The Markets October 26, 2015

Portfolio Concentration Better than Diversification?

University researchers found institutional investors using concentrated investment strategies fared better than more diversified investors.
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Traditional asset pricing theory implies that diversified portfolios are optimal and suggest investors do not take advantage of international diversification opportunities, but more recent studies argue that portfolios can be under-diversified but optimal if they are formed on information advantage, say researchers from the University of Wyoming, the University of Wisconsin-Madison and Brock University.

The researchers’ own study shows that concentrated investment strategies in international markets can be optimal. Their results suggest that investors rationally choose to overweight certain markets and industries because of information advantage from specialization and economies of scale.

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Using data about security holdings of 10,771 institutional investors from 72 different countries, the researchers tested whether concentrated investment strategies resulted in superior abnormal returns. They measured three measures of portfolio concentration: home bias, foreign country concentration and industry concentration, and they used two measures of performance: overall portfolio performance and performance of the part of the portfolio invested in a target country.

Overall, the results indicate that portfolios more concentrated in a few countries and industries perform better than portfolios more diversified across countries and industries. The researchers say the result is particularly strong for portfolio concentration in foreign markets and industries. “These findings suggest that investors have some information advantage when forming concentrated portfolios, which results in better portfolio performance and risk-adjusted basis,” the researchers wrote in their paper.

While the sample in the study consisted of different types of institutional investors, mutual funds dominated the sample, so the researchers did their analysis separately for mutual funds. Results were the same, showing that portfolio concentration in country and industry is beneficial for the performance of mutual funds as well as other types of institutional investors.

The research report is here.

Compliance October 26, 2015

Fidelity Accused of Adviser Registration Issues

A complaint filed by state securities regulators in Massachusetts accuses Fidelity of allowing unregistered individuals to utilize its platforms and perform inappropriate functions.
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Massachusetts Secretary of the Commonwealth Matthew Francis Galvin says his office is commencing an adjudicatory proceeding against Fidelity Brokerage Services LLC, under the authority of the Registration, Inspections, Compliance and Examinations (RICE) Section of the Massachusetts Securities Division of the Office of the Secretary of the Commonwealth.

According to a complaint filed by Secretary Galvin, Fidelity is accused of acting in “a dishonest and unethical manner” in breaching its “obligation to observe high standards of commercial honor and just and equitable principles of trade in the conduct of its business.” Specifically, Fidelity is accused of “knowingly allowing unregistered investment advisers to utilize Fidelity’s trading platform to conduct unregistered activity in Fidelity customer accounts, including the accounts of Massachusetts residents, and facilitating the transfer of funds from Fidelity customer accounts to compensate unregistered investment advisers for providing investment advisory services.”

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Fidelity is thus accused of violating parts of Chapter 11 of the Massachusetts Uniform Securities Act, Galvin notes.

The RICE Section seeks an order “finding as fact” the allegations it sets out, censuring Fidelity and requiring the firm “to permanently cease and desist from further dishonest and unethical conduct that allowed unregistered investment advisers to utilize the Fidelity trading platform to conduct unregistered investment advisory activity in the Commonwealth and to be compensated from Fidelity customer accounts for providing unregistered investment advisory services.”

The state regulator is also seeking to levy fines against Fidelity for specific breaches, and for Fidelity to be required “to engage an independent compliance consultant to review written policies and procedures regarding trading authorizations and ensuring that such policies include methods for enforcement and compliance oversight.”

According to the Massachusetts Secretary, “for at least 10 years, Fidelity Brokerage Services LLC, as registered broker/dealer, has knowingly allowed its retail customers to be advised by least 13 unregistered Massachusetts investment advisers, serving as a haven from regulatory oversight by ignoring blatant unregistered investment advisory activity.”

NEXT: Potentially problematic practices 

As such, the regulator accuses Fidelity of breaching its duty to act honestly and ethically and breaching its obligations “to observe high standards of commercial honor and just and equitable principles of trade in the conduct of its business … But for Fidelity allowing their trading platform to be utilized, the unregistered investment advisers would have had no business. By allowing unregistered advisory activity, Fidelity put its own retail customers at risk and undeniably weakened the protections afforded to those retail customers through the Division's oversight of investment advisers who register with the Commonwealth.”

A play-by-play of the allegations is available in the text of the complaint, but at a high level Fidelity is accused of allowing unregistered individuals to use the Fidelity brokerage system to operate trading and advisory businesses that were not properly licensed or adhering to required registration practices.

For example, one individual, referred to as “Unregistered IA 1,” apparently commenced advisory activity “around January 2005, when two individuals submitted trading authorization forms to Fidelity allowing Unregistered IA 1 unlimited trading ability on their Fidelity customer accounts. Over approximately the next 10 years, the trading authorizations submitted by 20 additional Fidelity customers repeatedly indicated Unregistered IA 1's relationship to the Fidelity customer as the customer's ‘financial adviser,’ listing Unregistered IA 1's employment as ‘self-employed’ and his occupation as ‘financial adviser.’ Those forms, which were unambiguous and also permitted Fidelity to conduct background checks on Unregistered IA 1, were ignored by Fidelity as Unregistered IA 1 conducted his openly unregistered advisory activity.”

The state regulator says Unregistered IA 1's unregistered activity “was so blatant that on three separate occasions, twice in 2006 and once in 2014, Fidelity instructed him to register.”

“Despite its demonstrated knowledge of unregistered activity, Fidelity continued to allow Unregistered IA 1 to advise Fidelity customer accounts,” the complaint says. “Over the approximate 10-year timeframe, seven Fidelity customers serviced by Unregistered IA 1 paid Unregistered IA 1 a total of $732,271.83 in advisory fees from their Fidelity customer accounts. The majority of these disbursements noted that the payment to Unregistered IA 1 was for advisory fees.”

Fidelity shared the following comment with PLANADVISER: "We can assure you that we take very seriously the trust investors place with us and out obligation to manage our business in accordance with all relevant laws and financial industry regulation. We do not believe that Fidelity has violated any laws or regulations in connection with this matter. We look forward to reviewing the details of this matter and addressing them appropriately."

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