The Deception Series, Part 2--The History of the APF

Part 2--The History of the APF
The APF evolved from its origins as part of a managed account, or WRAP program, into a more simplified revenue sharing agreement which rewarded investment professionals for keeping their clients invested in the SAM Portfolios.

The APF payment program stopped making payments to new SAZM Portfolio sales made after March 1, 2006, however, all sales made prior to that date were still honored. As of this writing (June 2009) APF payments are still being made to advisers who made SAM sales prior to the March 1, 2006 cut-off date.

As the regulatory environment changed, accompanied by greater need for disclosure, some broker-dealers did not allow the APF program to be used in their wire house or branch networks. This focused the APF on independent financial advisers who readily agreed to accept the payments.

According to a WM Group of Funds memo, the APF began in 1990 and was adopted to stem shareholder redemptions. The memo states that “the payment of the Advisor Paid Fee is just one of the steps WM Advisors has taken to positively and effectively manage their strategy of maintaining a long-term consistent investment platform.”

While the fee was unusual (only two fund companies in the U.S. out of a possible 700 ever used it), it paid off in terms of reducing redemptions. (A redemption happens when a shareholders sells their mutual fund shares.) A 2007 memo said “We believe this strategy (using the APF) is working given our statistics that our redemption ratios are 50% lower than the industry average.”

From an operational perspective, the APF was paid from profits of net revenues from the management fees of all its portfolios. This included all five SAM Portfolios, the retail funds and its institutional class. As a result of this structure, there was no direct correlation between the management fee charged by the SAM portfolios and the advisor paid fee.

Based on comparative studies with other mutual fund companies using the Lipper database, WM found that its management fees were 5% to 16% lower than other funds within their peer categories. This was admirable, but it may not have occurred without the APF and it questionable ethical practices it created.

The APF, Revenue Sharing, and 12b-1 Fees
While there is a technical and legal distinction between APF, revenue sharing, and 12b-1 fees, they all fall into a gray area from the shareholder’s perspective.

These types of fees are difficult for shareholders to understand, and commonly are not actually explained by investment advisers. In many cases, these types of fees can compromise fiduciary relationships, and create an unnecessary conflict of interest between advisers and their clients. What all of these fees have in common is that they are very controversial.

For example, in 2007 the brokerage firm of Edward Jones settled a charge filed against it in 2004 by the SEC. In the 2007 settlement, Jones agreed to pay a $37.5 million fine, and also return $37.5 million in “ill gotten gains and interest.” Jones incurred these fines after the SEC said it failed to disclose the revenue sharing agreements it entered into with seven mutual funds. Instead of disclosing that the fee arrangements were the main reason why Jones was selling these mutual funds, Jones told its customers that the funds were chosen because of their exceptional performance and investment objectives.

Controversial Fees
Of these fees, 12b-1s have a direct effect on total fund expenses which directly affect shareholders’ net investment returns.

In 2008, the SEC estimated that over $12 billion in 12b-1 fees were collected from shareholders, but it was unclear exactly how they were used to meet their stated benefit of lowering shareholders expenses.

When this fee was first introduced in the 1980s, the cover story told to Congress was that the fees would improve the level of communications between shareholders and their investment reps which would build stronger relationships. In turn, this would attract more shareholders, and improve the scale of economy to reduce overall fund expenses.

These are very admirable goals if we lived in an ideal world. Merrill Lynch says the 12b-1 fees are used to cover the cost of its infrastructure supporting Merrill's financial advisers. In turn, this allows its advisers to provide advice to investors in the selection of mutual funds, according to an executive in Merrill Lynch’s Office of General Counsel.