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Brokers' Funds and the Bulls of Pamplona By Stephen J. Butler

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Ever wonder what it might be like to run with the bulls in Pamplona? Young men (including American tourists) deliberately run through the streets of the Spanish city just ahead of a herd of charging bulls. Predictably, accidents happen that are horrible to watch. Keeping that mental image in mind could be highly motivational for the person responsible for your plan's investment choices. It's easy to confuse brains with a bull market.

The New York Times and Forbes Magazine have both weighed in recently on the subject of poor performance at the mutual funds owned by brokerage firms. Combine this with the $300 million class action law suit from employees at First Trust Bank. What's the connection? These employees have a bone to pick over the fact that First Trust offered only their own proprietary funds. In the light of this publicity, any company owner should reflect on whether they have picked quality funds (or a quality advisor) for their 401(k) investment offerings.

If your 401(k) plan's advisor works for a brokerage firm and has recommended only their own firm's funds, the stage is set for a possible disappointment. All brokerage firms can sell a wide variety of funds from many fund families into the retirement plans they offer. Some, however, have as a condition of the plan that at least half the fund selections be from their own offerings. If proprietary funds predominate in a plan, then you have to ask why. Ideally, the funds representing each fund category should be the ones with the highest past performance and/or the lowest annual expenses. Too often, funds owned by the brokerage firm will almost always manage to creep into the mix regardless of quality. To avoid it is like trying to hold back the tide.

Why does this happen? To paraphrase both the NY Times and Forbes articles, the brokerage industry analysts are not paid to be skeptical. They are paid to generate trading business for the firm. The more a fund churns stocks, the more the brokerage firm makes in trading commissions from the fund. Because of this, brokers are directly or indirectly paid more for selling the firm's own funds. Theoretically, this practice was stopped by the SEC only two years ago, but the culture within the firm still persists, and indirect sales incentives still cling like barnacles according to the NY Times.

Cerulli Associates, a research group in Boston, estimates that 80% of the money invested in funds by Morgan Stanley Dean Witter's customers goes into the firm's own funds. That compares with 45% at Merrill; 35% at Salomon Smith Barney; 25% at Prudential, and 10% at PaineWebber.

When it comes to results, the proof is in the pudding. The five major firms had average cumulative three year returns of approximately 60% for 97-99 while the mutual fund industry as a whole averaged 77%. This is a huge difference. Forbes also ranked the various brokerage firm fund families and compared them with the industry as a whole. The results were equally disappointing.

Fundamentally, the problem lies in the status of mutual fund money managers within a brokerage firm. The brokerage industry's fast track tends to be on the investment banking side. The mutual fund analysts, by comparison, are lower on the totem pole. Therefore, anyone with extraordinary stock picking skills wants to work at an independent fund family where they enjoy more stature as a bigger frog in a smaller pond.

For plan sponsors and activist participants, the decision should be clear. It is time to talk with the broker handling your plan and ask to see comparable funds for each fund in your plan that the broker could otherwise offer. In other words, for the growth fund option, ask to see five of the best performing growth funds offered by the firm based on a comparison of three-year average annual results. Look at the past year and at the past five years as well. If one or more of these fund offerings is clearly better than the proprietary fund, insist that a case be made for NOT making the substitution. If the list still includes a few proprietary funds after this cleansing experience, those funds will be there because they made the cut as good bargains for plan participants. Most important, the plan's legal fiduciaries will have demonstrated some common sense and analytical skill on behalf of employee participants. Even if the chosen funds eventually lose the struggle to maintain competitive returns, at least the selection process cannot be faulted.

Marshal McCluen used to say about television that it was the Medium not the Message that was important. In choosing retirement plan investments it is the process; not the outcome. Only the process of choosing is something we can control, and that needs to be above reproach. The future outcome is anyone's guess and subject to the "dark science" of economic forces. All retirement plans should have an Investment Policy Statement which amounts to a list of selection criteria used by decision-makers. (It is wise to demand the same of yourself for your IRA accounts.) If you ask to see your company's written policy it may constitute a wake-up call leading to a thorough review of your plan's investment selection. Ask a simple question, and you could be a winner.