An article in the personal finance magazine Smart Money has described the way in which many broker-sold mutual funds are currently marketed.  For those who would seek the opinion of a financial advisor expecting unbiased advice, the process might be revealing and raise questions.

Competition among mutual funds today is fierce.  Large fund families employ hundreds of sales representatives, or “wholesalers,” to encourage brokers, financial planners, and investment advisors to sell their funds.  In theory, the wholesalers provide information about the funds and the current strategies of the portfolio managers.  In reality, they and their companies offer many inducements to use the funds that have nothing to do with investment performance or portfolio benefits.  These include:

1. Free meals.  The Smart Money article described how the brokers at one firm’s Texas office expected a wholesaler to bring in tacos for breakfast.  While this may seem petty, expensive lunches and dinners for top-selling brokers, or “producers,” are commonplace.

2. Tickets to sporting events, rounds of golf, and other forms of entertainment.

3. Paid vacations.  Typically the fund company will sponsor sales “campaigns” that reward brokers or planners who sell a minimum dollar amount of a particular fund or funds with free trips to attractive destinations, such as ski resorts, Hawaii, or Florida in the winter.
 
4. Marketing assistance.  Fund companies will pay for the mailing of letters and advertising brochures for brokers who give them significant business.   They might also agree to sponsor a broker’s radio program, and/or make a popular fund manager available for an interview on or off the air.
 
Besides helping the individual broker, the fund companies pay large sums of money to the brokerage firms themselves to get on the firms’ “preferred list” of mutual fund companies.  The preferred list is comprised of those fund companies that get the great majority of the brokerage firm’s business.  For this privilege, fund companies pledge $563,000 per year, on average, to the brokerage firms, according to Financial Research Corporation.  Much of this consists of sponsorship of sales conferences put on by the brokerage firms.  The fund companies thereby assist in the “training” of brokers.  Moreover, fund companies give their own trading business to those brokerage firms that use their funds, i.e., put them on their preferred list.  With some $6.9 trillion in total mutual fund assets in the U.S., this represents millions of dollars in business to the brokerage firms.

Note that the above is in addition to the commissions that mutual fund companies pay for selling their funds, which is borne directly by the mutual fund investor.  That compensation is split between the broker and the brokerage firm.  The commission may be in the form of an upfront “load”, or sales charge, or deferred over several years.  In the latter case, the charge is often invisible, being added to the expenses of the fund.  Some funds pay a marketing fee, a so-called “trailer,” to the broker indefinitely as an incentive to continue to hold the client’s money in the fund.

In other words, a mutually beneficial relationship exists between the brokerage firms and those mutual fund companies that sell their funds through brokers.  The brokerage firms sell the mutual fund companies’ products.  In return, the brokerage firms receive dollars for marketing and the training of brokers, and considerable trading business, from the fund companies.

While we believe the overwhelming majority of financial advisors want their clients to do well, we prefer to avoid the conflict of interest that this arrangement creates.  If Fund A is offering an all expenses paid trip to Hawaii in return for dollars invested, and Fund B is not, will an advisor be truly objective in his or her choice of funds to recommend to his or her client?

The brokerage firms have added further to the conflict by sometimes paying higher commissions to brokers for selling their own proprietary, or “in-house” mutual funds than “outside” funds.  Moreover, under the traditional commission system, brokers are paid more for selling some types of financial products than others.  For example, variable annuities are extremely profitable to sell, while U. S. Treasury bonds are not.   Does this not tend to color the judgment of an advisor when making an asset allocation recommendation?
 
Even mutual funds that are sold directly to the public have placed greater emphasis on marketing in recent years.  This has resulted in the hiring of product managers, who employ the marketing strategies of consumer packaged goods companies.  They look for market niches in which to create and sell funds.  Advertising expenditures have sharply increased.  One Denver-based mutual fund company spent millions to sponsor the local professional sports stadium.  If a fund is small, marketing expenses that result in increased assets under management may be beneficial to current fund investors by realizing greater economies of scale and thus lowering expense ratios.  Beyond a certain point, however, studies have shown that greater girth hinders investment performance and only serves to increase fund management fees.  That means investors pay more for less.

At Metrics Money management, LLC, we have one overriding mission - to provide unbiased financial advice to our clients.  We do not wish to be paid more for one type of investment recommendation than another because we think that will render us less than completely objective.  We prefer a compensation system that aligns our interests with those of our clients.  We want to have an incentive only for providing good advice.  Accordingly, we do not receive commissions but are compensated exclusively as a percentage of assets under management.  We are not remunerated in any way from outside sources, and accept no gifts, “free” services, or offers of vacations.  We earn more fee income when our clients’ assets grow, and less if they shrink.  We assess our investment recommendations only in light of how we expect them to perform and how appropriate they are for our clients.  Our loyalty is totally to our clients.