The Deception Series, Part 1--How Hidden Mutual Fund Payments Hurt Shareholders

Over 100,000 mutual fund shareholders over the past 12 years unknowingly generated extra commissions for their financial representatives when they specifically bought shares in any of the five Strategic Asset Management (SAM) Portfolios offered by the Principal Funds, Inc. and its predecessor, the WM Group of Funds.

While these extra commissions generated millions of dollars for investment professionals who sold the five SAM Portfolios, the direct link between the sale of these mutual funds and the extra commissions they generated were not fully explained to shareholders.

The enticement of offering extra commissions to financial professionals in exchange for preferential selling agreements favoring the SAM Portfolios also created an ethical conflict of interest between investors and their financial advisers, according to a number of experts on ethics.

This conflict arose as the fund company rewarded advisers and/or intermediaries to accept payments for the preferential sales of a proprietary product which may, or may not have, benefited the investor. In the process, advisers who accepted these payments chose to put their own monetary benefit ahead of their customers' interests.

Thee extra commissions were made as part of an “advisor paid fee” (APF) program which gave investment professionals 150 basis points (1.5%) for any sales they made in the SAM Portfolios, in addition to the standard 12b-1 fees which were also paid. The APF payments were made to investment professionals for as long as their shareholder clients remained invested in the SAM Portfolios.

Ethical Problems
Ethicists contacted for this story said this APF arrangement clouded the fiduciary relationship which exists between an investment professional and their clients since it introduces a conflicting monetary reward system which works against making objective decisions about what is best for the client.

For instance, if a client’s investment needs change, or the SAM Portfolios performed poorly, an investment professional could put their monetary award ahead of suggesting that their client invest in another mutual fund.

The APF also raises the issue of whether shareholders in the SAM Portfolios are entitled to any of the APF sums paid over the years they remained shareholders. Some ethicists contacted for this story suggested that since shareholders in the SAM Portfolios generated the extra payments to their investment professional, they should be entitled to a portion of those APF payments.

In many cases, these APF payments, which were paid alongside of the traditional 12b-1 fees, could become very significant. For example, if an investment advisor had his clients in SAM Portfolios for 10 years they could generate $131,484 in total fee income for the investment adviser alone. Plus, this would have been income generated from the sale of one fund alone.

The APF was offered for all share classes (A.B,C) for all five SAM Portfolios, and while this payment changed over the 10 years it has been in effect, the APF at its most lucrative level (from the investment adviser’s perspective) was paid in addition to 12b-1 fees of 25 bps (paid monthly), plus an up-front maximum 4.75% dealer re-allowance for class A shares. Similarly lucrative packages were offered for B and C shares. The APF was paid to the selling broker/dealer, and at its discretion was passed along to the selling representative. In the majority of the cases, the investment adviser received the bulk of these APF payments.

In SAM sales literature distributed in 2000 to investment professionals, the distributor (WM Group of Funds) clearly spelled out how SAM sales could produce an exceptional payout based on initial SAM sales of $1 million.

As described in this sales flier, if the SAM assets grew at a 10% annual rate, these sales generated an upfront payout ranging from 4% to 4.75%. If SAM assets grew at a 10% annual growth rate, the SAM payout of 75 bps in total fee income would generate $8,250 in total fee income. By the fifth year, the SAM payout would amount to $50,367. If a shareholder held the SAM Portfolios for 10 years, the total SAM payout would rise to $131,484. This same piece of sales literature said SAM Portfolios were “a unique asset allocation service that will treat all your clients like millionaires.”

This arrangement was so lopsided that in some cases, the investment adviser would have made more in APF payments than the actual shareholder would have earned from their investment in the SAM Portfolios. Plus, the adviser would not be assuming any market risk.

As of June 2009, the APF was still being paid to advisers who had accounts on the books as March 1, 2006. After that date the APF was closed to new sales, but payments are still being made on SAM sales prior to that cut-off date.

Aside from the actual size of the APF payments, another key selling point was that transfers were allowed at NAV, so there would not be an additional charge to shareholders. This meant advisers could still “triple their trails” as the internal sales slogan went, so advisers could collect their 50 BPS APF, in addition to the 12b-1 fees.

APF Still Going Strong
While the SAM APF compensation plans have changed over the years they have been in effect, its purpose has not. The APF was clearly aimed at revenue sharing which offered investment advisers a direct way to increase their fee income. The APF made the SAM Portfolios more distinctive from a revenue point of view from other mutual funds which were on the adviser’s selling platform.

As described in official WM Group of Funds company literature, the APF program allowed investment advisers “to triple their trails” (based on the monetary incentives of the APF and 12b-1 fees) and for SAM shareholders to be treated “like millionaires.”

While the additional monetary incentive is unmistakable, the reference to shareholders was a gross misstatement since the vast majority of SAM shareholders never even knew their investment advisers were participating in this revenue sharing agreement and how it even affected their fiduciary relationship with their advisers. It also was never explained how they would be treated "like millionaires."