Broker Incentives and Mutual Fund Market Segmentation

Mutual fund families that sell via the direct channel ... outperform comparable funds sold through other distribution channels by 1 percent per year.

Some mutual fund investors seek to optimize their investment returns by taking a do-it-yourself approach: they choose to invest in low-cost fund families with the best-performing funds. Others prefer a fund family that provides personalized service through a broker. Because brokers have no financial incentive to recommend mutual funds that investors can purchase at low cost online, or through another broker, it is difficult for mutual fund families to simultaneously serve both investor types. As a result, only 3.3 percent of all fund families serve both groups.

In Broker Incentives and Mutual Fund Market Segmentation (NBER Working Paper No. 16312), co-authors Diane Del Guercio, Jonathan Reuter, and Paula Tkac find that fund families internalize the preferences of their target investors when setting fees and fund management strategies. Investors in the direct channel are more sensitive to performance -- they are more likely to buy when historical returns are high and to sell when returns are low. As a result, mutual fund families that sell via the direct channel invest more in portfolio management. For example, these funds are more likely to employ mutual fund managers who attended the 25 most selective U.S. colleges and universities, and more willing to pay for higher quality managers when outsourcing portfolio management to outside firms. Perhaps because of these differences, funds sold through the direct channel outperform comparable funds sold through other distribution channels by 1 percent per year, the authors find.

Investors who value personalized financial advice tend to invest in mutual funds through a broker. For example, some investors may value outsourcing their decisions about asset allocation or rebalancing their portfolio. The mutual funds that are sold through this channel need to charge higher fees to compensate brokers for providing that service. These funds also invest less in portfolio management and the funds earn lower before-fee returns.

The researchers analyze data from Financial Research Corporation covering the period 1996 to 2002. They study 524 of the 547 mutual fund families operating in 2002, and 452 of the 473 fund families that offered at least one actively managed domestic equity fund during this time period.

-- Frank Byrt