Attracting Flows by Attracting Big Clients: Conflicts of Interest and Mutual Fund Portfolio Choice

by Lauren H. Cohen & Breno Schmidt

Overview — Retirement assets make up a large and growing percentage of the mutual fund universe. In 2004, nearly 40 percent of all mutual fund assets were held by defined contribution plans and individual retirement accounts. This percentage is steadily increasing largely because these retirement accounts represent the majority of new flows into non-money market mutual funds. With such a large and growing percentage of their assets coming from retirement accounts, mutual funds are likely to be interested in securing these big clients. This paper examines a new channel through which mutual fund families can attract assets: by becoming a 401(k) plan's trustee. HBS professor Lauren Cohen and colleague Breno Schmidt provide evidence consistent with the trustee relationship affecting families' portfolio choice decisions. These portfolio decisions, however, have the potential to be in conflict with the fiduciary responsibility mutual funds have for their investors, and can impose potentially large costs. Key concepts include:

Mutual fund families systematically distort their portfolios to attract 401(k) clients, presenting a conflict of interest.
Mutual fund families that become trustees significantly overweight 401(k) sponsor firms' stock in their fund families.
The trustee family performs a valuable service to the sponsor company by buying or holding its stocks around times of substantial selling of the sponsor firm by all other funds.
Increased buying of sponsor firm shares by its trustee can have substantial price impact by propping up the sponsor firm's price.
The overweighting can in some cases result in a large cost to the mutual fund investors.
One possible remedy is to require the trustee to be independent of the mutual fund providers in the plan. This could greatly reduce the overweighting behavior currently seen by ostensibly ridding the relationship of its embedded, and unneeded, conflict of interest.

Author Abstract

We explore a new channel for attracting inflows using a unique dataset of corporate 401(k) retirement plans and their mutual fund family trustees. Families secure substantial inflows by being named trustee of a 401(k) plan. This affords the plan sponsor potential influence on the family's portfolio decisions. Consistent with this, we find that family trustees significantly overweight their 401(k) client firm's stock. Trustee overweighting is more pronounced when the conflict of interest of the trustee family is more severe and when other mutual funds are selling the client firm's stock. This overweighting is not explained by superior information. We quantify a potentially large benefit to the 401(k) sponsor firm of having its price propped up by its trustee fund's more severe overweighting. We also estimate the resulting loss to mutual fund investors, which can be large in some cases.