intermediated investment strongmanagementstrong - youchangwu.com.pdf

THE JOURNAL OF FINANCE • VOL. LXVI, NO. 3 • JUNE 2011 Intermediated Investment Management NEAL M. STOUGHTON, YOUCHANG WU, and JOSEF ZECHNER∗ ABSTRACT Intermediaries such as financial advisers serve as an interface between portfolio man- agers and investors. A large fraction of their compensation is often provided through kickbacks from the portfolio manager. We provide an explanation for the widespread use of intermediaries and kickbacks. Depending on the degree of investor sophisti- cation, kickbacks are used either for price discrimination or aggressive marketing. We explore the effects of these arrangements on fund size, flows, performance, and investor welfare. Kickbacks allow higher management fees to be charged, thereby low- ering net returns. Competition among active portfolio managers reduces kickbacks and increases the independence of advisory services. THE MONEY MANAGEMENT INDUSTRY has been recognized as having substan- tial influence on financial markets. The Investment Adviser Association es- timates the total amount of assets managed by investment advisers regis- tered with the U.S. Securities and Exchange Commission (SEC) to be $42.3 trillion at its peak in April 2008.1 An important reason for the enormous size of the money management business is that there are often multiple layers of advisory services between investors and the ultimate portfolio manager. In many cases, investors do not delegate their wealth directly to money man- agers, but rather rely on intermediaries. Examples of such intermediaries include financial advisers who manage separate accounts for their clients, ∗Neal Stoughton is at the School of Banking and Finance at UNSW Sydney. Youchang Wu is at the Wisconsin School of Business at Unive