Fund Middlemen Need to Shape Up

We’re glad to see the SEC is moving to reform fund sales practices. Inappropriate sales practices have cost investors far more than market-timing. A few common practices that need to change harm investors by driving up costs and biasing recommendations given by advisors. Add up all the fees and biased advice and it becomes clear why so many funds post subpar results.

Regulators and brokers have long played cat and mouse games over systems that reward brokers for favoring in-house funds and those from a select group of fund companies. Originally, investors just paid higher commissions on in-house funds straight to the brokers, but the NASD put a stop to that. In response, the brokerage industry switched to sales contests and other practices that more or less did the same thing. After they got busted for that, the industry switched to preferred lists, which paid branch chiefs and brokers more for selling selected funds.

These practices are bad news for a couple reasons. First, they raise costs because fund companies have to pay to get in. For the most part, these costs are supposed to be borne by the fund companies, not investors. But you can bet it gets priced into the cost of the funds in one way or another.

For proof, witness the funds that are available in load and no-load format from the same firm. Invariably the load version has a higher expense ratio in addition to a commission, which is supposed to be the way the broker gets paid.  Mutual Beacon (BEGRX) charges just 0.80% for its older, no-load Z share class, but the expense ratio on the A shares of the same fund is 1.15%. The gap is even more stark between  Columbia Acorn (ACRNX), which charges 0.82% for its no-load Z shares and 1.42% for its A shares. Thus, it’s now possible for a fund to be cheap and overpriced at the same time.

Perhaps more troubling than the impact on costs is the fact that these practices lead brokers to choose funds for their clients based on which firms are paying the broker or the brokerage more, rather than what’s best for the client. This is a practice that has cost investors billions.

Consider, for instance, what happened when brokerage firms sold the heck out of in-house funds Morgan Stanley Dean Witter Competitive Edge Best Ideas and PaineWebber Strategy, two overhyped funds that were designed to capitalize on the firms’ brilliant sell-side recommendations. I made a joke about it at the time, but the real joke was on the investors who got talked into pouring billions into the funds before they were launched.

In November, the SEC took steps toward reforming these practices in a settlement with Morgan Stanley. The agreement requires that brokers and their managers earn the same commission regardless of whether the fund they place their client in pays for prime shelf space. It also requires disclosure of revenue-sharing arrangements, though a better idea might be banning them outright.

In our view, an advisor should always recommend what’s best for the client. If a firm creates a preferred list, it should be based entirely on the fund companies’ merits--not on how much they pay to get listed.

Directed Brokerage Fees
Regulators are also starting to focus on the practice of directed brokerage commissions. The way these "soft-dollar" arrangements work is that fund companies reward brokerages for selling their funds by sending some of their mutual fund trades to the broker. The NASD has said that’s OK as long as the fund company believes it is getting good execution. However, that’s a vague standard and it’s not clear whether fund companies really are getting the best execution possible.

The Morgan Stanley settlement shows just what a bad deal that can be in reality. According to the complaint, fund companies paying in soft dollars had to pay a multiple above the fee in hard dollars. In other words, a premium was baked into the price so that they were in effect agreeing not to get the best execution available. 

This practice should be outlawed completely so that fundholders know they are always getting the best execution. Putnam’s board recently ordered Putnam to end the practice, and we’d like to see more follow suit.

B-Share Blues
Another facet of the Morgan Stanley settlement was reform of the firm’s sale of B shares. Ever since B shares were created, some brokers have exploited the fact that they can appear to be no-load funds since the commission is embedded in expenses rather than being assessed up front. In addition, there have been a rash of cases at brokerage firms where brokers put clients in B shares rather than A shares even though they were eligible for reduced commissions in A shares that are available to investors who meet certain asset-level thresholds. The reason is that sometimes brokers earn more from the sale of B shares.

The SEC is rightly requiring greater disclosure of commissions on fund sales and tighter monitoring of sales to ensure investors are in the right share class. Once again, this reflects a conflict where brokers incentives are not aligned with their clients. Both the brokerage industry and the fund industry need to do a much better job on this front. The long history of B-share abuses shows the limits of disclosure. Fees are clearly disclosed in prospectuses, yet investors don’t read them and too many brokers have been following the letter of the law while ignoring the spirit.

The Problem with Supermarket Fees
There are problems with the way no-load funds are sold, too. Supermarkets like Schwab’s and Fidelity’s have thousands of funds, and the investors make the call, so bias isn’t really a problem. However, costs are.

Schwab charges fund companies 40 basis points to participate in its no-transaction-fee program, and Fidelity charges about 35 basis points. The problem is that it only costs those firms about 10 to 15 basis points for them to service the accounts, and the remainder amounts to a direct transfer from fund investors to the supermarkets.

In raising its fee to 40 basis points, Schwab cited new added advice services available to investors as part of Schwab’s effort to find a middle ground between full-service and discount. Unfortunately, even the Schwab customers who don’t use those services have to pay.

Now here’s the part that would even make those service-bundlers in Redmond blush: You’re paying for those services even if you don’t buy your fund through Schwab or Fidelity. Schwab and Fidelity prohibit funds in their no-transaction-fee lineups from offering a lower-cost share class to investors who purchase the fund directly from the fund company.

Schwab has often argued that its program actually lowers fund expenses by bringing in more assets and because they charge less than many participants would have to pay to service the accounts themselves. If that’s true, though, there would be no problem with allowing fund companies to offer differently priced shares directly. Likewise, it’s difficult to explain the lack of cheap bond funds other than those from Schwab and Fidelity that are available in their own supermarkets.

Defenders of fund costs often argue that the marketplace should decide. If fund investors feel expenses are too high, they say, those investors should actively seek out lower-cost funds. While this idea has some validity, the supermarket rule against offering cheaper fees is meant to prevent competition on fees. In order to level the playing field, Schwab and Fidelity should either lower their fees to a modest premium above costs or they ought to allow fund companies to offer cheaper share classes for direct investments.

In sum, most of the middlemen are forcing higher costs on investors while stifling competition. Fund boards should look closely at whether these arrangements are in fundholders’ best interests and pull out if they decide that fundholders would be better off without them.