining a light on it, making firms admit it, the firms are now saying, boy, you know, we don't really want to disclose exactly that we're doing this, partly because it kind of makes us look kind of bad. And so, we are going to just stop doing it.
Ptak: So, if you could wave a wand and prescribe a policy response, let's say, for managing off some of these conflicts, really sort of mitigating them altogether, one would hope--I think you mentioned before that revenue-sharing is maybe one of the things that you would look to outlaw altogether--but what else would you try to do?
Boyson: I would definitely go after revenue-sharing. And I think that the SEC could do a revenue-sharing disclosure initiative just like they do the share class disclosure initiative and probably get some pretty good results. I'd go after the 12b-1 fee double-dipping, which again, the SEC already seems to be doing. So, that I'm not going to say it's totally gone, but it seems to be improved.
One of the other issues I would really be concerned about is affiliated mutual funds. So, one of the things that I find in my paper--and I'm not the first to show this, but I am kind of the first to show this in this context--is that the funds that are affiliated with the large dual registrants tend to be expensive and underperform. Others have shown that for different reasons. My reason is related sort of directly to, we have a captive salesforce who's going to sell these funds for us. I think at the very least putting some additional due-diligence around that would be nice.
One of the things that comes out of my paper is that many times the dual registrants will state that they prefer their affiliated funds and they will say, we perform less due-diligence on these funds. Now, you could sort of say, well, that makes sense because we know the manager, he works around the corner, we kind of have this implicit due-diligence. But in my view, due-diligence should also include comparing performance. And while past performance can't predict future performance, there's some value in thinking a bit about that.
And then, finally, I think, thinking about these fees. Firms have to charge really high fees for their small clients, otherwise they can't make money. But it seems like there has to be a better way than charging them 2.5% a year and not necessarily giving additional service. And so, that's not a regulatory thing. That is actually a market-based solution. And I think there's a lot of room for independent advisors to come in. We're already seeing it with some of these robo-advisors. I think that's great to come in and have more creative fee schedules, hourly fees, or lower percentage of asset fees in ways that can still be profitable for the firms but that aren't very obviously expensive and conflicted relative to what they're doing on the other side of their business in many cases.
Ptak: Well, Professor Boyson, this has been a fascinating discussion. Thanks so much for coming on The Long View and sharing your insights and perspectives. We've really enjoyed it.
Boyson: Thanks so much for having me.
Benz: Thank you so much.
Boyson: Thanks, Christine. Thanks, Jeff.
Benz: Thank you so much.
Ptak: Thanks again.
Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcast.
Benz: You can follow us on Twitter @Christine_Benz.
Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1. Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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