Among the myriad of conflicts of interest shrouded by the brokerage industry are payments made by mutual fund companies to brokerage firms in exchange for accessing the brokerage firms’ mutual fund platform, often referred to as ‘shelf space’. The payments, known in the industry as revenue sharing agreements, are driven by the mutual fund companies need for distribution of their products, sort of like cereal makers need for room at the grocery store. A recent article in the Wall Street Journal highlights a recent trend toward brokerage firms demanding higher payments from mutual fund companies for shelf space. The question is how does any of this benefit the client?
Brokers Raise Fees, but Not for Investors: Why You Should Care
Big brokerage firms are finding it difficult to raise fees on their clients who buy mutual funds. So some brokers are turning to a different source for higher fees: the mutual-fund companies themselves.
Starting Jan. 1, UBS roughly doubled the rate it asks mutual funds to pay, seeking as much as $15 for every new $10,000 invested by a UBS client and up to $20 a year going forward. Morgan Stanley Smith Barney also recently raised its rates to $16 a year, from the $13 it previously charged for stock funds and the $10 it charged for bond funds.
The brokerages “are testing to see what they can get away with,” says Alois Pirker, research director at Aite Group, which follows the industry. “They are trying to squeeze more money out of any area they can.”
The payments, known as “revenue sharing,” have long been part of brokerages’ business and are considered perfectly legal. Industry veterans liken the payments to “shelf-space” arrangements, in which cereal companies pay grocery stores to get brand names stocked at eye level.
But the payments are negotiable, experts say, so not all firms necessarily pay the same rates. A few, like Vanguard Group and Dodge & Cox, say they don’t make these types of payments at all. For investors, the fees raise the question of whether brokerages have a financial interest in pushing some funds over others.
The payments can have a huge impact on firms’ bottom lines. Edward Jones, which discloses more information about revenue sharing than its competitors as a result of a 2004 regulatory settlement, says 2011 payments made up nearly a third of its $481.8 million profit.
Wall Street firms say that since the payments go to brokerages rather than to individual financial advisers—who receive separate payment streams—they don’t affect advisers’ judgment in picking funds. However, in the wake of the financial crisis, questions have swirled about whether financial firms really offer the unvarnished advice they often promise.
UBS said rates are merely list prices, subject to negotiation, and that “recommendations are based solely on what’s in the best interest of the client.” Morgan Stanley Smith Barney declined to comment on its move, which, like UBS’s, had been flagged by industry researcher GatekeeperIQ. A review of disclosure forms on Morgan’s website confirms a recent rate increase.
Critics have long questioned Wall Street’s characterization of the mutual-fund payments. John Freeman, an emeritus professor of business and professional ethics at the University of South Carolina Law School, says the payments should be disallowed. “It’s an unholy alliance between mutual-fund firms and brokerages to exploit their customers,” he says.
The legal framework that governs the industry may be inching in the direction critics prefer. One proposal, favored by Securities and Exchange Commission Chairman Mary Schapiro, would make all financial advisers so-called fiduciaries. If adopted, such a rule could raise new legal hurdles for revenue-sharing payments.
In general, legal experts say, brokerage firms can inoculate themselves against legal problems by disclosing revenue-sharing agreements, typically in the fine print on their websites. But as of Monday, the UBS website still included links leading to client disclosures citing the older, lower rates. The company says it updates some materials only periodically.
Similar disclosures on Morgan Stanley’s website changed to reflect newer, higher rates following SmartMoney questions about them.
is the founder and principal of Westchester, New York-based, Fifth Set Investment Advisors LLC, a Fee-Only, SEC registered investment advisory firm. Following a career in equity research, an examination of competing investment management approaches led Ian to create Fifth Set to offer clients customized wealth management strategies built on a foundation of evidence-based financial theory.