KIM: Mutual fund choices influenced by conflicts

KimHave you ever wondered how and why the mutual funds your brokerage firm recommends or those that appear on your 401(k) plan’s menu of investment options were chosen?

Certainly, there are qualitative factors involved, such as a fund’s performance record and ratings by the major fund research providers, Lipper and Morningstar.

However, how brokerage firms or other intermediaries get paid also plays a significant role in which mutual funds they recommend.

Brokerage firms have three ways to be paid. As discussed in my last column, funds sold by brokers typically carry a sales charge, or “load,” used to pay a commission. These commissions may be paid upfront (Class A shares), over time (Class B shares) or in perpetuity (Class C shares). Think of this as a “you can pay me now, or you can pay me later” proposition.

So-called 12b-1 fees for “distribution and service” also can be used to compensate brokerage firms. These charges likewise are paid by the shareholder and can vary by share class.

The third potential revenue stream is known euphemistically as “revenue sharing.” Unlike loads or 12b-1 fees, these payments are borne by the fund’s management, not the shareholders. Further, these payments are generally based on sales volume and the amount of customer assets the brokerage firm has with the fund.

You may be wondering, “If fund shareholders don’t pay for revenue sharing, why should I care?”

Funds with multiple share classes and different loads and structures can be complex to analyze, but the information is readily available. With a little work, you can “connect the dots” to see what the broker’s financial incentive may be to recommend one fund or share class over another.

Revenue sharing is a common and perfectly legal business practice. It is opaque by nature, so any link must be inferred. However, it can have a huge impact on which funds a brokerage firm recommends or appear as menu options for 401(k) plans.

For illustrative purposes, let’s look at the revenue-sharing practices of two nationally known brokerages, Firm X and Firm Y.

Firm X played a significant role in shedding light on this practice when it paid a $75 million fine in 2004 for failing to adequately disclose revenue-sharing payments it received from a select group of seven mutual fund families, which accounted for over 95 percent of its fund sales.

Firm X’s current disclosure states the vast majority of mutual funds, 529 plans, insurance products and retirement plans it sells involve “preferred product partners,” each of which pays revenue sharing. For 2011, Firm X received revenue-sharing payments of $152.2 million, which accounted for over 30 percent of its profit.

Firm Y states bluntly, “Funds that do not enter into these arrangements are generally not offered to clients.”

Firm X’s and Firm Y’s practice of recommending only funds willing to “share revenue” is the rule, not the exception. There is no such thing as unbiased advice.

That said, conflicts of interest are not always bad. Your best protection is being an educated consumer. Ask, “Is the fund you are recommending paying revenue sharing?” Then decide for yourself if the advice you are receiving makes sense for you.•


Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or [email protected]

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