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| | Mutual Funds
Why brokers pitch the worst funds hardest
Your brokers choices: Sell you a good mutual fund or sell you a really lousy fund that carries his employers name and makes him a lot more money.
By Timothy Middleton
Most of the stockbrokers who work for American Express (AXP, news, msgs) are what those in the real estate business call motivated sellers. But only of Amexs proprietary, or house, funds.
Beginning next month, if those brokers, whom Amex calls financial advisers, sell funds other than Amexs own, their commissions will effectively be reduced. If the brokers sell the portfolios of the confusingly similarly named American Funds, which are among the best in the industry, the back-door commission cut could actually cost the broker money.
The reason: American Express funds are lousy. Only three of the complexs 189 funds ranked in the top quarter of its Morningstar category over the three years ended June 30, and only 27 ranked in the top half. An astonishing 86% were below average. Since the beginning of 2000, investors have yanked nearly $3 billion from the complex.
American Express is not the only Homer Simpson among proprietary fund companies; they're all underachievers. Lipper compared all of them with independent mutual funds, both load and no-load. Among the most widely held funds, the performance of house funds trails them all.
This is no accident. While not designed to be as egregiously awful as those of American Express, house funds are intended to be middle-of-the-road portfolios that never call attention to themselves, and thus invite brokerage clients to wonder why they own such dogs.
They have to be designed this way because house-fund companies cannot attract the best managers. Fortunately for the companies, their funds dont have to be very good: They have thousands of brokers constantly flogging them.
The standouts have tended to be few and far between from these firms, says Christine Benz, editor of the Morningstar Fund Investor newsletter. Financial giants such as Merrill Lynch (MER, news, msgs) and Morgan Stanley (MWD, news, msgs) live and die on the strength of their core brokerage and investment banking businesses. Fund management is kind of an afterthought, Benz says.
Independent funds trounce brokers
Proprietary mutual funds also charge big loads and fees that subtract from performance, but so do a host of independent fund complexes, notably Pimco and American Funds. The most widely held funds, whether load or no-load, all tend to outperform house funds, both in equity and fixed-income portfolios.
| 10-year performance of independent and brokerage funds | | Fund family | Equity (%) | Fixed income (%) | Combined (%) | | Pimco | 11.32 | 7.21 | 9.76 | | American Funds | 11.27 | 5.68 | 8.68 | | Fidelity | 11.30 | 4.96 | 8.49 | | Vanguard | 10.27 | 5.74 | 7.92 | | Oppenheimer | 10.16 | 5.00 | 7.45 | | Franklin Templeton | 9.68 | 5.42 | 7.07 | | Putnam | 8.89 | 5.21 | 6.83 | | Smith Barney | 8.32 | 5.56 | 6.60 | | American Express | 7.33 | 5.52 | 6.42 | | Prudential | 9.08 | 5.00 | 6.16 | | Merrill Lynch | 8.54 | 4.59 | 5.80 | | Morgan Stanley | 8.36 | 4.30 | 5.69 |
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Notes: Proprietary fund companies in bold. 10-year period selected to include both bull and bear markets. Average annual performance of funds with 10-year records. Smith Barney is part of Citigroup. Performance is not load-adjusted.
Period 06/30/92 06/30/02
Source: Lipper Inc.
Compounded over long periods, these seemingly modest differences in performance are huge. Some $10,000 invested 10 years ago in a 50/50 blend of stock and bond funds would have been worth $25,364 today at Pimco. At Morgan Stanley it would have grown half as much, to $17,386.
A. Michael Lipper, founder of Lipper, says brokerage firms want their funds to be in the middle of the road in whatever category they are in. They offer outside funds for extremes.
The risk of racking up outsize performance is that it can take you down as well as up. Thats why, among the independent funds on this chart, everybody beat Putnam. Putnams sin, if you will, was attempting in short periods to be the best -- and sometimes that doesnt work, says Lipper, who left Lipper Inc. after it was bought by Reuters. He now manages money under the name Lipper Advisory Services.
But a structural element that dooms house funds to mediocrity is that their managers have only limited opportunity to advance.
I would call this the problem of Napoleons baton, Lipper says. The emperor famously said that each of his soldiers carried a marshals baton in his knapsack. In his merit-based army, if a soldier had the ambition and the ability to lead, he would get the opportunity.
Most proprietary-system portfolio managers realistically dont have a chance to become the overall boss of the organization, Lipper says. As a result, the most gifted and ambitious flee house funds for independents, where the boss commonly is, or was, a portfolio manager.
Creative compliance
House funds also dont have to sell themselves: They have a horde of hustling brokers to do that job.
Technically, its illegal for brokerage firms to pay their workers more to sell their own funds than those of an outside organization. The National Association of Securities Dealers adopted this rule in 1999, because before that it was a routine industry practice.
American Express skirts the rule by punishing some of its brokers not with commissions, but with administrative fees. Called ticket charges, these are assessed on salespeople who are franchisees of Amex, rather than its own employees, which is the majority of Amex brokers.
Aimed at covering the cost of processing a fund transaction, ticket charges arent collected on Amexs proprietary funds. But all others incur a charge of at least $15. Beginning next month, they can go as high as $85.
That maximum applies to American Funds, which Amex says refuses to pay it fees that rival firms do. But on a fund purchase of only a couple of thousand dollars, that fee could exceed the brokers commission.
American Express denies that the charges are intended to encourage its brokers to push its funds at the expense of others. It also says its trying to rehabilitate its funds.
American Express currently believes that the performance of our mutual funds is a top priority and something were working very hard to improve, a spokesman says. He notes that in the last year, the fund complex has installed a new chief investment officer and lured three managers away from Fidelity.
No-load investors are spared the lower mathematics. Fidelity and Vanguard Group, respectively the nations No. 1 and No. 2 fund companies, excel in this comparison, as they do in most others, and they do it more cheaply than load funds do.
But investors who use brokers face the possibility of being guided into bad funds on purpose. Thats analogous to what used-car salesmen do, but you can be stuck with a financial lemon for life. Before you buy a fund on a salesmans say-so, look under the hood. You can start by using MSN Moneys Easy Fund Finder.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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