Wednesday, November 28, 2012

Mutual Fund Investors versus Banks: The Bank Wins

Investors versus Banks:  The Bank Wins

You probably think of your mutual fund holdings as an investment.  You wire cash into the account, and a portfolio manager strives to meet your objective for capital appreciation, income, or capital preservation.  However, the executives who oversee mutual funds look at them as businesses opportunities.  The best part is that those opportunities can be exploited using your investment capital. 

True, the mutual fund has its own board of directors, and a majority of the board members, including its chairman, are supposed to be independent of the advisor.  In practice, the independent directors aren’t very independent at all.  While they aren’t former employees of the advisor or any of its affiliates, they usually have some prior business or social relationship with senior management.  Most mutual fund boards act as well-scripted puppets for the advisor.  The board is given reams of data and sits through endless presentations, but if board approval is required, it will be given.  Mutual fund boards only have a life of their own after something goes wrong.

Shuffling Share Classes (1999)

The advisor is interested in generating more fees.  If a bank or insurance company owns the advisor, they also want to generate more fees.  These aren’t investment organizations.  Rather, they are asset-gathering machines.  As assets flow into the mutual funds, profit margins expand, and few of the benefits are bestowed where they belong: with mutual fund investors.  In previous posts, I’ve written about the various marketing techniques used to seduce potential investors, such as highlighting “hot” performance.  I’ve also pointed out that investors pay for most of these marketing efforts.

In a financial conglomerate like a large bank, the pressure to generate more fee income is enormous.  Most bank executives are fairly far removed from the day-to-day requirements of the mutual fund business.  They simply decide that the people running the business ought to generate 15% or 20% more in profits.  At the same time, the bank executives are loath to invest the bank’s capital in building the mutual fund business.  As a result, the mutual fund executives are left to devise plans that are, at a minimum, in conflict with the best interest of their clients.  At worst, as we will see tomorrow, some of these schemes have turned out to be illegal.

Let’s return to my days at NationsBank and look at two techniques for building up mutual fund profits.  One sure-fire way to increase profits is to shift asset allocation models into higher fee products.  As I arrived at the bank, an effort was underway to add international and emerging market funds to the asset allocation.  Obviously, there’s a good rationale for international investing as it diversifies the source of an investor’s returns.  However, the bank’s true aim was to generate higher fees as domestic equity and fixed income investments were liquidated in favor of overseas investments.  Trust officers all over the country were instructed to make the switch.  By the way, the timing was absolutely awful.  NationsBank waited until international and emerging market returns had been outstanding for three or four years.  When we finally added them to our clients’ portfolios, those markets swooned.  To this day, the asset allocation trick continues to serve as a great way to boost fees.  Quick aside: I could never get never get an index fund into the asset allocation model.  I bet you can guess why.

The bank was also a great believer in common trust conversions.  Common trust funds are very inexpensive investment vehicles organized by bank trust departments.  Unlike mutual funds, they are usually not priced every day, so you cannot buy or sell at the end of each day.  They also don’t have all the marketing and administrative expenses associated with mutual funds.  At NationsBank, we systematically converted common trust funds into mutual funds, generating higher profits for the bank.  Clients got a bunch of glossy reports and daily pricing in exchange for larger fees and in some cases, a whopping tax bill.  While most of these conversions have now taken place, you still have to be alert.  Mutual fund companies are continually closing funds or share classes and transferring balances.  All too often, it is their wallet that is fattened by these actions.

About two months before I exited NationsBank, a group of mutual fund executives came to see me.  At that point I was running TradeStreet, the bank’s largest money manager, which sub-advised all the domestic mutual funds.  My desk was on the trading floor, so they insisted we find a conference room for our chat.  During the year they had signed distribution agreements with brokerage firms to sell our mutual funds.  Despite the agreements and generous sales commissions and distribution fees, the funds weren’t selling.  While the investment performance of most of our funds was competitive, why would a Merrill Lynch or Smith Barney broker want to sell a bank-sponsored mutual fund to a client?  The executives had a potential solution to this problem.  They strongly suggested that I direct a bunch of our trading volume to certain key brokerage firms, and that those firms would then feature our funds.  In a word, my answer was “no.”

The cost of trading was borne entirely by our clients, so TradeStreet’s responsibility was to achieve the best possible execution at the lowest possible cost.  This scheme looked like a case of “pay to play,” and I wasn’t going to play.  Sixty days later, I was out of the bank for entirely different reasons.  I am sure if I had stayed the issue would have resurfaced.   NationsBank was far from the only institution intent on squeezing more fees out of their mutual fund complex.

Tomorrow we’ll cross from the grey zone into the forbidden zone.

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