Investor Protection Act Highlights Conflict of Interest Problems

There are an estimated 88.5 million investors in U.S. mutual funds, but only a small fraction have ever heard of 12b-1 fees and revenue sharing deals. These are the two subterranean practices which create conflicts of interest between financial professionals and investors, and help drive down investor returns from their mutual fund investments.

But that may be changing.

The Investor Protection Act (IPA) has passed a key U.S, House of Representatives vote and it has some provisions which should alarm some load mutual fund company marketing and sales executives.

Specifically, the House bill gives the SEC more authority to adopt rules that require a broker or investment adviser "to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice."

While this sounds benign, and most investors probably assumed this was already the way their broker or investment adviser acted, the reality is very different.

Instead of providing investors with objective advice, too many financial professionals have been receiving revenue sharing deals, or in plain English, commissions, to steer investors into certain mutual funds as opposed to others. This advice is dispensed even if there is a better find which is more suitable to an investor.

The determining factor for too many investment professionals (and there are no official numbers to show the extent of this) is the size of this commission, or revenue sharing deal. The financial professional gets this commission (called a trail) for as long as an investor owns the mutual fund. In real life, this gives the seemingly objective investment professional a motive to keep an investor in a poorly performing or unsuitable fund just so they can continue to receive the commission.

To make matters worse, this commission is paid regardless of a fund's performance. In the current mutual fund market meltdown which saw funds falling by 25%, the revenue sharing deals were still being paid. This may explain why many exasperated investors asked their financial professional what they should do and they got a canned response: "Stay the course," or "Don't be a market timer," or "The rally could come at any time." In short, the investor assumed all the risk, while the broker still was being paid a commission.

The unethical aspects of this arrangement have finally attracted the attention of legislators and the SEC. This practice has been going on for years, but the powerful mutual fund investment lobby, the Investment Company Institute, downplays this embarrassing ethical abuse in a variety of way. Until recently they have simply avoided discussing it in public. As a matter of fact, the best way to dampen any mutual fund trade gathering is to publicly start a discussion regarding fees and expenses. It is simply a Pandora’s Box of conflicts and embarrassing details.


Ever hear of Fiduciary Responsibility?
As Peter J. Henning writes about the proposed SEC provisions regarding broker-dealer fiduciary duty: “The responsibilities of brokers to their customers does not involve the same level of protection as that imposed on investment advisers, who have a fiduciary duty to put the customer's interest first. What this means is that a stockbroker can recommend investments to a customer without a concern that the broker also receives a benefit from the transaction, such as commissions from a mutual fund company whose shares are recommended.”

Most surprising, Henning also writes that while the change has been requested by the SEC, “the securities industry has acknowledged (that) the current reality is hostile to brokers by supporting the higher fiduciary standard.” If the industry made this admission, it was only because they finally realize that hidden fee and revenue sharing deals cannot be tolerated any longer given the lousy returns most actively-managed funds delivered since the current recession began.


The Challenge for Mutual Fund Marketing and Sales Execs
For mutual fund marketing executives, the passage of the IPA by the House should send a shutter through the industry. If it passes in the Senate (and that is by no means assured since this is as contentious as health care reform), mutual fund company execs should finally realize that they are really in the commodities business.

The reality is that despite multi-million marketing budgets derived from 12b-1 fees, mutual fund marketers have not done a good job of explaining why there fund is different than another. Or, the other explanation is that there is not much difference between the 5,000 domestic large-cap growth funds (in all share classes) listed by Morningstar.

If some entrepreneurial financial analysts want to create a great Web site, just list the 12b-1 fees and revenue sharing deals of the top 100 mutual fund families, so investors can compare performance versus how much these fund companies were paying financial reps to buy their funds. This would be welcome news to shareholders, but very embarrassing to many fund complexes and mutual fund sales people.

So what should mutual fund marketing execs do in light of these impending new SEC regulations?

First, they should realize there will be a new way of selling and marketing funds. This means some new talent is needed.

Dismantling old-boy sales networks and competing on a fund’s merits will require:
--Creating more sophisticated, higher-level marketing messages;
--More knowledgeable marketing communicators and wholesalers who have the knowledge, credibility and ethics to acknowledge that competing products, such as ETFs, hedge funds, or managed futures, have distinct advantages over mutual funds.
--Marketers should be aware of the larger picture and consider that the entire role of mutual funds in investment and retirement wealth planning has been taken down a few notches.

The decline in housing prices, higher equity-risk premiums, a declining dollar and the rise of new middle-classes overseas all point to lower investment returns and managing investor expectations. Basically, it involves new ways of competing, innovating and thinking, which unfortunately, have not been strong points in the mutual fund industry.

Lastly, marketing and sales execs should openly acknowledge that the most important customer a load-mutual fund company has is their shareholders, not their fund wholesalers or the brokers who have been receiving their revenue sharing payments.


Source: What the SEC Gains from the Financial Bill
by Peter J. Henning
Thursday, December 17, 2009
Yahoo Finance