Commentary: The Dirty Little Secret of Mutual Funds

Regulators should probe deals in which fund companies pay high fees to be on a preferred list that a broker recommends to its clients

By Lewis Braham

When money manager Phillip Toews launched a new mutual fund last July, he thought he would have no trouble finding investors. Given the stock market's volatility, he figured his Toews Nasdaq-100 Hedged Index Fund would be a surefire hit. Yet two brokerage houses refused to let Toews contact their brokers about selling the fund. Why? He wasn't willing to pay to be on the firms' preferred list of funds.

Such "pay-to-play" arrangements are a dirty little secret of the mutual-fund industry. True, all fund companies pay to get a selling agreement with a national broker--and that can cost $300,000 or so. But that money doesn't get a fund any attention--in other words, a place on the preferred list. Toews does have selling agreements with 30 different brokers, primarily regional ones where the initial set-up fees are small. Even so, because he's not on any preferred lists, the likelihood of investors hearing about his fund from brokers is slim.

These preferred list deals, though legal, are unfair to investors and are anticompetitive to many smaller fund companies. Regulators should investigate them, and either ban them or force fund companies and brokers to completely disclose their dealings.

Arrangements are always privately negotiated, but industry sources say getting on the preferred list starts with a higher sign-up cost, perhaps $500,000 to $1 million at national brokers. The fund company will then have to pay either a percentage of the brokerage's gross sales, about 0.25%, and/or an annual fee of 0.25% to 0.35% of the fund assets held at the company.

As distributors, brokers have a right to charge for shelf space--a common practice, for instance, in the food and publishing industries. But in mutual funds, preferred relationships create conflicts that can harm investors. Brokers may overlook funds that may be most suitable to an investor's needs. St. Louis-based broker Edward Jones can sell funds of 180 fund families through its 7,500 branches. Yet only seven families--which include such powerhouses as American Funds and Putnam--are on its preferred list. "Those seven get 97% of our business," says Thomas Miltenberger, the firm's fund marketing chief.

That's not surprising. "Once you're a preferred sponsor," says Toews, "your fund is discussed in their publications and included on their recommended buy list for their financial planners." Although Edward Jones charges extra fees for the preferred list, Miltenberger says it selects preferred fund companies based on product breadth and ability to service brokers--make office visits, distribute information, and train brokers on how to sell their funds.

Servicing brokers is costly, too. "If a fund company comes to Merrill Lynch and says, `We'll spend a lot of money to train your brokers on certain aspects of wealth management,' Merrill Lynch looks favorably on that, and it increases competition for everybody else," says James Hawkes, CEO of Eaton Vance funds. Such training often takes place at cushy resorts. "A lot of firms will say, `We want you to give us $100,000 to attend our broker convention in Hawaii,"' says Joseph Rob, CEO of Sentinel Funds. "We rarely go to those."

So who's really footing the bills? Funds can charge investors up to 0.25% of assets for distribution--it's part of the so-called 12(b)-1 fee--but that's not enough. Often fund companies dip into their own cash to cover pay-to-play costs. Since the payments are not from fund assets, the company is not required to disclose these costs to investors. But pressure on fund-company profit margins means shareholders will bear some of the costs in the form of higher management fees. In fact, a 2000 survey of major fund companies by Financial Research, a fund consultant, found an average pay-to-play cost of 0.4% of every dollar invested in funds--a total of $1.5 billion.

Why do fund companies agree to these ridiculous fees? Because they need brokers more than ever. Some 6,000 funds are competing, and a place on the preferred list gets the fund's name in front of clients. Even so, investors need to know whether the funds their broker is recommending were among a handful that paid for preferential treatment.

Staff Editor Braham writes about mutual funds.

    Before it's here, it's on the Bloomberg Terminal.