Herd Mentality

Brokers are betting heavily on just a few fund families. Remember the Van Wagoner Funds?

A diversified portfolio, brokers say, is the bedrock of investing — for everyone except themselves. That brokers don't practice what they preach is a view heard more and more often from Wall Street professionals. Now, there is some tangible support in the findings of a recent survey, which found that about two-thirds of brokers invest more than half of the assets they manage with a single mutual fund family.

It doesn't seem to matter what kind of brokerage they work for, either, with wirehouse brokers at 62 percent and independent broker/dealers at 68 percent, according to Tiburon Strategic Advisors, which conducted the survey. Indeed, instead of being the value-adders they're supposed to be, brokers seem to be following the larger herd of investors. For example, the top five mutual fund companies — Vanguard, American Funds, Fidelity Investments, Franklin Templeton and Barclays — grabbed nearly 90 percent of net sales in 2005, up more than 100 percent in the past 10 years. In fact, American, currently the biggest asset gatherer, took in nearly one out of every three dollars invested in funds last year.

To be sure, there is much to recommend in the five families. As a group, they've built time-tested reputations for turning in solid performances, offering a wide selection, charging reasonable fees and having clean regulatory records. But that's only part of the case brokers make for using them. They also throw in a few reasons for clinging to the dead center of the mainstream that don't make a lot of sense for their clients, like their fear of being sued, being slammed by regulators, qualifying for fee discounts and avoiding having to do their homework. If all this concentration and self-serving reasoning sounds like a performance problem waiting to happen, it is, experts insist.

“The value-added is diluted if you go the mainstream route,” says Jeff Keil, principal of Keil Fiduciary Strategies, a mutual fund consultancy in Littleton, Colo. “There should be an investigation of a wider breadth of money managers. To have above average returns, you have to have some level of a contrarian view.”

“You can be too insular in your thinking,” adds Don Cassidy, senior research analyst at Lipper. “It could backfire big time.”

Recent history is not kind, even among the top five. Where Janus was once a member in good standing, ranked No. 5 with assets peaking at around $250 billion in the bull market, it now places 16th in assets among fund families with a mere $90 billion in long-term assets.

Investors also loved Firsthand Funds and Van Wagoner Funds in the 1990s for their gaudy returns. Their flagship funds had $1.4 billion and $1.5 billion in assets, respectively. Now they have $480 million and $41 million, respectively. Performance problems appear to be the key. All five Firsthand funds rank in the bottom third of their peer group for the last five years, according to Morningstar, while the Van Wagoner funds rank in the bottom 1 percent of their peer group for the last five years. Worst of all, 1838 Investment Advisors shut it doors last August after once managing as much as $15 billion in assets.

Yet, these real-life examples don't appear to build much of a case for diversity, or at least not one brokers are buying. If anything, there is plenty of anecdotal evidence that they continue to place most of their eggs in one basket.

The Lure of the Big Brand

Many brokers are afraid to stray from the elite brands because they fear if they put a client in a lesser-known fund and it performs poorly, the client could vote with his feet. Brokers know that they can't get fired if they're putting clients in the popular American Funds or some Fidelity offerings, so it makes for a much easier sale.

“They're afraid of putting a client in a lesser-known fund and having it underperform by two points, because [the client] could sue or leave them altogether,” Cassidy says.

Another fear factor, says David Levine, senior vice president at brokerage firm GunnAllen Financial, is brokers' concern of getting in trouble with their own firms over their sales practices. This is an outgrowth of new regulation, like the SEC's new rule requiring enhanced disclosure of breakpoint discounts; the aggressive prosecution of brokerage and mutual fund firms by New York State Attorney General Eliot Spitzer over market timing and B shares; and other enforcement actions by the NASD and the NYSE. Brokers have come to feel that the government attacks have limited the number of money managers that they and their clients can trust.

“The Spitzer effect has pared the number of viable money managers,” Keil says. Typically, recent enforcement actions related to brokers' failure to deliver breakpoint discounts, like the $21.5 million fine handed down to 15 brokerage firms in February 2003, are never far from brokers' minds. Says a top producer at Morgan Stanley: “Advisors are going with fewer money managers because there's the risk of being sued for not ensuring that clients get breakpoint discounts.”

For example, some funds require a minimum investment of $50,000 to qualify for a breakpoint discount off the price listed in the fee schedule. If a client has $100,000 to invest but it is split five ways, he or she does not meet the requirement for the discount. Another way to avoid delivering breakpoints was to invest a little chunk of the client's money at a time. Done intentionally to circumvent breakpoints, this is unethical and not in the client's best interest. Regulators responded accordingly by fining brokers and mutual fund companies for failing to oversee the process and protect the customer. Along the way, however, the honest brokers, who were actually splitting client assets to get adequate diversification and selling B shares when they were appropriate, also got punished. If money is spread across a number of houses to ensure diversification, it's a prudent investment strategy for the client. “It's tougher now with B shares being phased out,” the Morgan broker says.

Too Much Homework

Another factor driving brokers into the arms of just a few families is the amount of material brokers need to digest in making a recommendation, says Lisa Cohen, director of product development at Evergreen Investments.

“There's an overwhelming amount of product and information out there,” she says. This forces many advisors to use a “default option,” one of the top five brands out of a sea of more than 800 fund families. She likens the situation to buying your favorite detergent. There are so many choices on the shelf but you stick to the one you have because it works.

Sticking with a few firms not only means there's less to study, but by pouring more money into one family, brokers get more help from the teacher, that is, they're entitled to more quality research, Levine says.

Low-Cost Lovers

Chip Roame, managing principal at Tiburon, says that the biggest factor driving the trend towards fewer money managers is what he calls “a flight to cost consciousness.” He argues that each of the top brands have little else in common aside from the fact that they are the category killer in their respective spaces. American Funds is the low-cost provider among load-bearing funds. Vanguard is the premiere low-cost index provider. Dodge & Cox is king of the fund supermarkets, having been on a torrid pace in gathering assets since getting on Schwab's platform in 1997. T. Rowe Price is another low-cost provider that remains one of the few growth shops to have escaped the bear market without heavy losses.

PIMCO is the top fixed-income shop and, therefore, garners a bulk of bond inflows. Barclay's Global Investors has the most comprehensive exchanged-traded fund lineup, which positions it well for asset growth seeing as ETFs are all the rage right now, with 30 percent growth in assets expected for 2006. The common thread, Roame says, is that they all provide low-cost funds with above-average performance. And to a large degree, they all managed to avoid being implicated in the fund scandal, which profoundly affected preferences to the benefit of four brands in particular — American Funds, Fidelity, T. Rowe Price and Dodge & Cox — according to Lipper's Cassidy. In 2002, these fund families took in $37 billion net flows, representing more than 100 percent of total flows, he says. In 2003, they grabbed $113.9 billion, or 61.2 percent of total flows, and, in 2004, they took in $143.6 billion, or 65.2 percent of total flows. In the first 10 months of 2005, they collected $76.3 billion, or 73.7 percent of flows.

More of the Same

Given that there are many factors fueling the trend toward advisors consolidating the number of managers they use, it's not likely to change any time soon. In fact, Roame predicts further consolidation in the next few years with big complexes increasing their market share. So how might it end? The answer may lie with the clients, not with the brokers.

“Investors need to ask the pertinent questions to make sure their advisors earn their keep,” Keil says. Like dealing with any other service providers, from auto mechanics to building contractors, they have to do their homework.

Brokers might be a tougher sell. “It takes some sort of catalyst, maybe even getting burned,” he says.

Big four, anyone?

Buying American

American Funds collected nearly one in every three dollars invested (on a net basis) in mutual funds in 2005.
JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC ‘05 TOTAL
American Funds:
9,133 8,094 8,066 7,105 5,496 5,378 5,627 6,215 6,034 5,385 5,664 6,664 78,843
Overall Industry:
24,414 27,429 30,007 8,173 17,916 16,366 17,592 14,705 16,719 25,935 29,679 20,442 249,190
Source: Financial Research Corp.

Family Favorites

Percentage of advisors that put more than half their client assets in a single fund family.
Wirehouse and regional broker/dealers
62%
Independent broker/dealers
68%
Registered investment advisors
8%
Source: Tiburon Strategic Advisors
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