The Cyclicality of Investment Advisor Misconduct

Abstract

Stock market cycles affect an investment advisor's income, as a significant portion of their compensation is fees from AUM. However, the effect of the market-induced variation in income on the advisor's propensity to commit misconduct is unclear. Given no change in expected lifetime income, it is not apparent that temporary deviations in income would affect advisors. Assuming the effect holds, the benefits from misconduct during a market bust are expected to be higher than in boom times as avoiding loss generates higher utility than income gains. Yet, the potentially higher absolute value that can be gained from misconduct due to weaker due diligence may lead to further misconduct in a booming market. To resolve this tension, we empirically show that misconduct occurrences increase with declines in the stock market and validate the results across various endogeneity tests. Disentangling the influencing factors on the advisor's decision to commit misconduct, we show that the change in income is the main driver for the counter-cyclical effect of the stock market on advisor misconduct.

Keywords: Stock Market Cycle, Financial Misconduct, Investment advisor, Income

JEL Classification: D14, D18, G20, G24, G38, J44, K42, L22, M53