Felix TV: Action bias

By Felix Salmon
July 20, 2011
post on financial advisors last week, Josh Brown, a/k/a the Reformed Broker, got in touch saying that at some point he and I should discuss action bias -- the way in which advisors feel the need to do something just to make their clients think they're earning their keep.

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After my post on financial advisors last week, Josh Brown, a/k/a the Reformed Broker, got in touch saying that at some point he and I should discuss action bias — the way in which advisors feel the need to do something just to make their clients think they’re earning their keep. I was happy to oblige.

Josh is convinced that the new Pimco Total Return ETF is going to be the big game changer in the battle between mutual funds and ETFs: I think he’s right about that, since there’s no conceivable reason why you’d want to pay a 1% fee on a Total Return mutual fund when you can pay 0.55% on a Total Return ETF instead.

In the short term, this means a loss of income for Pimco, as investors rotate out of their mutual funds and into cheaper ETF flavors of substantially the same investment pool. But as Ari Weinberg will tell you, the main job for Pimco is to gather up as many assets under management as it can; the income flows from there. And the ETFs mean many fewer headaches for Pimco, too:

Mutual funds no longer have to divide the rents from buying/selling mutual fund shares on their behalf. In fact, with in-kind creation, they don’t even have to pay commissions internally to collect assets. Assets just walk in the door through creation.

Funds operating this way can now keep even more of the expense ratio and, theoretically, spend more of it on doing what they are supposed to be doing: providing returns for investors.

One of the ugliest parts of the mutual-fund world is the way in which many fund managers essentially bribe brokers to push their funds by loading them up with enormous fees and then kicking back commissions to the broker in question. ETFs don’t have that problem. But they do pose another risk: they’re so easy to buy and sell that many brokers and advisors are tempted to trade in and out of them far too much. That’s the action bias.

Frankly, you don’t want a broker or advisor keeping an eye on a fluctuating market and actively investing on your behalf. You want someone who will tell you that you’re overreacting, and that the best thing to do is nothing. That’s a truly valuable service.

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