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Ole Miss professor remains focused on index fund issues

Consumers might have the expectation that by using a broker to select an index fund, they would be referred to a superior product. But a recent study suggests the opposite.

“What we found instead is that by paying the broker, consumers paid a penalty by being referred to a more expensive mutual fund instead of a less expensive mutual fund,” said Mercer Bullard, a securities law professor at the University of Mississippi School of Law in Oxford who is recognized as one of the country’s leading advocates for mutual fund shareholders. “Although one would expect using a professional advisor to improve an investor’s performance, instead the investor pays a significant penalty. We found that load index funds charged substantially higher fees — even before counting the fees paid to the broker — than true no-load (no 12b-1 fee) funds. In other words, when investors used brokers they paid twice: first, they paid the broker; second, they paid a broker penalty in the form of higher fund fees.”

Bullard recently co-authored a study with Eddie O’Neal, a professor with Wake Forest University, sponsored by the Zero Alpha Group, that looked at index funds. An index fund is a type of passively managed mutual fund that seeks to track the performance of a benchmark market index such as the S&P 500.

Bullard said in the context of a fund where performance is determined by the amount of fees, you would expect the use of a professional advisor to lead you to a lower cost fund rather than a higher cost fund.

“In fact, paying a broker meant you not only coughed up the broker fees but paid again in terms of the higher fees for the index fund to which the broker refers you,” Bullard said. “This is substantially attributable to the regulatory structure for mutual funds which permits mutual funds to pay brokers to sell the mutual fund shares. At the same time, the broker is allowed to pretend that he is working on the behalf of the investor. The overwhelming majority of funds are purchased through an intermediary, often a broker. Brokers ostensibly work for investors, but our study suggests that brokers actually work for fund companies.”

There is an obvious conflict of interest, one that Bullard believes needs to be addressed. Mutual funds have become Americans’ investment vehicle of choice, so it is important to fix significant problems in the way mutual funds are chosen. The current law encourages brokers to choose funds based on the compensation the broker receives rather than the best interests of the client.

“The fix is to have investors to pay brokers out of their own pocket for the services provided by the broker,” said Bullard, who was formerly an assistant chief counsel at the SEC and before that was in private practice representing fund companies and other financial services firms. “That way no matter which product the broker recommends, they are paid the same amount for the same services.”

Adding up

The penalty for using a broker can be significant, according to the Bullard/O’Neal study. On a $10,000 investment earning an annual return of 10% over 20 years, the average investor in no-load, no 12b-1 fee index funds would pay approximately $2,582 in operating expenses. The average investor holding a no-load fund that charges a 12b-1 fee would pay $3,744, while the average investor holding load index funds would pay $7,600 in operating expenses.

Both the Security and Exchange Commission (SEC) and Congress could make changes to address the problem. Bullard advocates the SEC repealing rule 12b-1, and says Congress should repeal the price fixing provision of the Investment Act that allows the funds to set prices that brokers charge to sell those funds.

Until the law is changed, Bullard has this advice for consumers: Find a broker who is not paid by the fund, but receives an asset-based fee and no other form of compensation.

“There are brokers who are recommending the best index funds, but those brokers are not getting paid under the traditional broker compensation structure,” said Bullard, who is president and founder of Fund Democracy, a non-profit advocacy group for mutual fund shareholders.

Excessive mutual fund fees have been an issue with Fund Democracy since July 2003 when the fund joined with the Consumer Federation of America to issue a report that showed that some investors in index funds and money market funds were paying grossly excessive fees. Some funds charged more than 10 times the fees charged by their lowest cost competitors.

Bullard said the response from the Investment Company Institute, a trade organization for the U.S. fund industry, is that excessive index fund fees were acceptable because there were valid reasons why some funds cost more to operate than others, such as differences in size.

‘Simple and troubling’

“That may be true, but what really matters is not why some funds are more expensive but why investors choose more expensive funds,” Bullard said. “The answer is both simple and troubling. Investors buy more expensive funds because that is what their brokers recommend. What investors receive in return for the extra fees they pay to brokers is the opportunity to pay extra fees to fund companies.”

Federal law requires that mutual funds — not brokers — set the fees that brokers charge. Bullard said it is only natural that brokers respond by serving the hand that feeds them.

“Brokers need not worry about violating their fiduciary duties to investors because the SEC has changed the law so that brokers generally no longer have fiduciary duties to investors,” Bullard said. “The SEC also has repeatedly promised to reform the rules governing brokers’ compensation practices, but has made virtually no progress toward this end. What is most troubling about our findings is that Congress and the SEC seem to have no interest in changing the status quo.”

Another effort by Fund Democracy and the Consumer Federation of America to better protect American investors is a proposal to require independent fund chairmen and a 75% independent board.

“Many funds currently have the fund manager also serve as chairman of the board, which means the chairman of the board is overseeing his own activities and negotiating the fee with himself,” Bullard said. “The definition of conflict of interest for fund manager and board members needs to be expanded. People can have significant conflicts of interests and still be able to serve.”

Other efforts of Fund Democracy, in cooperation with a consortium of consumer groups, include submitting comment letters on rule proposals, publishing articles on mutual fund practices that are harmful to shareholders, asking for hearings on requests for exemptions from fund regulations, lobbying federal and state legislators, submitting rulemaking petitions, filing briefs as a friend of the court in cases that may affect mutual fund shareholder interests, and participating in selected litigation on a pro bono basis.

Bullard has been quoted by many of the leading financial publications in the country, and in late March appeared on CNBC to discuss executive compensation issues.

Fund Democracy, a non-profit organization founded by Bullard in 2000, is funded solely by the public. For more information, see the Web site http://www.funddemocracy.com.

Contact MBJ contributing writer Becky Gillette at bgillette@bellsouth.net.


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