Trust and delegation: A case to consider on broker rebates and investor sophistication

Following a notice of the Israeli Securities Authority, portfolio managers had to obtain their clients’ proper and legal approval, in writing, so that they can receive a fraction of the transaction costs, their clients pay the broker executing the trades. One would expect an overwhelming opposition to the kickback as consenting investors are exposed to avoidable losses due to (moral hazard) excessive trading. Yet about 89% of the investors in our sample allowed their manager to receive a kickback. This is quite remarkable considering that not responding implies a prohibition. Indeed, the more sophisticated investors tend to disagree. We find that portfolios of consenting investors underperform in the year following their decision. In addition, the empirical evidence indicates that consenting is not a reward on past success.