mark to the market
scheinbaum
boca raton, fl
aug. 27, 2003
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BEWARE OF 'IN-HOUSE" MUTUAL FUNDS
by Mark Scheinbaum
columnist

BOCA RATON, FL (Aug. 27, 2003)--The publicity ax has fallen on Morgan Stanley (Dean Witter) over the use of "in-house" mutual funds, but the widespread practice is not limited to that venerable firm.
The headlines (WSJ 8/11/03) told about an alleged "contest" where sizable cash prizes would be given to brokers, "teams" of brokers, and branch offices pushing Morgan Stanley's own mutual funds over those of potential competitors.
The story broke when Massachusetts regulators planned charges against the firm for giving up to $100,000 in prize money to brokers, who supposedly never told their clients that the investment decisions might be driven by sales incentives.
One aspect of the story which caused smiles, if not outright laughter around Wall Street trading rooms, was the revelation by regulators that a brokerage supervisor promoting the contest begged his brokers to spread the word about the contest but under no circumstances put anything about it in writing. You guessed it: his method of communication of this wonderful caveat was an e-mail message which anyone could (and did) print out and save.
"In-House" is another word for the old term "Proprietary Funds or Proprietary Products."
How do you know if you own them?
Well, a usually accurate test is to ask yourself, "Are the funds positioned on my brokerage statement carrying the same name as the company on the top of the statement?"
For example, a Merrill Lynch statement showing you own shares in the Merrill Lynch XYZ retirement growth portfolio, or the Merrill Lynch ABC growth and income fund, would be suspect.
This does not mean that mutual funds carrying the name of UBS Paine Webber; Salomon Smith Barney; Morgan Stanley, or Merrill are bad, it's just that they are suspect.
Generally speaking, brokers make higher commissions pushing their own company products. In addition to higher commissions, they might also receive higher "pay out" on commissions in these funds, or both.
It comes down to basic suspicions, the need for brokers today to be purer than Caesar's (or Ken Lay's) wife, and protect a perception of honesty. Loading up clients with in-house funds always leaves open the question "was the investment good for the client, or just for the broker?"
Over the years retail clients have pressured the big "wire house" brokers to carry wider selections of low-load, load, rear-end load, or even no-load funds.
Let's say a Merrill broker gets a 40 per cent "pay out." This means on each $100 in commission, Merrill keeps $60 and the broker gets $40 before taxes and expenses (which can be considerable). The broker might think a certain Franklin-Templeton Fund would suit his client best, and the fund has a 4 per cent "load." A $100,000 purchase would generate 4 per cent commission or $4,000. The broker would get $1,600 and his firm would keep the other $2,400.
But what if Merrill or any other broker was having a sales "contest?" Forget the cash bonuses allegedly offered by Morgan Stanley, let's just say a similar--but perhaps not as proven--fund portfolio sponsored (issued and/or managed) by Merrill paid 4.5 per cent commission. Also, to grease the contest wheels, for 30 or 60 days all sales in the Merill Lynch Cucamonga Emerging Tech Tofutti Fund would receive a 50 per cent payout, instead of the usual 40. (actually it could be much more depending on the seniority and production "grid" achieved by the broker).
The same "in-house" or "proprietary fund" purchase of $100,000 now generates $4,500 for the firm. The broker gets $2,250 and the firm receives $2,250.
Both the broker and his or her firm made more money, and the firm has captured more assets instead of sending the money out to be managed by Franklin, Dreyfus, Delaware, Janus, etc.
If the in-house funds had a reputation for being the thoroughbreds of Wall Street it might not be so bad, but the opposite is true.
A number of years ago Prudential touted the stellar returns of its Pacific Rim (Asia) mutual fund, which had been very well managed. The reason it was news was because (1) compared with competitors there are very few brokerage firm in-house funds which can show a 20, 30, or 50-year track record, and (2) most in-house funds were only moderately successful.
Investors have a thirst for investment information and investment choice, and seem to thrive better with more independent opinions and choices, rather than the captive audience approach. This might be just anecdotal on my part, but I think this philosophy has fueled the growth of discount and online brokerage firms.
It's similar to getting one kind of auto insurance at Sears (Allstate), or having an independent agent pick and choose from many companies offering various programs for your lifestyle and type of car.
The savvy consumer needs to do some homework in any case. In the story about Morgan Stanley, for example, Massachusetts investigators said they were also checking into brokers pushing Van Kampen funds ahead of other funds. Not every investor (unless they read the prospectus carefully) would know that Van Kampen is owned by Morgan Stanley.
Again, I'm not making a blanket statement that in-house funds are "bad" per se, but think there is tremendous validity in the text of the WSJ report which noted:
" Because of the commission structure on Morgan Stanley funds, brokers can take home substantially more money when they sell a Morgan Stanley fund over a nonpartners fund. This information hadn't been disclosed to Morgan Stanley clients."
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MARK SCHEINBAUM is chief investment strategist for Kaplan & Co. Securities, www.kaplansecurities.com in Mizner Park, Boca Raton, Fla. He is a certified NASD arbitrator, and former member of the Government Relations Committee of the Securities Industry Association. He has also served on the local ethics committee of the Gold Coast Chapter of the International Association for Financial Planning.

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