Mark Brandon is the Managing Partner of First Sustainable (http://www.firstsustainable.com), a registered investment advisory catering to socially responsible investors. In addition to Socially Responsible Investing (SRI), he may opine on social venturing, microfinance, community investing, clean technology commercialization, sustainability public policy, green products, and, on occasion, University of Texas Longhorn sports.

Monday, November 13, 2006

Yet Another Mutual Fund Industry Scandal

The SEC is investigating 27 mutual fund companies, along with fund service provider Bisys (NYSE: BSG), for allegedly paying kickbacks in return for fund servicing contracts. In addition to the market timing scandals of 2003, this provides another black eye for an industry that has long been a cesspool of corruption and long overdue for regulatory scrutiny.

Bisys provides back office processing work for various mutual fund companies. They might perform the fund accounting, prepare the statements and confirmations, mail out all correspondences to customers, etc. It is not bad work if you can get it, because the process is mostly automated, and it provides annuity-like revenue streams for the company. Usually, the service provider charges the company a percentage of assets under management, just like the management company itself, even though the marginal cost of adding additional investors is close to nothing.

The allegations are that Bisys and fund management companies colluded to overcharge investors for these services. Bisys then provided a "rebate", which amounts to a kickback, back to the management company. Because expenses are deducted from the fund before prices are calculated, this whole process is invisible to fund investors, who are getting robbed. This case is only the tip of the iceberg, as other fund service companies have come under scrutiny as well. The largest fund complexes typically do their own processing, so the fund companies under the microscope are smaller private-labelled funds, such as those pushed by your bank branch.

When I say "tip of the iceberg", I am referring to the myriad ways that funds management companies are getting kickbacks. Fund servicing is only one. For example, many companies, including the largest fund complexes, get overcharged on transaction costs in return for free research, office equipment, data terminals, even office space and travel junkets. Broker A charges Fund B 50 basis points per share when a reasonable cost might be 5 basis points. Transaction fees are not included in the quoted expense ratios, but those other costs are. The fund gets to publish a lower expense ratio, even though their actual expenses are probably far higher.

The real outrage here is that the "mutual" in mutual fund has been totally perverted. In the beginning, mutual funds evolved so that small investors could pool their funds, creating an economy of scale that could enable them to hire professional management and decrease their expenses. Since the 1980's, mutual fund assets have risen twenty-fold, but expense ratios have actually inched up a bit. At the same time, the digitalization of trading, trade processing, and clearing have enabled fund costs to go down. Lower costs distributed across many more investors should have equated to dramatically lower fund expenses. Instead, those savings are going straight to the bottom line of the fund industry and their willing (sometimes colluding) partners.

Far be it from me to say that fund companies should be exempt from raising their prices, just like any other business. However, they are doing so in ways that are not transparent. Fund investors do not even know they are being overcharged for services, until 30 years down the line when they notice that their fund underperformed the market benchmarks by a percent or two every year. That does not sound like much, but it can mean that your nest egg is half or a third what it would have been had the "mutual" in mutual fund remained.

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