Funds: Don't Ignore The In House BrandAmey Stone
Time was, you had good reason to wonder if your broker had your best interest at heart if he pitched a mutual fund with his firm's name on it. Only a few years ago, brokers were given to pushing trendy, high-commission in-house investments, many of which have flopped.
Brokers can still earn incentives by selling in-house funds, but they seem to be shying away from the aggressive sales tactics that tarred their reputation. More important, firms have beefed up the breadth and quality of the fund offerings and are boosting old faithfuls, such as utility and growth and income funds, rather than flashy new products.
If you need convincing, look at the numbers. Stock funds sold by the five big houses--Dean Witter, PaineWebber, Merrill Lynch, Smith Barney Shearson, and Prudential--have averaged 19.7% gains through Oct. 22, while independent load equity funds averaged 15.96%. Prudential, the star, returned nearly 25% on equity funds this year.
TOE-TO-TOE. On the fixed-income side, PaineWebber, Dean Witter, and Merrill Lynch all narrowly beat the average for nonproprietary load funds through September. In other categories and in general, proprietary funds are virtually neck and neck with load fund rivals for the year-to-date, 5-year, and 10-year returns. But, although their averages are the same, "you tend to see a more narrow range of performance," says Don Phillips, vice-president at Morningstar, a mutual-fund rating service. That means brokerages can be credited with having fewer winners, but also fewer losers.
Morningstar has found that returns for funds with sales charges and direct-marketed (no-load) funds are comparable--when the sales charge is factored out. But brokerage houses, as well as other load fund companies, argue that advice from their representatives is well worth the extra cost.
That's not to say the brokerages haven't launched some real stinkers. The fixed-income arena, especially, has been a graveyard of new, untested products sold to investors without an explanation of the potential risks. Many proprietary high-yielding junk bond funds, government funds, and short-term global funds have been disappointments.
Morningstar recently listed the funds that had the most redemptions. The unenviable top four are all brokerage funds: Dean Witter Convertible Securities, Dean Witter High-Yield Securities, Smith Barney Shearson Government Securities B, and PaineWebber U.S. Government Income A. Merrill Lynch's Federal Securities A and Balanced Fund For Investment and Retirement B were also among the top 10 "sinking ships." "With a gimmicky product, a highly motivated sales force, and an easy sale--that's when fund companies tend to overpromise and underdeliver," says Phillips, who thinks brokerages have learned from past mistakes.
Despite its sorry redemption record, Dean Witter's High-Yield Securities fund is a turnaround story. It declined 40% in 1990, only to shine when manager Peter Avelar took over at the end of that year. Morningstar rates it second of 76 high-yield corporate bond funds this year. But most of the redemptions had already taken place. From a high of $2.1 billion total assets in 1986, it fell to $312 million by 1990 and has slowly climbed back to $534 million this year. Jim Flynn, a Dean Witter spokesman, says this is just one of several improved funds in its lineup.
OLD STANDBYS. Current hot sellers among brokerage funds have long track records and good managers. Merrill Lynch Capital A and Basic Value A, both growth and income funds, have averaged better than 14% returns for 10 years. Prudential Utility A, which is up 19.1% through Oct. 22, and Smith Barney Shearson Special Equities B, up 43.2%, are winning praise.
Sometimes, new products pay off. Merrill boasts that it offered some of the first funds to invest in Pacific Rim countries and other emerging nations. Prudential's Pacific Growth is ranked No.1 of 26 Pacific stock funds, and its Global Genesis B is second of 60 world stock funds for one-year returns.
Just because their funds have performed well lately doesn't mean that you shouldn't still be wary when your broker suggests an in-house fund. No matter how good its lineup, no fund company has the top performers in all major investment categories. While brokerage houses have filled out their product lines and weeded out losers, they still give their brokers good reason to push the company brand.
Some firms, including Prudential, Dean Witter, and PaineWebber, offer brokers a bigger cut of the commission to sell proprietary products. A $300,000 producer would typically earn 41% of the total sales commission for a private-label fund, while he or she would get 36% for selling an outside fund. That means, on a $10,000 transaction, the broker would pocket about $25 more for putting a client in an in-house fund.
While that's hardly a windfall, other incentives may be at work. Firms often run special promotions on certain funds, offering prizes, trips, and bonuses to brokers who sell enough of the product. For example, says John Keefe, president of Keefe Worldwide Information Services, a financial services consultancy, firms might let brokers keep the full commission--rather than a percentage--for the next 30 days for the sale of a specific fund. Another, more subtle incentive is that brokers can curry favor with their branch manager by selling firm products. Managers can respond by doling out new accounts and parts of hot new stock deals to the broker.
When incentives aren't enough, brokerage houses have used other tactics. Dean Witter, which attributes 70% of its fund sales to in-house names, was flooded with bad publicity when it restricted representatives of independent fund groups from visiting branch offices in 1991--a temporary policy, Flynn says.
Merrill Lynch does not have a separate commission structure for in-house and outside funds. And when Smith Barney, Harris Upham officially merged with Shearson Lehman Brothers on Labor Day, the two firms agreed to offer the same commission on all funds, although Smith Barney had a different payout structure for in-house funds before. But executives from companies that offer incentives don't apologize for creating an apparent conflict of interest. They say the incentives are modest and brokers are trained to pick the best fund for their client. "But if all things were equal between two funds," says Richard Redeker, president of Prudential's mutual fund operations, "I would expect them to give stronger consideration to the in-house fund."
Brokers do have some substantial incentives not to sell the proprietary product. For one, if they want to change firms, it will be easier to bring along clients who are not invested solely in their former firm's products. Also, many brokers learned the hard way during the 1987 stock market crash that they will lose clients if they peddle investments that are too risky or perform poorly. "The better brokers will judiciously choose those firm products that are in their client's best interests," says Mark Elzweig, a New York brokerage recruiter, who says fewer brokers are complaining of product-pushing than years ago.
SAY "NO DUDS." Brokers have forced their employers to
reduce that pressure, says Todd Robinson, chairman of LPL Financial Services, an independent brokerage that does not sell in-house products. "They've become slightly less heavy-handed," he says. "But if you look at economics, the fact is that a sale on a proprietary fund is four or five times as profitable as an outside fund."
To make sure your broker isn't trying to saddle you with a dud, ask for the fund's complete track record and stick with funds that have outperformed the average for their category for at least three years. Make sure your broker can explain the objective of the fund and how it fits into your portfolio. Brokers are there to help you choose among investments, explains Keefe. "Don't just walk into an office and let someone else make a decision for you."
And feel free to ask if your broker gets any extra goodies from the sale, such as bonus points or gifts. If he or she is earning a free cruise because you bought the in-house fund, at least make sure that fund is a good one.
HOW BROKER FUNDS STACK UP Firm Equity funds Bond and muni funds 1993* 5-year** 1993* 5-year** DEAN WITTER 22.12% 13.59% 11.18% 9.01% PAINEWEBBER 15.64 14.27 11.92 10.69 MERRILL LYNCH 19.91 10.74 10.63 10.13 SMITH BARNEY SHEARSON 17.10 12.60 10.19 10.13 PRUDENTIAL 24.88 13.03 9.94 9.19 NONPROPRIETARY 15.96 14.11 10.47 9.99 LOAD FUND AVERAGE *Returns through Oct. 22 ** Average annualized returns DATA: MORNINGSTAR INC. IN-HOUSE FUND QUESTIONS -- What is the fund's track record? -- How does it compare with outside funds in the same category? -- What compensation do you get out of it? -- Are there any bonus- es or prizes attached to this product? -- Where does it fit into my overall investment strategy? DATA: BUSINESS WEEK