Pay to Play

The impact of fees on your investment returns

There is an inherent conflict of interest when a person giving investment advice also works for a sell-side investment company (i.e., a brokerage) that manages mutual funds. Often, their advice will include their company’s own mutual fund offerings regardless of the funds’ merits (or lack thereof). This biased advice can diminish investors’ portfolio returns.

Brokerages are in the business of selling investment products and services like car dealerships are in the business of selling cars. Their goal, despite what they say, is to sell their products and services at the highest price possible.

Many brokerages restrict access to mutual funds from competing brokerages and mutual fund companies. By limiting clients’ choices, these brokerages can sell to their clients the highest-priced mutual funds, which are usually their affiliated funds rather than independent companies’ funds.

These conflicted brokerages disserve their clients when their funds’ expenses inappropriately impair one of the services they claim to provide: investment returns.

Observe, for example, total returns for the following S&P 500 index funds. Each of the following funds has the same simple objective (gross of fees and expenses): track as closely as possible the total return of the S&P 500 index by, generally, investing in the 500 large US companies in the index.

S&P 500 Fund Returns Table

There’s an obvious pattern to the data in the table above: the funds with the highest expenses also had the lowest returns. Each of these funds, however, has the exact same objective, and yet there is as much as a 6.45 percentage point difference in holding period returns!

Some brokerages allow their clients to invest in competing funds, but only for a price. Competing funds must pay the brokerage to make their funds available to the brokerage’s clients. Unfortunately for investors, these payments increase the expenses incurred by the competing mutual fund and, ultimately, diminish their returns. These competing funds, however, may still be a better alternative to brokerage firms’ affiliated mutual funds.

Thankfully, this “pay to play” game is increasingly under the scrutiny of lawmakers. Recently, New York Attorney General Eliot Spitzer announced a probe into the dealings of insurance broker, Marsh & McLennan. It is alleged that Marsh accepted abnormally high bids in exchange for fees they called, “market service agreements.” So instead of offering unbiased advice, Marsh allegedly steered their clients to the highest bidder in exchange for a kickback. This same sort of bad advice is still the status quo at full service brokerages with affiliated mutual funds.

Investors seeking investment advice and/or services should seek the counsel of investment companies whose interests are unbiased, aligned with shareholders’ interests and independent of any conflicts. After all, bad advice, conflicts of interest and high fund expenses could cost thousands of dollars in investment portfolio returns.

Note: A version of this article appeared in the October 27, 2004, edition of The Daily Record, a law and business newspaper published in Rochester, New York. The newspaper, however, put the wrong name on the article (they attributed the article to a co-worker with a similar last name), and they published the wrong title for the article. The newspaper published a correction notice in the October 28, 2004, edition.