Directed Brokerage no More: The Effects of New Regulation in the Mutual Fund Industry

Abstract

There is an extensive literature documenting a mutual fund performance deficit, whereby a large number of mutual funds underperform the market index. One possible cause is conflicts of interest between mutual funds and investors. I explore the consequences of a new regulation prohibiting funds from rewarding brokers' promotion efforts via trade execution. While this new rule targeted the elimination of excessive trading commissions, I document that it indirectly affected portfolio management style, fees, performance, and the competitive dynamics of the industry. The new rule led to a decrease in portfolio turnover and an increase in returns for affected funds. However, evidence also indicates that brokers have begun compensating for lost revenues from directed brokerage commissions by implementing revenue sharing agreements. Although affected funds have lower inflows after the regulation, suggesting that brokers' bias is partly eliminated, revenue sharing agreements appear to be the new means of increasing fund inflows.

Keywords: Mutual funds, Regulation, Conflicts of interest, Brokerage, Bias

JEL Classification: G23, G24, G28, M41