U.S. laws and regulations on investment management address potential conflicts of interest between investors and managers through disclosure requirements. Surprisingly little is known about the effectiveness of these standards in resolving such conflicts, says finance professor Greg Kadlec.
Kadlec co-authored a recent study that offers new empirical evidence on the role of disclosure, finding that greater transparency about a fund’s operating expenditures lowers the fund’s conflicts of interest and improves return performance.
Fighting conflicts of interest
Agency conflicts can arise whenever people delegate control of assets to others. A particularly important agency conflict exists between shareholders and managers of a corporation. “Shareholders want managers to maximize the value of the corporation, whereas managers want to maximize their own welfare. This conflict can result in managers acting inefficiently or even corruptly with respect to the shareholders’ interest.”
The colossal failures of Drexel Burnham Lambert, Enron, Lehman Brothers, and the Madoff fund, he says, “all stem from agency conflict.” Anticipating and resolving these conflicts improves the efficiency of corporations and capital allocation in the economy.
Expensed payments improving visibility
In their study, Kadlec and his co-authors Roger M. Edelen, of the University of California, Davis, and Richard Evans, of the University of Virginia, investigate the role of disclosure in mutual fund agency conflicts by examining the two different ways that fund managers can pay for operating costs — approaches that differ greatly in transparency — and comparing their effects on return performance.
Mutual funds, Kadlec says, can pay for their operating costs either directly, in a highly visible manner — through itemized expenses that are widely reported via the expense ratio in the fund’s income statement — or indirectly, in a relatively invisible manner — through “soft dollars,” payments that are bundled with the commissions paid to brokers for trade execution. Bundling payments reduces transparency on two fronts: commission payments are not itemized and are “buried in obscure SEC filings.”
Measuring effects of disclosure
Comparing the impact on fund performance of expensed and bundled payments provides direct insight into the role that disclosure plays in mitigating agency costs, Kadlec says.
A key requirement for the study, he notes, is the comparability of goods and services received for expensed versus bundled payments, to ensure that differences in return can be reasonably attributed to transparency. “Fund operating costs can be grouped into three general categories: advisory (fund manager salary, research, data feeds, transaction cost analytics); administrative (shareholder services, legal, accounting, custodial, transfer agent); and distribution (sale of fund shares).
“Advisory and administrative costs are difficult to compare across funds, because the categories are relatively broad; moreover there can be considerable overlap between the two.” Distribution costs, however, “are relatively narrow in scope and governed by statute and are thus uniquely suited to our tests,” he says.
Kadlec and his co-authors obtained expense and brokerage commission data for domestic equity mutual funds in the Morningstar database from January 1996 through June 2009 and from a database of N-SAR filings (semi-annual reports for registered investment companies) with the Securities and Exchange Commission.
“Our evidence indicates that fund return performance is significantly higher when funds use the more visible means of expensing payments to pay their operating cost than less visible commissions bundling,” Kadlec says.
Doing what's best for the fund
Why would a fund manager use commissions bundling if it is less efficient? “A possible answer lies in managers’ incentive to hide fund expenses, such as high fees, that decrease the attractiveness of the fund to investors,” he says. “Our evidence supports this explanation, showing that such obfuscation by fund managers works — soft dollar payments have a less negative impact on investor demand than expensed payments.”
He adds that the study results also suggest that the negative impact of commissions bundling on fund performance extends well beyond the direct cost of higher commission payments. “In particular, we provide evidence that commissions bundling is associated with excessive trading — likely, the acquisition of additional goods and services via commissions.”
The use of brokerage commissions to pay for distribution costs was banned in December 2004, Kadlec notes, but commissions bundling before then may have been a proxy for misuse of investor assets. He cites a 1998 SEC report that found that 35 percent of broker-dealers examined had used bundled commissions to pay for items unrelated to either distribution or research and, thus, not allowed by law — including rent, office furniture, electric bills, personal travel and dining expenses, limousine service, psychology training, and concert tickets. A 2009 study showed that their use by registered investment advisors is a strong predictor of future fraud.
While bundled payment for distribution is now prohibited, “other forms of agency conflict in delegated investment management surely continue to exist,” Kadlec notes. “Our study provides some of the first direct evidence that disclosure is fundamental to addressing those conflicts.”
The study, “Disclosure and Agency Conflict: Evidence from Mutual Fund Commission Bundling,” is published in the Journal of Financial Economics.