Overview:
Tiwari and colleagues reviewed “cross-trading” by fund advisers in which transactions were made among funds with the same management. They reviewed 1,636 actively managed U.S. mutual funds, linked to 560 investment advisers, between 1995 and 2011. They analyzed responses to questions posed by the U.S. Securities and Exchange Commission. “We construct an index on the degree to which the conflicts exist,” Tiwari said. 

Cross-trading refers to transactions between a fund adviser and other funds managed by the same adviser, or between an adviser’s client funds and an affiliated broker, the University of Iowa noted in a news release.

Results: 
The researchers found that mutual fund investors in the United States lost hundreds of millions of dollars a year as a result of their financial advisers’ cross-trading. The losses were as much as 1 percent per year. 

Conclusion: 
Tiwari and a colleague from the University of Technology in Sydney, Australia, found that with more than $4 trillion invested in actively managed U.S. stock mutual funds, the issue is significant. Not only did the cross-trading among managers’ various funds raise a flag, but the study found the managers paid themselves higher commissions for working on the transactions among affiliated brokerage houses.

“The main takeaway for the average investor is to focus on low-cost, broadly diversified, passively managed investments,” Tiwari said. That will help sidestep the problems with cross-trading. 

Among the other lessons from Tiwari:

• The conflicts had the worst effect when there was a larger number of employees on an adviser’s staff who were registered representatives of the broker-dealers; when there was a higher value of assets subject to the advisers’ trading authority; and in cases where there were a large number of clients. 
• The incentives for the cross-trades are strong. 
• The practices appeared to be legal. “They are legal as long as there is proper disclosure and consent,” Tiwari said. 

Research needs: 
“There is a need to gain a better understanding of both the incentives that exist for investment advisers and the effect on investors,” Tiwari said. “Investors tend to chase recent performance. 

“Some swing for the fences. They make a huge bet. We call this the tournament effect. This might not be in the best interests of investors.”

To learn more:
Read a news release: http://bit.ly/1UnR0xM
Read the report: http://bit.ly/1UcZFab
Contact the author: ashish-tiwari@uiowa.edu