Brokers vs. Retail Investors: Conflicting Interests and Dominated Products

Mark  Egan

Article | Journal of Finance | June 2019

Brokers vs. Retail Investors: Conflicting Interests and Dominated Products

Abstract

I study how brokers distort household investment decisions. Using a novel convertible bond dataset, I find that consumers often purchase dominated bonds—cheap and expensive versions of otherwise identical bonds coexist in the market. The empirical evidence suggests that broker incentives are responsible for the inferior investments, as brokers earn a 1.12 percentage point higher fee relative to the notional invested for selling the dominated bond on average. I develop and estimate a broker intermediated search model that rationalizes this behavior and quantifies the distortions in these markets. In the model, consumer search is endogenously directed according to the incentives of brokers, and brokers price discriminate based on a consumer's level of sophistication. The model estimates indicate that costly search is a key friction in retail financial markets, but the effects of search costs are compounded when brokers are incentivized to direct the search of consumers towards high fee inferior products.

Keywords: Brokers; Fiduciary Standard; consumer finance; structured products; Household; Investment; Decisions; Motivation and Incentives; Conflict of Interests;

Format: Print

Find at Harvard

Citation:

Egan, Mark. "Brokers vs. Retail Investors: Conflicting Interests and Dominated Products." Journal of Finance 74, no. 3 (June 2019): 1217–1260.

McDonald’s reported its fifth consecutive quarter of declining same-store sales growth in early 2015. Despite McDonald’s recent poor performance, Jonathon S. Jacobson, the founder and Chief Investment Officer of Boston-based Highfields Capital Management, had initiated a large position in McDonald’s stock. Jacobson and his team believed that there was enormous upside in McDonald’s stock if management successfully implemented what they perceived to be straightforward operational and financial changes. McDonald’s needed to return to its core competencies of producing quick and reliable burgers and fries. In addition, they believed that financial restructuring could unlock sizable value for investors. Jacobson and his team debated whether to more forcefully articulate their vision for the company and began drafting a letter to Andrew McKenna, McDonald’s Chairman.

We use a revealed-preference approach to estimate investor expectations of stock market returns. Using data on demand for index funds that follow the S&P 500, we develop and estimate a model of investor choice to flexibly recover the time-varying distribution of expected returns. Our analysis is facilitated by the prevalence of “leveraged” funds that track the same underlying asset: by choosing between higher and lower leverage, investors trade off higher return against less risk. Although generated from a different method (realized choices) and a different population, our quarterly estimates of investor expectations are positively and significantly correlated with the leading surveys used to measure stock market expectations. Our estimates suggest that investor expectations are heterogeneous, extrapolative, and persistent. Following a downturn, investors become more pessimistic on average, but there is also an increase in disagreement among participating investors.

Working Paper | HBS Working Paper Series | 2019

The Value of Intermediation in the Stock Market

Marco Di Maggio, Mark Egan and Francesco Franzoni

Brokers continue to play a critical role in intermediating institutional stock market transactions. More than half of all institutional investor order flow is still executed by high-touch (non-electronic) brokers. Despite the continued importance of brokers, we have limited information on what drives investors' choices among them. We develop and estimate an empirical model of broker choice that allows us to quantitatively examine each investors' responsiveness to execution costs and access to research and order flow information. Studying over 300 million institutional trades, we find that investor demand is relatively inelastic with respect to commissions and that investors are willing to pay a premium for access to top research analysts and order-flow information. There is substantial heterogeneity across investors. Relative to other investors, hedge funds tend to be more price insensitive, place less value on sell-side research, and place more value on order-flow information. Furthermore, using trader-level data, we find that investors are more likely to trade with traders who are located physically closer and are less likely to trade with traders that have misbehaved in the past. Lastly, we use our empirical model to investigate the unbundling of equity research and execution services related to the MiFID II regulations. While under-reporting for the average firm is relatively small (4%), we find that the bundling of execution and research allows some institutional investors to under-report management fees by up to 15%.

Keywords: financial intermediation; Institutional investors; research analysts; Financial Institutions; Investment; Financial Services Industry;

Citation:

Di Maggio, Marco, Mark Egan, and Francesco Franzoni. "The Value of Intermediation in the Stock Market." Harvard Business School Working Paper, No. 20-016, August 2019. View Details

Cite View Details SSRN Read Now

Faculty & Research

Brokers vs. Retail Investors: Conflicting Interests and Dominated Products

Abstract

Citation:

About the Author

More from the Author