Mutual funds and brokerage firms exchange favors to ensure their success — a tight business relationship that emerges in times of trouble, according to research from the University of Notre Dame and Portugal’s Nova School of Business and Economics.
“Funds act as buyers of last resort for their brokers’ parent companies,” Notre Dame finance professors Benjamin Golez and Rafael Zambrana and Nova School’s Antonino Emanuele Rizzo said in a recent paper. “In return, brokers provide funds with investment information.”
This “quid pro quo” relationship is widespread and has “real consequences for both fund performance and financial stability of financial conglomerates,” the researchers found. Most brokers are owned by publicly-traded financial companies, with as much as 5 percent of their stock held by mutual fund clients of their brokerage businesses, according to the paper.
“In times of distress when investors tend to decrease exposure to financial companies, client funds increase ownership in their brokers’ parent companies,” the professors said. “They contribute to the financial stability of brokers’ parent companies.”
Brokers are vital to institutional investors, who rely on them for daily trade executions and retail distribution support, according to the professors. It’s within such “repeated interactions” that part of the quid-pro-quo relationship unfolds.
Brokers provide prime services and “leak information” to their most valuable asset management clients, according to the paper. The shared information might stem from the lending unit of the brokerage firm’s parent company, they suggested, or brokers might share expected stock price movements based on their observation of a “large part of smart money stock order flow.”
This competitive edge gives fund managers “strong incentive to curry favors with their brokers,” according to the paper. “In order to win over their brokers and preserve long-lasting relations, asset managers may step in and invest part of their portfolio in a way that benefits their brokers.”
Asset managers invest in brokers’ parent companies in times of distress to preserve their business ties with their brokers, the authors suggested. Distressed financial firms may wind up allocating fewer resources to their brokerage units, selling them, or losing employees from the unit — and that could jeopardize the success of fund managers, according to the paper.
Asset managers tend to be “buyers of last resort” in cases where brokers provide more valuable investment services, with the paper drawing a positive link between their performance and purchases of their brokers’ stock.
“While funds appear to lose money trading brokers’ parent stocks, they create alpha on non-connected stocks,” the researchers said. “The documented effects are strongest for funds that have long-lasting business ties with their broker.”