Financial Advisors and Multiple Share Class Mutual Funds

Abstract The development of multiple share class mutual funds has complicated the investment decision for individual investors such that the advice of financial advisors is heavily relied upon to make the best choice. However, there have been accusations that advisors are influenced by factors other than the client's best interests. This study surveys financial advisors as to their compensation and recommendations with respect to multiple share class funds. Our results suggest that advisors may not be sufficiently informed regarding the relationship between share classes, investment size, and investment horizon. We also find that advisor compensation appears to influence the frequency of sales of various share classes. © 2005 Academy of Financial Services. All rights reserved. Jel classification: D14; G24; M31 Keywords: Multiple share class mutual funds; Financial advisors 1. Introduction As investors direct money into mutual funds instead of individual stocks and bonds, they are doing so primarily with the help of financial advisors. The Investment Company Institute (ICI) finds that 72% of fund purchases outside of retirement plans involve a financial advisor.1 The advisor's role has also become increasingly important with the advent of multiple share class (MS) mutual funds. The MS structure provides investors with choices regarding the payment of commissions. However, this payment choice directly impacts the returns investors receive in such a way that even the National Association of Securities Dealers (NASD) admits the complexity inherent in the choice (see NASD Notices to Members 95-80). Thus, it is incumbent upon financial advisors to understand the financial impact of different share classes when assisting investors. This study surveys financial advisors regarding their selling of and compensation from MS mutual funds. While previous studies examine mutual funds along varying dimensions [e.g., performance (Carhart, 1997), costs (Dellva & Olson, 1998), tournaments (Chevalier & Ellison, 1997), and flows (Jain & Wu, 2000)], little research exists examining the practices of financial advisors. Bigel (1998) measures the ethical development of financial advisors in general, but does not specifically address the selling practices of advisors. Additionally, Benson, Rystrom, and Smersh (1995) investigate brokers at one brokerage firm to test the effects of compensation on sales volume. The issue of advisors and MS funds is particularly timely. As of this writing, Morgan Stanley has been charged by regulators for reportedly using inappropriate commission structures (i.e., share classes) to make sales of in-house mutual funds-essentially placing investors in the wrong classes of MS funds (Lauricella, 2003). The information we hope to discover should be valuable to investors, regulators, and financial service firms. For investors, the results should provide an indication of advisors' selling tendencies relating to MS funds. The results could also be beneficial to regulators who must determine if advisors are meeting the fiduciary responsibilities expected with regard to MS funds. Financial services firms could also use the study's results to better assess current advisor practices relating to MS funds, which could then be used to improve employee training. Our findings indicate that the compensation structure the financial advisor receives is related to their recommendation among different fund classes. Specifically, higher commissions are positively related to the frequency of a particular class being sold. Additionally, an advisor working for a firm offering proprietary funds tends to recommend the class that is most profitable for the firm. Finally, we show some confusion exists among advisors regarding the optimal fund class over various holding periods-especially intermediate periods. The next section of this paper provides background on MS funds and motivation for the study. …