Brokers' Favorites? Funds That Pay Well

Want to buy a mutual fund or exchange-traded fund? There are more than 9,600 choices. If the selection is overwhelming, you can start by picking a fund company. But there are at least 700 of those, including independent firms and firms that are tucked into banks, insurance companies and brokerage houses.

No wonder more than half of households still buy mutual funds through professional advisors instead of buying directly from fund companies. Some of these advisors are paid for their time, but many get a cut of sales fees on the money invested, whether those fees are obvious or not. This group—salespeople, really, although they have titles like financial consultant or registered representative—cost plenty. According to one analysis of 2002 sales fees, front-end loads (the most obvious kind of fee) totaled $3.6 billion, back-end loads (a less obvious kind) totaled $2.8 billion and 12b-1 fees (the least obvious kind) came to $8.8 billion. It cost $23.8 billion to pay the people who buy and sell investments within the funds and to cover the operational expenses of fund companies.

That’s like a Ford that costs $24,000 to make and carries a $15,000 sales commission. Put differently, if investment instructors charged $25 an hour, fund fees paid in 2002 would have bought five hours of advice for every household in America.

Of course, the salespeople are worth their fees if they find funds customers otherwise wouldn’t know about, funds that provide returns large enough to make up for the cost of hunting them down. Do they? Two new studies suggest not.

Professors from Harvard and the University of Oregon looked at more than 10,000 share classes for over 4,500 funds (some funds have more than one share class to denote whether the fees are paid right away or gradually) for the six years ended 2002. They found some evidence that brokers focus on smaller, younger funds, but no evidence of better returns. In fact, the funds sold through brokers did worse than the ones that were bought directly, whether adjusting for risk or not—even before deducting for the sales fees. You’d think salespeople would at least find funds that have lower operational costs beyond their sales fees. They didn’t. Any benefits that exist among brokered funds “must be found along less tangible dimensions,” the authors tactfully concluded.

The benefits to the brokers are all too tangible, of course. Richard Evans, a physicist turned finance professor at the University of Virginia whose previous research showed how some mutual fund companies artificially sweeten their returns, has moved on to broker compensation. He and two colleagues looked at U.S. stock mutual funds over the decade ended 2004, and found that, after controlling for things like return histories, brokers prefer to sell funds that give them the biggest cut.

Perhaps it’s worth it for more investors to read up on mutual funds and pick their own. The first of the two studies mentioned above found that fund buyers who avoid brokers tend to be a little richer and a little better educated than those who don’t, but not much. In other words, many fund buyers who pay brokers can probably do it themselves.

And if I may take that a step further, perhaps the 6,000 or so stocks traded on major U.S. exchanges aren’t much more difficult to choose among than the 9,600 funds, and maybe company reports are long and dry, but no more so than mutual fund prospectuses. Somehow American investors have been infantilized, it that’s not too strong a word, into believing they can’t tell good businesses from rotten ones and buy stocks and bonds for themselves. But maybe more of them can, and at lower cost.

If I’ve listed too many choices here, forget the whole thing and curl up with “The Paradox of Choice,” a 2005 book about how a flood of options has exhausted and restricted consumers instead of freeing them. Good news: It’s available in hardcover or paperback, new or used, through either traditional or online booksellers, and as an electronic book, in either Kindle or non-platform-specific format.