Over the years, two questions concerning broker distribution of mutual funds have continued to stir controversy—whether investors understand the rami- fi cations of the increasingly complex commission schemes the funds have developed, and whether some distribution features cause confl icts of interest for brokers.
Investor confusion with commission schemes has drawn fi re from the regulators and the press from the time Rule 12b-1 was adopted to the pres- ent. Every SEC chairman and Investment Management Division head has commented on this question. The press has examined it repeatedly in critical articles. Twice the SEC has taken steps to try to resolve it. In 1993, the SEC amended the disclosure rules and directed funds to prominently display in the prospectus detailed charts of the effects of fees and commissions on a hypothetical investment in each share class. For example, here are the charts Colonial has in the prospectus for its Federal Securities Fund.
This table (Table 8.4), like all such static tables, holds only for the assumptions made—the amount invested, the fund’s rate of return, how long the shares are held, and so on. And of course the tables in a fund’s prospec- tus show only that fund. To help investors compare fund expenses using the assumptions the investors want to use, the SEC in 1999 put a mutual fund cost calculator on its web site (http://www.sec.gov). The cost calculator prompts the user to enter all the relevant data—amount of investment, fee and com- mission rates, holding period, expected fund return. It calculates and displays total cost (both fees paid and earnings foregone due to those fees), as well as the value of the investment at the end of the holding period. By running this calculator for different funds and share classes using the assumptions he or she fi nds relevant, an investor can make valid comparisons among funds.
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Fund Distribution: The Broker Channels 181
Example Expenses help you compare the cost of investing in the fund to the cost of investing in other mutual funds. The table does not take into account any expense reduction arrangement discussed in the footnotes to the Annual Fund Operating Expenses table. It uses the following hypothetical conditions:
l $10,000 initial investment
l 5% total return for each year
l Fund operating expenses remain the same
l Assumes reinvestment of all dividends and distributions
Example expenses (your actual costs may be higher or lower)
Class 1 Year 3 Years 5 Years 10 Years
Class A $586 $822` $1,076 $1,803
Class B did not sell your shares sold all your shares at the end of the period
$193
$693
$596
$896
$1,025
$1,225
$2,024
$2,024 Class C did not sell your shares
sold all your shares at the end of the period
$193
$293
$596
$596
$1,025
$1,025
$2,219
$2,219 Source: Colonial U.S. Government Funds Services
As long as brokers have sold securities, investors have been concerned about confl icts of interest—temptations for brokers to make recommendations because they are in the broker’s best interests, not the client’s. Two potential confl icts of interest result from specifi c mutual fund characteristics. First, if funds distributed by proprietary brokers pay those brokers higher commission rates than do other fund families, this gives the broker an incentive to steer clients toward those proprietary funds. For example, an XYZ broker selling the XYZ U.S. Large-Cap fund might receive a three percent (out of the total fi ve percent) front-end commission, whereas he or she only gets a two percent commission selling a Putnam or Pioneer equivalent. If the Putnam or Pioneer fund is really better for the client, and the broker still pushes the XYZ fund, then the broker has succumbed to a confl ict of interest. In early 2000, this appeared to be a declining practice—Morgan Stanley remained the last wirehouse (large national broker dealer) that paid its representatives more to sell its proprietary funds.21
Second, different share classes are appropriate for different investors based on the time the investor expects to hold the fund. A front-end load with little or no ongoing 12b-1 is better for the investor who expects to hold the fund for a long time; no front-end load and a larger 12b-1 is better for the short-term investor. The total commission earned by the broker is higher if
Table 8.4 Example Expenses
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Monthly Mutual Funds Review—Wholesale Changes:
Have Fund, Will Travel
Small-Town Pitch Can Make for Some Big-Time Profi t If It’s Taken to the People
By Pui-Wing Tam, 12/06/1999, The Wall Street Journal
(Copyright © 1999, Dow Jones & Company, Inc.)
WENATCHEE, Wash.—The trip that salesman Tom Schinabeck has planned is complicated and circuitous.
Arriving by plane in the small town of Pasco, Wash., from Seattle, he will head fi rst to Richland, a rural town in the eastern part of the state, to meet fi ve long-time clients.
Then he’ll drive one hour to the Oregon town of Pendleton. And then it’s two more hours in the car, through fl atlands to Sunnyside, Wash., for sessions with a few more clients, and several more hours to yet two more little towns. By the end of the day, Mr. Schinabeck will have logged one hour of plane travel, six hours of driving and three fast-food meals (two at Burger King, one at Taco Time).
All this just to sell mutual funds. That’s right, mutual funds.
Mr. Schinabeck’s willingness to travel to small towns across the Pacifi c Northwest illuminates how the world has changed for wholesalers, the people who pitch mutual funds to the securities brokers who then pitch them to you. While the business has always been competitive, wholesalers in the past could count on a growing pot of investor money brought on by the long bull market to whet brokers’ interest in the funds they peddle.
And they could mostly confi ne themselves to the bigger cities, selling funds to the urban monied masses.
he or she steers each investor in the other direction. For example, if a share- holder is likely to redeem in two or three years, the broker gets more if the shareholder buys class A shares with a front-end load than if he buys class C with only an annual 12b-1 fee.
These opportunities for confl ict have been analyzed by academics,22 decried in the press,23 and examined by the SEC and NASD.24 Both remain controversial issues. The SEC has repeatedly strengthened disclosure rules to help investors understand the implications of different load structures. In 1999, NASD proposed prohibiting brokerage fi rms from paying their regis- tered representatives more for selling their proprietary funds than for sell- ing outside funds. Both the ICI and the Securities Industry Association have fought the proposal, saying that the rule was ambiguous, and that it was not justifi ed by any demonstrated record of abuses. At this writing, it remains uncertain whether any rule will be adopted.
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