Destabilizing Financial Advice: Evidence from Pension Fund Reallocations
Research Retrieved: June 2018
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Institutional equity ownership has grown sizably in the last decades. Often, individual investors consult financial advisers’ recommendations. When one financial advisory firm reaches many investors, this can lead to coordinated fund flows, price pressure and heightened volatility. This paper investigates the situation of the Chilean Defined Contribution system. Once one participates in a fund by a pension provider, individuals can switch between five fund types. These fund types vary in riskiness. Specifically, the paper analyses the results of recommendations by Felices y Forradoes (FyF), a financial advisory firm especially active on social media.
Following recommendations by FyF, participants trade 20% of the fund’s assets worth US$4 billion. This trading activity leads to a statistically significant price pressure of 1% in the first three days after the recommendation. After five days, prices reverted. Given this price reversal as well as analyses controlling for market factors and stock fundamentals, the authors conclude that FyF recommendations are not very informative for investors. The latter also do not gain financially from following the recommendations, when compared to buy-and-hold or contrarian strategies.
Most of the trading occurs between retail investors. It might then be that individual investors trade earlier on FyF recommendations, as pension funds are bound by law to exert the trades a few days later. As a result, retail investors try to front-run the pension plan participants, leading to higher trading volumes as well.
Last but not least, pension funds have also changed their asset allocation. As funds need to be liquid due to the frequent switches from one fund to the other, they increase cash and other liquid assets (such as ETFs) and decrease illiquid assets. This asset allocation is likely to result in adverse effects to the interests of long-term pension fund investors.
The paper shows that financial advisers can have a significant impact on returns, turnover, and volatility of financial markets if the (pension) system allows it. In the Chilean case, investors harm themselves and other market participants by following FyF’s recommendations en masse. The authors suggest introducing a fee for switching between funds to price the negative externalities of excessive trading and to deter investors from trading excessively. This fee can be rebated to the participants who stay in the fund. Together with delayed pricing of fund flows, it is less likely that coordinated fund flows destabilize the financial markets.