Mutual Fund Reform and the Law of Unintended Consequences

In a complex society, rules and regulations have an impact far beyond their initial intent.

This would become the case if a reform is enacted which would make brokers follow fiduciary standards.

As cited from the post below ("Do Shareholders Deserve an Even Break?") a fiduciary puts the investor’s interest ahead of their own. In practice, this means a broker would recommend a mutual fund which is most appropriate for a specific client in terms of risk, performance, costs and the thorniest issue, commissions, revenue sharing deals and other under-the-table rebates.

The downside of too many client-financial advisers’ relationships is that are tainted by conflicts of interest. As shown in detail in the Deception Series on this Web site, one fund company paid a revenue sharing commissions to advisers to sell its proprietary fund, in addition to paying them 12b-1 fees. This double commission arrangement has been in effect for a decade and it skirted the issue of authentic, forthright disclosure, as defined in Webster’s.

As ethicist Julie Anne Ragatz, a fellow at the American College Center for Ethics in Financial Services in Bryn Mawr, Pennsylvania, noted, this revenue sharing deal (aka the Advisor Paid Fee), created an unnecessary conflict-of-interest between the investor and their financial professional. This conflict was in addition to the one which existed due to 12b-1 remuneration.

According to Knut Rostad, a member of the Committee for the Fiduciary Standard, this is the right time to advance the adoption of the fiduciary standard for brokers so that investors’ interests can be put before those of the investment professional and the mutual fund company.

As cited by Kathleen McBride, editor of Wealth Manager magazine, and a Committee member, the five core fiduciary standard principles are:
• Put the client’s best interests first;
• Act with skill, care, diligence and good judgment of a professional;
• Do not mislead clients; provide conspicuous, full and fair disclosure of all important facts;
• Avoid conflicts of interest;
• Fully disclose and fairly manage, in the client’s favor, unavoidable conflicts.

Fund Reform and The Law of Unintended Consequences
If this reform, or others which have a similar intent, become part of the financial reform movement, it will re-shape the way load funds are sold.

This is because load-funds largely rely on national sales networks which push proprietary product fueled by revenue sharing deals and 12b-1 fees. Both of these types of compensation create a conflict of interest between brokers and their clients. With a fiduciary standard in place, load-fund wholesalers would have to re-think their business function.

Similarly, what would happen to the practice of revenue sharing if brokers had to present the best possible fund which would also be the best match for their clients? Could they conduct business, while adhering to the fiduciary standards outlined by the Committee for the Fiduciary Standard?

The answer is that business could be done, but in a way which is entirely different from the way it is being conducted today.

Under the current sales-driven load fund sales model, fund wholesalers and their broker reps get the largest share of attention from the mutual fund company's marketing department, while shareholders get the least. This relationship would be reversed if the financial reform debate in Washington heats up.

As this debate become more public, it will also push the mutual fund industry closer to a crossroad. At the junction, the load-fund industry can choose to do business as it has in the past and act as if no recession ever occurred and that actively-managed load mutual funds, including the touted target-date funds, successfully withstood the market's decline through intelligent defensive measures. Or, it can act as if nothing ever happened.

The other choice, which presents itself to a few intrepid mutual fund marketing senior vice presidents who want to think outside the box, is to become pro-active and admit that the load fund business has to decide whether it will act on behalf of shareholders or work to preserve the status quo. That's a choice which will re-shape the industry.