Your mutual fund broker is there to help you save for retirement or your daughter's education by helping you select investments that match your tolerance for risk and your time frame for saving.
Your mutual fund broker is also there to save for his own retirement and his daughter's education by selling you investments that pay him and his firm commissions and other fees.
Investors who don't keep both facts in mind may find themselves getting a lot less than they should from their financial choices, according to regulators, academics and consumer advocates.
Over the past two years, the brokerage industry's main regulators, the Securities and Exchange Commission and NASD, have uncovered and punished unsavory practices, including failing to give investors their promised commission discounts and accepting secret payments to push particular mutual funds. The exact details varied, but all of the cases had a common thread -- brokers who engineered transactions to earn themselves a benefit rather than primarily thinking of their customers.
"You should always be suspicious of your broker, just like you should be suspicious of your lawyer or other professionals you deal with. Is their advice 100 percent in my benefit?" said Walt Woerheide, vice president of the American College in Pennsylvania, which specializes in training financial industry professionals.
More than 91 million Americans -- and almost half the nation's households -- own mutual funds, and the vast majority of them don't buy their shares directly from the fund company. Many invest through a retirement plan that limits their choices and negotiates discounted fees and commissions. But almost one-third of fund customers rely on advice from someone who works for a broker-dealer, according to the Investment Company Institute, a mutual fund trade group.
Many of the fund buyers who turn to brokers are new to the financial markets and less sophisticated about money matters. They really do need help sorting through the nation's 8,100 mutual funds.
"Like any other important decision, investors can benefit from advice. . . . You can do it yourself, but you probably won't do as good a job," said Bruce Fenton, president of Atlantic Financial Inc., a Massachusetts brokerage firm. He likened a good broker to a good doctor. "You can go online, choose a drug you want and get a service that can give you Canadian drugs, but you aren't getting the best health care."
But regulators and consumer advocates say that the customers who use brokers often don't really understand their relationship. Although many brokers call themselves investment counselors or financial advisers, and some sit in the lobby of a bank or even a retirement center, they are fundamentally salesmen who make their money from commissions, just like car salesmen.
"Despite their ads, brokers are not advisers, they are salespeople. . . . They have no legal obligation to recommend products that are in your best interest. Their obligation is to recommend products that are financially suitable, and that's a much lower standard," said Barbara Roper, director of investor protection for the Consumer Federation of America. "The broker is going to get paid, and that payment is going to come out of your pocket."
Mutual fund brokers officially get paid in a variety of ways, depending on which class of shares an investor buys. On Class A shares, investors pay an upfront charge of about 5 percent, called a load, most of which goes to the broker who sold the fund to them. The commission for B shares is collected at the back end, when the investor withdraws money from the fund, and C shares pay the broker by charging higher annual fees than the other classes.
Bentley College finance professor Leonard Rosenthal warned that unwary investors sometimes confuse broker-sold B and C shares with "no-load" funds that are bought directly from the fund company and charge no commission at all.
Remember, he warned, "every time you buy or sell, [brokers] earn a commission."
Investors also need to keep a close watch on the annual fees charged by the funds their broker recommends, said Edward S. O'Neal, a professor of finance at Wake Forest University. He said that many of the mutual fund companies that pay high commissions to brokers specialize in actively managed funds -- in which a fund manager continually makes investment decisions, buying and selling -- instead of low-cost funds that simply replicate market indexes by holding the same stocks.
The differences are not trivial: Actively managed funds can charge 2 percent or more a year, while the Vanguard Group's famously cheap fund that mimics the Standard & Poor's 500-stock index charges 0.18 percent.
"All mutual funds have costs that lower your investment returns, and even small differences today can have a dramatic effect over time. Before you invest, be sure to ask your broker or the fund about the fees you'll have to pay . . . as well as ongoing expenses that come out of the fund's assets," said Geraldine Walsh, of the SEC's investor education office. "It's your money, so don't be shy about getting the facts you need to make an informed investment decision."
Still, Taeya Lauer, a Seattle broker with D.A. Davidson & Co., notes that the SEC and NASD require funds and brokers to show potential investors their net returns after all fees.
Investors also need to be aware of the various abuses that the SEC and NASD have recently uncovered. Among them:
* A regulatory examination found that brokerage firms failed to give promised discounted commissions -- in Street shorthand, breakpoints -- to 20 percent of investors who put $25,000 or more into Class A shares. That was 288,300 accounts, with an average overcharge of $243. The entire industry is refunding $64.3 million to customers.
* Some brokers improperly steered customers into Class B shares, which have the back-end load, and failed to point out that they would qualify for breakpoints if they invested another way. In one 2002 case, NASD found that a broker sold $2.1 million in Class B shares -- netting himself a huge commission -- to an investor who would have paid no commission at all if he had bought A shares in the same fund.
* Brokers switched clients from one fund to another similar product to generate new commissions for themselves. This has been a particularly large problem in the arena of variable annuities, which are life insurance products that include mutual fund investments.
* Firms were accepting side payments from particular fund companies but failed to tell clients. Last fall, Morgan Stanley paid $50 million to settle SEC and NASD allegations that it failed to tell customers it was getting extra money from 12 fund companies to promote their products. Some of the payments were in cash, while others were in the form of "directed brokerage," in which the fund companies sent Morgan Stanley their stock- and bond-buying business in exchange for favored treatment by the firm's retail brokers.
Some critics say the current setup is untenable and should be changed. "IBM doesn't pay brokers to push IBM stock, but the whole mutual fund industry is premised on the idea of paying brokers to push mutual funds. You need to divorce the product from the salesperson. There's too much abuse," said University of Mississippi law professor Mercer E. Bullard, who runs a shareholder advocacy group.
But the industry defends the commission-based system, saying that some investors need help choosing investments and that commissions are a fair way of compensating brokers for their time and effort.
"You're getting advice, and there is value to advice. But it has to be paid for," said James D. Spellman, spokesman for the Securities Industry Association.
But perhaps not if that advice isn't completely unbiased, consumer advocate Roper cautions: "Brokers aren't necessarily looking to recommend the best possible funds for you. They're looking for the ones that are appropriate for you among the group that pays them highly."
Regulators for their part are opting for smaller fixes, focused mostly on disclosure. Brokers now have to do a better job of telling customers they may be eligible for breakpoints and must keep better records to ensure that the discounts actually materialize.
The SEC has also proposed banning directed brokerage and requiring brokers to tell their customers -- at the point of sale -- exactly how much the brokers and their firm receive for selling the products they are recommending. The SIA is lobbying hard against the point-of-sale proposal, saying it would be prohibitively expensive to provide individualized statements to each investor.
But mutual fund trade group ICI has come out in favor of it. "Disclosure at the point of sale is a very powerful tool to bring to an investor's attention those relationships that could influence a broker's recommendations," said the group's president, Paul Schott Stevens.
The SEC and NASD continue to look for new abusive practices but, in the end, regulators and academics said, customers must still look out for themselves.
"Examiners are focusing on the sales of mutual funds to investors, given their popularity, and we're looking for sales that may be unsuitable or inappropriate for the investor," said Lori A. Richards, who heads the SEC's compliance and inspection division.
"But it's important that investors be educated about what they are buying."