Investors in some mutual funds may be seeing a drag on their returns of almost 1 percent a year because of a potential conflict of interest in their fund’s management that they probably don’t even know about, according to 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 that engage in cross trading of securities tend to suffer from poorer performance.

Cross trading refers to transactions between a fund adviser or its affiliated broker, and one or more client funds, or transactions among multiple client funds in which the adviser acts as an intermediary. While legal, it could pose potential 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 fees. But he said the practice presents a potential conflict because 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 985 actively managed U.S. mutual funds that were linked to 536 investment advisers between 1995 and 2007. Based on information contained in the Form ADV 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 that funds managed by advisers with a higher conflict of interest score performed more poorly, with performance dragged down by 0.83 percent a year as measured by the fund’s adjusted return during the study’s 12-year window.

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. He said the study found that the significantly higher trading commissions paid by client funds of advisers with a higher conflict of interest score was a major reason for the funds’ underperformance.

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. However, the SEC has recently filed lawsuits against two investment advisory firms for allegedly defrauding investors using illegal cross-trading schemes. In one case, the adviser is alleged to have repeatedly exchanged securities from one client account to another in order to artificially drive up the price of the securities.

In the second case, an investment advisory firm is alleged to have falsely represented to its clients that it was buying and selling securities on the open market, thus giving the impression that the securities were liquid when in fact they simply exchanged the securities between client accounts.

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.”

The study was presented at the Fifth Conference on Professional Asset Management at the Rotterdam School of Management in Rotterdam.