Mutual-fund investors are losing hundreds of millions of dollars in annual returns because of a potential conflict of interest in their fund’s management they probably don’t even know about, according to a newly published paper by a University of Iowa researcher.

A study by Ashish Tiwari, an associate professor of finance in the Tippie College of Business, found funds with advisers who engage in cross trading of securities could cost investors as much as 1 percent per year in underperformance.

Cross trading refers to transactions between a fund adviser and other funds managed by the same adviser or transactions between the adviser’s client funds and an affiliated broker. Though legal, advisers and brokerage houses can benefit financially from the transaction, posing serious conflicts of interest.

“Cross trading is legitimate if it’s in the best interest of the investor and follows SEC regulations relating to consent and disclosure,” says Tiwari. “But it could also lead to situations where the advisers violate their fiduciary duty to the client.”

Tiwari says cross trading in some cases can save investors large sums of money by avoiding brokerage or other transaction costs. But conflicts of interest abound. For instance, the fund adviser could favor one of its client funds over another or generate excessive fees through portfolio churning.

Tiwari and his co-author, Lorenzo Casavecchia, of the University of Technology in Sydney, Australia, looked at the performance of 560 actively managed U.S. mutual funds that were linked to 536 investment advisers between 1995 and 2007. Based on information contained in adviser filings with the SEC, they gave each adviser a conflict-of-interest score that reflected the degree to which an adviser was subject to a conflict of interest related to cross trading of securities.

They found a link between increased cross trading-related conflicts of interest and decreased fund performance. Those funds that managed by advisors with cross trading-related conflicts of interest saw their performance dragged down by about 1 percent per year compared to funds managed by advisors with fewer cross trading-related conflicts of interest.

On top of that, the study found the advisers’ affiliated brokerage houses earn significantly higher commissions for executing cross transactions, which was a major reason for the funds' underperformance.

Tiwari points out that with more than $4 trillion invested in actively-managed U.S. stock mutual funds, that amounts to hundreds of millions of investor dollars funneled to advisers and brokerages that investors probably don’t even know they’re losing.

Among the potential factors for a conflict of interest that seemed to most affect a fund’s performance: a larger number of employees on the adviser’s staff who are registered representatives of broker-dealers, a higher value of assets subject to the discretionary trading authority of the adviser, and a larger number of clients managed by the adviser.

Tiwari says the results suggest that the opportunity to generate revenues through affiliated broker-dealer operations provides powerful incentives for advisers to execute cross trades. Tiwari says his research found only that performance is dragged down by potential cross trading–related conflicts, and he found no direct evidence of legal violations.

Tiwari says investors are either unaware of the cross trading–related potential conflicts of interest or don’t care because the amount of money that was invested in potentially conflicted funds was no different than what flowed into other funds.

“Investors chase performance and ignore potential conflicts of interest or other past bad actions by the advisers,” says Tiwari. “If a fund has performed well in the past, people will invest in it, even though it’s been established that performance chasing is a poor investment strategy.”

Tiwari’s paper, “Cross Trading by Investment Advisers: Implications for Mutual Fund Performance,” is published in the current issue of the Journal of Financial Intermediation.