Product Pushers or Knowledgable Professionals?

The SEC investigations into mutual fund sales practices at Morgan Stanley and Prudential Securities are fueled, in part, by a familiar catalyst: investor anger.

And, as was apparent early on in that “other” Wall Street case (the research scandal), the brokerage industry is unlikely to escape being tarnished by the current round of scrutiny.

However, the similarities between the two cases end there. The biggest difference is that brokers are on the front lines of the mutual fund issues. At issue, of course, is whether back-end commission arrangements might result in brokers pushing unsuitable, or less-than-ideal, mutual funds on their clients.

But any thoughtful discussion of that subject is going to lead to one place: to the brokerage industry's identity crisis. With the push towards fee-based practices and the availability of an ever-widening array of investment vehicles, the brokerage industry aspires to an advisory image, but for better or worse, a good portion of its constituents are more salesman than investment advisor.

“Let's face it,” says Steve Winks, a Richmond, Va.-based industry consultant. “The brokerage industry is in the business of stimulating sales…even if some people are embarrassed by it.”

The distinction is an important one — particularly where investors are concerned. If an investor views a broker as a pure salesman, he understands that product discussions are at heart sales pitches, not advisory sessions. (Of course, by NASD rules, they must be sales pitches for suitable investments.) However, if the rep positions himself as an advisor, which more are doing, the rep's responsibility rises. (See related story, page 52.) In this case, the advisor would be required to disclose fees and compensation arrangements (such as 12(b)-1 fees, etc.), including that he's paid more to sell the parent company's fund rather a third-party's fund. Whereas the NASD says the responsibility of a registered rep to disclose fees and compensation ends when he provide his clients with a prospectus, RIAs (Series 65) have a fiduciary responsibility.

“If we take a page out of the playbook for the registered investment advisors, their compensation is product neutral,” says Dennis Gallant, a director with Cerulli Associates, a Boston-based consultancy.

But wirehouse neutrality is not yet universal. Morgan Stanley, for example, declares that it desires a 50-50 split in proprietary funds to third-party fund sales. In some cases, Morgan brokers get paid more on proprietary funds than on out-of-house funds. (Morgan says that fund companies are free to charge what they want on its platform, so long as the fund company doesn't pay a bigger commission than Morgan funds.)

That said, the definition of a proprietary fund at Morgan changed within the last year, sources say, and now includes about a dozen or so well-known fund families such, as Pimco and American that are defined as “in-house” funds. However, the fact remains that branch managers' compensation does depend on the sale of proprietary mutual funds, if only indirectly (because those funds are more profitable and a branch manager's comp is based on branch profitability).

Other companies have quit paying more for in-house funds. In June, American Express, which also had the reputation for favoring in-house funds, created a select group of mutual funds from 12 companies, says David Kanihan, a spokesman for American Express Financial Advisors in Minneapolis. Sales incentives on the funds from this preferred list, which includes American Express products, are the same, he says.

But it's these incentives that regulators believe should be more clearly defined if investors are going to benefit from the expertise of firms that are moving towards expanding the breadth of their advisory practices — while still selling lots of product.

Brokers say that if a client wants to know how a rep is compensated, the information should be available, but it's not necessary to cram it down their throats. “If they want to know what an expense ratio is, it's not as if: ‘Oh my God, we're keeping it a secret,’” says industry consultant Russ Alan Prince.

The SEC began focusing on the state of disclosure in the spring, says Lori Richards, director of the office of compliance inspections and examinations at the SEC. Examiners are looking at whether the information brokers give their clients is clear, when they provide it and how it is provided. The SEC is adding about 90 people to its broker/dealer exam program. In addition to increasing exams, the SEC is stepping up surprise visits, which provide a clearer picture of what's truly going on at branches and headquarters.

The fact that some firms have curtailed the favoring of proprietary funds doesn't mean that soft-dollar deals between the firms and the mutual fund providers don't exist — because they most assuredly do. But there are some trends that soften their impact, including the use of increased pay for reps to convert clients to fees.

But reps need to remember that an increased emphasis on fees will not will eliminate investor complaints, says Cerulli's Gallant — and this is particularly true in a down market.

“When people were making money, they weren't focused on whether they were paying too much for advice,” he says. But bear markets have a funny way of rearranging investor priorities.

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