Conflicts and Capital Allocation

In the aggregate, retail investors allocate tremendous amounts of capital and often turn to financial advisers to help them pick the best investment opportunities. In a recently published article, I describe how financial adviser conflicts of interest now distort overall capital allocation by driving capital to investment opportunities that reward financial advisers—altering the flow of capital.

Our capital markets work best when they efficiently move capital from savers to opportunities in need of capital. Financial intermediaries make our capital markets work by connecting savers to these opportunities. Of course, these intermediaries do not work for free. Stockbrokers receive commissions when their clients invest in particular offerings. Notably, issuers decide how much of a securities offering to allocate to intermediaries. In some instances, the intermediaries may receive a 2 to 3 percent commission if a client invests in a particular offering. In other instances, the stockbroker may collect a 6 to 7 percent commission. This difference in commissions creates a conflict of interest that can cause stockbrokers to advise suggestible retail investors to invest in offerings that pay the stockbrokers more instead of the possible investments that offer the best returns relative to their risk level.

There are good reasons to care about conflicts of interest in investment advice. On the investor protection front, one study from the White House Council of Economic Advisers conservatively estimates that Americans paid about $17 billion a year in excess fees because of conflicts. Such lost savings may cause many individual investors to run out of retirement funds sooner than they would have if they had received better advice.

The focus on individual investor harm misses a potentially larger problem: Conflicted investment advice skews capital allocation and undercuts capital formation. Consider the problem from a different angle. An efficient capital market should reward issuers with capital when they present promising investment opportunities. Differential commissions introduce a new dynamic. Instead of competing exclusively on the merits and the risks of their offerings, issuers must also compete along a different axis—how much capital they will share with financial intermediaries. Because financial advisers control the flow of capital, some issuers with less promising offerings may attract capital by kicking more funds back to financial advisers.

Consider the issues associated with non-traded real estate investment trusts (REITs). Many non-traded REITs appear deliberately designed to enable financial advisers to fleece their clients. The illiquid offerings are registered with the SEC and sold to retail investors even though their shares are not listed on an exchange. The initial offering fees and expenses average about 13 percent of the offering, a figure that includes 7 percent going to the financial adviser alone. This means that for each $100,000 invested in a non-traded REIT, about $13,000 will go to expenses and various intermediaries. The financial adviser will book about $7,000 in commission revenue as his or her share for selling the client a non-traded REIT.

Research reveals that these non-traded REITs significantly underperform more liquid alternatives. One study found that non-traded REITs provided 4 percent annual returns in contrast to publicly traded REITs, which returned about 11.3 percent over the same period. These lackluster returns appear particularly puzzling, because theory predicts an illiquidity premium—illiquid assets should offer investors higher returns in exchange for accepting illiquidity.

The differential commissions paid to financial advisers best explain retail investor decisions to allocate capital toward these products. At the least, the decision to invest in these offerings seems inconsistent with wealth maximization motives.

Putting investor underperformance to the side, this inefficiency affects the real economy. When these products attract capital because of conflicted investment advice structures, the result may be less efficient capital flows and inflated prices for real estate assets. These offerings may also increase the cost of capital for other issuers by forcing them to compete and increase the compensation they offer financial advisers in order to raise capital on even footing.

In theory, the solution to bad financial advice would be good financial advice. Ordinary market forces should drive financial advisers that exploit their clients out of business. But the market for financial advice does not operate efficiently. Americans generally lack basic financial literacy and rarely recognize when a financial adviser has acted against their interests. This inefficiency means that bad financial advisers may continue to misallocate client capital, creating inefficiency and harming the real economy.

Given the problems caused by differential commissions, I argue that a different compensation structure for financial advisers would likely improve capital allocation. The United States could follow the precedent set by Australia and the United Kingdom and ban differential commissions for financial advisers serving the retail market. This would remove the incentive to skew advice to favor one product over another. Of course, this does not mean that a financial adviser should not be able to receive transactional compensation. The compensation should be for the advice—not a kickback built into the product offering.

This post comes to us from Professor Benjamin Edwards at the University of Nevada’s William S. Boyd School of Law. It is based on his recent article, “Conflicts & Capital Allocation,” available here.