Somewhere over the jungles of Southeast Asia, I developed doubts about the perfectibility of man. Idealism quickly faded to pragmatism and realism. Watching Wall Street at work for over 20 years has not restored my faith. Fortunately, as realistic and pragmatic investors we can thrive and prosper in a jungle where not everybody wears white hats. Our job as good capitalists is to use the very best of a wonderful system while continuing to press for improvements where necessary.
Forcing improvements is remarkably simple. We don’t have to go on a mission or lead a charge. We can leave the moralizing to somebody else. Just refuse to patronize firms that abuse investors. A loss of market share will do more to help Wall Street’s denizens develop ethical business practices than a million new regulators.
While our focus is mutual funds, the problems we will discuss in this chapter are found in any form of managed accounts on Wall Street. Angels may not fear to tread on Wall Street, but they don’t exactly flock there either. I don’t want to imply that only devils are in residence on Wall Street; plenty of honest and competent professionals labor away there. We must suspect that both devils and angels are randomly distributed on Wall Street as in any other profession.
Mutual funds have been remarkably free from major scandal since Robert Vesco raped IOS over 30 years ago. They are perhaps the best regulated, audited, and straightforward investment mechanism available to us. As a result, fund managers have fewer chances to screw around with your money than many other Wall Street enterprises. But devious minds can always find a way to extract a little more than they are due.
Our mission is to explore the issues, learn the right questions to ask, and realize we have an absolute right to the answers. Then we can avoid those who either refuse to answer or give the wrong answers.
Advice from Mom
My mother once concluded a discussion about right and wrong with the observation that I would be all right if I never did anything I wouldn’t care to explain in church or see printed on the front page of the local newspaper. While philosophy was not exactly my favorite subject, this seemed a remarkably good system for judging ethical behavior. Of course, this sets a much higher standard than simply complying with the law or following regulations.
The gulf between compliance and ethical behavior can be enormous. Richard Breeden, a former chief of the SEC, once remarked to an assembled group of investment advisors that before his term ended he wanted, “to convince Wall Street that there is more to ethics than getting through the day without being indicted.” I hope he wouldn’t be offended if we observed that perhaps he finished his term before accomplishing his objective.
Most of the time, Wall Street complies with the law, but there is plenty they probably wouldn’t relish explaining to the local church. And a discussion of many of their business practices in the local papers always makes them squirm.
A Little History Lesson
As part of his campaign to restore faith in the markets, President Franklin Roosevelt’s administration had a series of laws enacted during 1940 and 1941 that regulated the securities markets. The Securities and Exchange Commission (SEC) was created and given broad powers. However, the SEC was encouraged to delegate many of their powers to industry Self Regulating Organizations (SROs).
As regulators, SROs fall far short of perfection. The chickens have been entrusted to the foxes.
NASD: The Name Says It All
The National Association of Securities Dealers (NASD), is the SRO entrusted to regulate broker-dealers and dealers in the over-the-counter market (NASDAQ). As the name implies, the NASD is an association of securities dealers. The majority of the members hale from the securities industry. Protecting the interest of securities dealers is their primary concern. While token representation is required for investors, in practice these minority members are remarkably tame lap dogs.
Regulations enacted by the NASD must be approved by the SEC, so there is constant pressure from above. Reform continues, each year a little better. But, like any good industry or trade association, true reform is resisted with great enthusiasm. What’s good for business is not always what is best for investors.
However, the appearance of high integrity is of the utmost importance. Confidence in the markets must be maintained, or investors will refuse to play. An enforcement mechanism exists that occasionally doles out harsh punishment to the worst offenders. In legend, at least, many elements of organized crime are reputed to patrol their neighborhoods on the theory that street crime is bad for business. Some activities are clearly beyond the pale. So a member who steals from clients, or embezzles from his firm, can expect to be banished with great dispatch. However, in gray areas we have come to expect all the moral sensitivity from the NASD that we find from the American Bar Association. Unfortunately, there are lots of gray areas in the securities business.
We can boil down the important issues to three areas, with some overlap: cost, conflicts of interest, and disclosure.
Given the enormous increase in assets under management in the mutual fund industry, we should expect to see a sharp reduction in expenses as a percentage of assets under management. Yet expense ratios have steadily increased. Consider the following: Assets under management by fund companies now exceed $2.7 trillion, an increase of 3,260 percent in 15 years. Stock and Bond Mutual Fund Fees will exceed $19.4 billion in 1995. Yet during the same time frame, average expense ratios have increased from .71 percent to .99 percent. (Wall Street Journal, November 28, 1995, and Morningstar.)
There are some justifiable reasons for increases in expenses. New asset classes such as foreign, emerging market, and micro cap are more expensive and difficult to trade. Consumers are demanding more and more services from fund companies. And, funds that cater to smaller investors will naturally have higher expenses than funds with higher minimum investments. Each investor, no matter how large or small, represents a fixed expense for mailings, prospectuses, etc.
But, given the economies of scale, and the efficiencies introduced by technology, there is just no excuse for increases in expense ratios of that magnitude.
We turn to one of America’s great philosophers, David Letterman, to explain this mystifying cost creep. When he asks why a dog licks his privates, his answer is: “Because he can!” Like the dog, mutual funds have found that they can increase expenses. Investors have been remarkably docile when it comes to accepting these cost increases. As long as they will roll over for it, investors can expect more of the same. They have nobody to blame but themselves. The cure is to focus on expense ratios, and reward funds and families that reduce costs.
Mutual Funds Marketplaces
When Charles Schwab created the mutual fund marketplace, investors and advisors flocked to embrace the concept. The convenience of being able to buy hundreds of funds with a single phone call, to receive a single consolidated statement, to have next day settlement, and to enjoy the safety of an exceptionally strong custodian justified the nominal transaction fees for many investors. The service was a runaway sensation.
The participating fund families received a marketing windfall. Schwab became an unbeatable distribution network at no cost to the funds.
As custodian of the funds, Schwab was required to assume many of the administrative chores that the funds normally supported. It became Schwab’s responsibility to mail out prospectuses, semi-annual and annual reports, proxy requests, and tax information. Schwab also provided accounting services for the funds in their omnibus account for all the fund shareholders using the service.
The next step was equally brilliant. Schwab offered to waive the transaction fee for fund families who agreed to pay Schwab between 0.25 and 0.35 percent per year. The No Transaction Fee (NTF) service was an even bigger hit with investors and fund families.
Initially, Schwab promised that fund families would not be allowed to pass the fee on to investors. The funds were receiving a windfall in two dimensions. The distribution channel was more cost-effective than anything else the no-load families had been able to generate for themselves. And, Schwab provided meaningful custodial services that relieved the funds of the costly burden of doing it themselves. In theory, no investors would ever pay a higher cost for an NTF fund than if they purchased it directly from the fund.
Right out of the box, some fund families found ways to pass on the additional costs. Some created entirely new classes of shares with the fees buried in either a generous management fee or a separate 12(b)-1 fee. Others have slowly increased their expense ratios to compensate. In practice, all investors of the NTF funds are having to pay for the service whether they use it or not.
For Schwab, the service generates an incredible cash flow, an annuity that can be expected to continue forever. However, not withstanding the success of the program in attracting assets, Schwab claims that it is not yet horribly profitable. The NTF service may attract a high percentage of small accounts that generate frequent trades — the worst of all possible worlds for brokerage firms.
Schwab’s fee to the fund families is a very high percentage of many funds’ total expense ratios. For a few, including many index funds, the fee exceeds the total expense ratio. Many simply cannot afford to pay. Those funds risk being denied shelf space (or at least prime shelf space) at Schwab’s store.
Of course, the success of the NTF program has spawned numerous competitors. Fidelity, Jack White, and other discount brokers have jumped on the bandwagon. However, Schwab’s fees to the funds have become the industry standard. Due to the structure of the program, no competitor could pass on a lower fee to investors even if they wanted to, and there is little to entice them in that direction.
The discount brokerage/NTF program is rapidly becoming the investor’s vehicle of choice. Today, no no-load mutual-fund family can afford to ignore the programs. Unfortunately, the NTF programs are a strong factor in cost creep. NTF funds have on average 50 percent higher expense ratios than other no-load funds.
Have Your Cake While Eating It, Too
Smart investors can develop a strategy to have their cake and eat it, too. A knee-jerk decision to use only NTF funds can be penny wise and pound foolish. It just takes a few seconds to calculate the trade off between the annual, embedded, hidden NTF fee, and a one-time transaction fee. Investors will quickly discover that they are often far better off paying the transaction fee. In some cases (large purchases) they can recover the transaction fee in less than a year. For instance, a $100,000 purchase might generate about a $300 transaction fee, while an NTF fund might cost in excess of $350 per year in additional fees inside the fund.
We have adopted a policy of placing the buy-and-hold core positions in index funds for their very low, annual, expense ratios and low trading costs. Here it definitely makes sense to pay the transaction fee. Smaller positions in NTF funds are used as the rebalancing mechanism for periodic small purchases for clients making repeat deposits or to generate a stream of income via redemption for our retirees. The resulting blended portfolio has a very low, annual expense ratio, and almost never pays a transaction fee after the initial purchases.
The Roll of Independent Directors
We might be tempted to wonder where the independent directors are while these cost increases are being rammed through to unsuspecting investors. By law, each fund must retain independent outside directors to represent the interests of investors. We would expect them to fight to the death for the rights of shareholders. Recognizing that cost is the enemy of the investor, our directors should resist increases to their dying breath. In practice, mutual fund independent directors lack any discernible backbone, and appear to be born with rubber stamps attached to their little hands.
Directorships are one of the ultimate plums of American society. Presumably only leading citizens who have “made their mark” are asked to serve. Board membership immediately places you among the power elite. In some ways it may be preferable to a seat in the U.S. Senate. Prestige and honor are great, compensation is generally nominal, and service is not generally considered burdensome or overly taxing. In return for dispensing a little wisdom, directors usually fly first-class, stay in five-star hotels or resorts, and enjoy rubbing shoulders with other truly great people.
Only a hard-core cynic could suspect that these great people could be influenced by a mere $10,000 to $20,000 honorarium. But suppose a fund family appointed this same great director to 20 or 30 separate fund boards at once? Now we are talking about some serious pocket money. Perhaps in this context even a truly, truly great director might find a request for an increase in management fee within the realm of the reasonable.
Perhaps there is a kinder explanation. Somehow it has eluded me.
I find it truly puzzling how outside directors on hundreds of fund boards can mindlessly approve the imposition of new 12(b)-1 fees. These fees are perfectly legal. And funds with 12(b)-1 fees may still have low to reasonable expense ratios. They allow funds to charge present investors so that the fund can go out and attract other investors. It’s easy to see how a 12(b)-1 fee helps fund management. The extra charge allows them to go out and attract more investors and generate even more fees. But it’s impossible to justify on behalf of existing investors. What possible benefit could they accrue? Yet outside directors supposedly represent existing investors.
The most charitable assessment possible on the roll of outside directors would be that they have been spectacularly ineffective in representing the shareholders they are charged to protect. The watch dogs are little better than lap dogs.
While we may not applaud 12(b)-1 fees, and we may not enjoy overall expense creep, at least these items are fully disclosed. The facts are right out there for all of us to see. We are free to avoid funds with high fees, and if we don’t, we have no cause to complain. The fault is ours. There are many very low cost funds and families from which to choose.
Deals Cut in the Dark
Other areas are inadequately disclosed, less understood, and occupy a gray area. The NASDAQ (National Association of Securities Dealers Automated Quotation System) market by its very nature encourages grayness. The NASDAQ market is really a group of dealers loosely tied together by a computer network. As the name would suggest, the NASDAQ market is regulated by the NASD.
Dealers publish a bid and ask price for stocks in which they make a market. Dealers buy at the bid and sell at the ask price. The difference is known as the spread. Spread represents profit to the dealer. Spread, of course, is also trading cost to the investor.
Spreads tend to be higher on small, seldomly traded stocks and bonds, and lower on larger, more frequently traded issues. A number of academic studies have found that the spread on NASDAQ trades is higher than would be the case if a stock with the same size and volume were traded on a listed exchange.
In theory, with a number of market makers for a stock or bond, competition will force the spread to a minimum. In practice, there appears to be little such pressure on prices. Once a spread becomes accepted, if all the market makers hold the line, then all of them will have higher profits. It is not necessary for all of the market makers to get together in a smoke-filled room for a loose conspiracy to emerge. Cases of retribution, harassment, and abuse directed against market makers who cut the spread have been extensively documented.
As you might expect, when these practices make The Wall Street Journal, the NASD studies the problem. Predictably, swift and certain justice has not been the general rule as dealers examine their own very profitable business practices.
Back in the bad old days, before May Day, commissions were fixed, and prices were bundled. All brokerage firms were “full service.” Because there was no price competition, brokerage houses competed based on research and other services. Heavy traders and large accounts could supposedly count on superior research and early warnings of pending events. In addition, a practice of reimbursing clients for other research that the clients carried on developed independently. These payments to clients by brokerage houses became known as “soft dollars.”
While commissions are now fully negotiable, the practice of soft dollars remains, and has been expanded. Today, brokerage firms are reimbursing large clients with computers, furniture, research, and other goodies in return for high volume trading. The problem with this practice as it applies to mutual funds, investment advisors, or other fiduciaries, is that soft dollars accrue to the investment manager, while a larger discount on commissions would accrue to the investors. One must suspect that the client investor ends up with higher brokerage costs, and the manager has a reduced incentive to minimize such costs.
Soft dollar practices are a clear conflict of interest for investment managers, including mutual funds. Inadequate disclosure makes it impossible for investors to properly assess the impact of costs on their portfolios. Investors who believe that they are paying a manager or fund to do research might be surprised to find that the fund or manager is “double dipping.”
Paying for Order Flow
Closely related to the soft-dollar practice is paying for order flow. Especially in the NASDAQ market, large accounts or frequent investors can expect payments from brokerage houses for order flow. If payment for order flow went to the investment account, it would simply represent a discount on commissions and benefit the investor. But these payments go directly to the manager.
This practice eliminates much of the incentive for managers to search out and demand the best possible execution. Again, lack of disclosure makes it difficult or impossible for investors to accurately determine the impact on the portfolio. After October 2, 1995, the practice of payments for order flow must be disclosed.
Often firms justify the practice as resulting in prices no worse than the best quoted price. But this argument is self-serving and simply doesn’t hold water. First, why shouldn’t the payment be credited to the investment account? Next, in this cozy little arrangement, where is the incentive for the investment managers to kill for the very best price and execution on behalf of their clients?
Lest you begin to believe that this is an occasional aberration rather than business as usual, consider the case of Charles Schwab’s attempt to end order flow at their fully owned market-maker subsidiary. Schwab announced an improved order system where not only would Schwab check all market makers for the best published prices, they would also do a thorough search of all standing but unexecuted orders for an even better price.
By making this extra effort, Schwab could guarantee buyers and sellers the very best possible prices, and execute many trades inside the spread. In return for improved prices, Schwab proposed to end the practice of order flow payments made by their subsidiary. When Schwab made their proposal in October, 1995 it was greeted by wide praise in the media, and even received favorable comment by the SEC.
It was not to be, however. Schwab was faced with a client revolt, and a threat of the loss of massive business. They were forced to withdraw the proposal in December, 1995. Brokerage houses and investment managers expressed their clear preference to continue to receive under-the-table kick-backs rather than the best possible price for their clients.
Directed Trades and Fee Sharing
Large broker-dealers can exercise considerable power over the outside load mutual funds that they distribute. In return for shelf space in their store, they routinely ask for and get a share of the fund’s management fee, increased sales allowances, or require the fund families to kick in for other marketing expenses. These expenses will be reflected in the funds’ expense ratio. Of course, this practice contributes directly to cost creep. Of course, funds that have low internal expenses can least afford to pay, so will be relatively disadvantaged in maintaining or establishing a sales network.
Broker-dealers or brokerage houses can require that outside mutual funds direct a portion of their trades through the facilities of the broker-dealer. An arrangement like this reduces the fund’s ability to negotiate the very best possible execution or commission structure for their investors. Directed trade agreements are not disclosed.
Funds that resist these tactics find their access to salespeople reduced, their sales agreements terminated, or the commissions paid to the salespeople reduced. Large broker-dealers have begun to exercise their power over distribution networks in rather brutal direct terms.
A few years ago, one of the nation’s largest broker-dealers requested increased sales allowances from all the outside funds they did business with. To their credit, American Funds refused to participate. American Funds has very favorable expense ratios, excellent marketing materials, a very fine reputation for integrity, and solid performance.
The dispute broke out in public at the broker-dealer’s national sales convention. American Funds, who had contributed over $30,000 to be a sponsor of the convention, was publicly identified as refusing to support the economics of the broker-dealer, and forced to endure the convention president’s request of the sales force to consider this refusal when recommending funds to their clients. In addition, the commissions to the salespeople would be cut on American Funds products to compensate the broker-dealer for American Fund’s refusal to cooperate.
Henceforth, salespeople would be caught between the fine reputation and proven performance of American Funds products and a direct cost to their own pocketbooks. To their credit, the sales force continues to recommend a high number of American Fund’s products. But few fund families have the economic clout (and backbone) to stand up to the big broker-dealers.
Where mutual funds or investment managers are associated with market makers, another interesting possibility for undisclosed profit emerges. Fund managers can funnel trades to a related market maker even where that market maker is not advertising the best price. The associated market maker gets first crack at all trade. If the market maker finds that it can accomplish a trade profitably at the best published price, it can execute the trade. Under preference bidding, the associated market maker receives a steady flow of profitable trades without even having to advertise the best price to the market.
Make no mistake about it. Making a market is a very profitable business. The associated market maker can rack up profits several times greater than the management fee of the fund or investment manager. And the investor is never the wiser. The practices of directing trades to associated market makers and preference are not disclosed. Of course, the profit the associated market maker makes on the trades is never disclosed. The additional cost is impossible to measure with any accuracy. We can say that competition for best possible execution is not encouraged under either practice.
Economic and Moral Implications
These types of practices are at best unsavory. While not illegal, they are a violation of trust. Whether investors pay commissions or fees, they have a right to expect that their representative, fund manager, or investment advisor is acting wholly on their behalf. Unfortunately, today they would be foolish to blithely make that assumption. As we have seen, it is not realistic to expect a self-regulatory organization to vigorously champion the investor’s cause.
Efficient markets are the central core of our economy. Integrity of the markets is not a concern of just a few pointy heads in academia. Efficient markets foster the optimum distribution of goods and services and result in the maximum wealth creation for the entire society. Few things are more important to all of us.
In perfect markets, buyers and sellers both have all the knowable facts available to them. Neither has an advantage. It follows that full disclosure is the appropriate standard.
As investors, we may have little interest in standing on our soap boxes and pointing fingers. Leaving aside a delicious sense of moral outrage, an important issue remains. In the absence of full disclosure, when deals are cut in the dark, we are deprived of necessary information on which to make our decisions. The result is higher costs, inefficient institutions, and less wealth creation for the entire society.
A Few Modest Proposals
It may not be possible to completely avoid all forms of abuse. But the investor is far from powerless. Investors can and should agitate for regulatory reform. This course of action is slow but sure. Our markets are among the cleanest on earth. Each year they improve and the progress is irreversible. Even SROs must react to an outraged public. After all, it’s good for their business. Remember also that this is an election year. Your representative or senator will be especially anxious to respond to your concerns. This stuff filters down. There is nothing like a call from a representative’s office to get the full, immediate, and undivided attention of even an entrenched bureaucrat.
Vote With Your Feet
While we wait for the regulators to discover ethics, investors still carry a very big stick. Never forget, Wall Street wants your money! Nothing gets through to them like a loss or gain in market share. Wall Street has seen regulators come and go, and is prepared to ride out a little negative publicity. But movement of a few billion from high-cost funds to low-cost funds like Vanguard will send a direct and powerful message.
It’s simple. Don’t buy or hold funds with high expense ratios or high turnover. You can improve your own bottom line while forcing reform. Do what is right for you, what serves your own best interest, and Wall Street will come around. Adopt the attitude that Wall Street is there to support you, not the other way around. Reward friends, punish enemies. Demand better, and they will supply it. This capitalism is pretty neat stuff!
Sunlight: The Best Disinfectant
The next step takes slightly more effort. Inquire about the business practices of your funds, managers, or investment advisors. You have a perfect right to know what fiduciary standards they employ. After all, it’s your money! And it’s their job to keep you happy. Demand full disclosure of their business practices and any potential conflicts of interest. You should expect that they act in your best interest alone. Accept nothing less. Reward funds, advisors, and managers who practice good ethics. If not, punish them by moving your funds. Each of you acting on your own, pursuing your own best interest, can enforce higher standards on the institutions that serve you.
To make this inquiry as painless as possible, I have supplied you with a sample letter. Copy it to your favorite word processor. Send it to the president or investment managers of any mutual funds you own or are considering. Email it to any fund family with a Web site, and ask for a public response. Be guided by their response, or lack of a response. Keep the heat on. Let them know you are looking over their shoulders (and let me know what kind of responses you get).
Playing the Hand We Are Dealt
Not being much of a philosopher myself, I refuse to speculate endlessly whether the glass is half empty or half full. From my vantage point, the glass is mostly full. We will leave the moralizing for someone else. As pragmatists and informed investors, we don’t have the luxury of withdrawing in a fit of moral self-righteousness. Rather, our task is to inform ourselves and then choose the best from an amazing number of great tools. That action is simultaneously the best for us and the most effective agent for reform.
Having developed an asset allocation plan and policy for fund selection, we must now turn our attention to important housekeeping details. Administration is not the glamorous part of the process, but it is vital to a solid long-term result. Left untended, your carefully designed garden will slowly revert to weeds.