- Gennaioli, Shleifer, and Vishny (2015)
- A version of the paper can be found here.
- Want a summary of academic papers with alpha? Check out our Academic Research Recap Category.
We present a new model of investors delegating portfolio management to professionals based on trust. Trust in the manager reduces an investor’s perception of the riskiness of a given investment, and allows managers to charge fees. Money managers compete for investor funds by setting fees, but because of trust, fees do not fall to costs. In equilibrium, fees are higher for assets with higher expected return, managers on average underperform the market net of fees, but investors nevertheless prefer to hire managers to investing on their own. When investors hold biased expectations, trust causes managers to pander to investor beliefs.
This paper gives an alternative take on the money management industry. The authors view of money managers is that these agents work as "money doctors."
Here is their description of the service provided:
In our view, financial advice is a service, similar to medicine. We believe, contrary to what is presumed in the standard finance model, that many investors have very little idea of how to invest, just as patients have a very limited idea of how to be treated. And just as doctors guide patients toward treatment, and are trusted by patients even when providing routine advice identical to that of other doctors, in our model money doctors help investors make risky investments and are trusted to do so even when their advice is costly, generic, and occasionally self-serving. And just as many patients trust their doctor, and do not want to go to a random doctor even if equally qualified, investors trust their financial advisors and managers.
The paper (and their model) claims that trust mediates the relationship, and lowers the utility cost to the investor for taking on risk. So in the end, investors are more willing to invest with the advisor they trust the most, and this allows the advisor to charge higher fees. However, this is sub-optimal!
Net of fees, investors consistently underperform the market, but experience less anxiety and earn higher expected returns than they would by investing on their own.
This is a theory paper, so here is my description of the theory at a high level (if you want the full details, check out the paper).
An investor must choose at time 0 how much of their wealth to allocate to risky investments, and can choose a financial advisor at this time. The advisors compete on fees, and eventually the client chooses one advisor. In the utility function, the advisor reduces the anxiety of the investor (the investor is assumed to be infinitely anxious of investing by him/herself -- very true for many investors). In the model, trust in the managers "tightens the return distribution of returns perceived by the investor, making it less costly for him to take risk." So in the model, anxiety reduction is good, as it allows the investor to take on more risk.
The paper walks through the model, and finds that investors allocate to the money doctor they trust the most. However, there are some results of allocating based on trust:
- Fees are higher in the "hot" asset class, and investors place too much wealth in these "hot" asset classes. The model finds that money doctors maximize profits by either encouraging, or not discouraging, investors to take risks in the "hot" asset classes (which tend to have higher fees). So it is sub-optimal for a money manager to correct misconceptions (chasing the "hot" asset class).
- Trust encourages pandering. Conventional wisdom is that value investing is good in the long-term, as this would allow the advisor to earn superior returns. If there is no manger-specific trust, it is optimal to be contrarian. However, if trust is in the model, pandering to client's wishes may be optimal. In some instances, it is never optimal for the advisor to be contrarian.
In summation, advisors have strong incentives to pander to clients, and the incentive for contrarianism is weaker when trust is involved.
Some implications from this model:
- Money managers can turn into noise traders, as this brings in higher fees from their trusting investors.
- When investors seek a "hot" product, money managers cater to these demands, and can destabilize prices.
Some final conclusions:
We should not forget, however, the central point of trust-mediated money management—that it enables investors to take risks, and earn returns, that they might otherwise not obtain. There are surely significant distortions in portfolio allocation that are inevitable when investors exhibit psychological biases. Despite these distortions, financial advice and money management represent an important service.
This is a well written paper, and makes sense intuitively. For those investors who know little to nothing about investing, trusting an advisor can reduce stress on the investor. While the optimal outcome is that the investor become educated, understand mean-variance portfolios, the fees and transaction costs paid, and tax implications, let's be honest ... for most investors, allowing an advisor to manage your money is a lot easier!
Most people know a family member that knows little about investing and has been working with an advisor for years. While it is easy to criticize the financial advisor for their high fees, without the financial advisor, your family member would most likely just have their money in a savings account. Let's take a hypothetical example from 1980-2014. Imagine the investor has three options:
- Work with an advisor and get charged 2% management fee. All the advisor does is invest in the S&P 500.
- Invest in S&P 500 on their own and pay 0.10% to Vanguard.
- Keep their money in a savings account and earn the Risk-Free rate.
Now, let's assume that option 2 is off the table, as the anxious investor is scared of investing in stocks (this can be scary to many people). So in reality, there are only two options: invest with an advisor (who charges 2%) or sit in a savings account. How would the investor have done from 1/1/1980-12/31/2014
Results are net of (1) 2.00%, (2) 0.10%, (3) 0.00% and (4) 0.00% management fees in columns 1-4 respectively; transaction costs are 0.00%. All returns are total returns and include the reinvestment of distributions (e.g., dividends).
Here are the results:
Now, clearly, investing at Vangaurd (0.10% fee) is optimal. However, even after the outrageous 2.00% management fee for investing in the S&P 500, as long as the advisor kept the investor in the market, the investor is better off compared to simply keeping their money in a savings account!
In conclusion, advisors serve a purpose as trust in them can make investors better off in the long run (not guaranteed however). So while fees in the investment advisory world may be compressing, they will most likely not go to 0%. Even the robo-advisors charge a fee, as people would still prefer to have someone (even a computer) run their money.