The Little Things Your Broker May Not Tell You

Does your broker treat you right? Can you expect to do any better by switching to the firm across the street?

If questions such as these have been nagging at you lately, a recent report on compensation practices in the investment business might be of interest.

The April study, prepared at the request of Securities and Exchange Commission Chairman Arthur Levitt Jr., identifies several areas that have traditionally made for strained relations between brokers and clients. Several unsavory practices involve mutual funds.

Despite the growing popularity of no-load products, roughly two-thirds of all mutual fund sales continue to be generated through brokers, financial planners and other middlemen who are compensated for their efforts.

Here are some of the study’s recommendations and comments regarding investors who buy funds through advisers:

* Brokerages should pay the same commissions on both proprietary and non-proprietary products.

Firms sometimes reward brokers who sell the company’s brand of mutual funds with a higher payout--a practice not usually disclosed to investors. The panel cited these uneven payouts as an area of particular concern, but also said most of the firms it surveyed no longer operate in this manner.

* Brokerages should encourage fees based on the assets under management for the client rather than commissions driven by transactions.

An ongoing fee arrangement makes it possible for brokers to earn a living even when they recommend that an investor take no action--sometimes the best advice a broker can give.

According to the study, the traditional linking of broker earnings with transactions has created conflicts of interest. Fees based on the size of a client’s assets may “reduce the temptation for [brokers] to create inappropriate trading activity,” the report says.

* Brokerages should prohibit, or at least restrict, sales contests designed to push specific investments.

These competitions “offer resort vacations, VCRs, television sets and other inducements to [brokers] who reach specified sales levels of a particular mutual fund” or other investment, the panel said.

Third-party vendors--such as load-charging mutual fund groups--often pay for the contests. Investors rarely hear about them. Such competitions could result in conflicts of interest if brokers put their own goals ahead of their clients’, according to the report. Contests involving mutual funds tend to be focused around newly launched funds, says Michael Schlein, the SEC’s chief of staff.

* Firms should make special efforts to educate investors and inform them of their rights.

“All brokerage firms distribute [educational] materials to their clients, as required by law,” the report says. “Typically, however, these are done in print so small that only the most diligent would wade through them.”

The panel urged firms to provide clear explanations of risk and return, the role of the broker, a summary of services provided by the firm and procedures for resolving complaints, among other items. The investment-knowledge gap that divides most brokers and clients not only makes for difficult communication, but also puts too much decision-making responsibility on the shoulders of brokers, the panel said.

Daniel Tully, chairman and chief executive of Merrill Lynch, headed the five-person panel that wrote the report.

Another brokerage chairman and CEO, Raymond Mason of Legg Mason, also sat on the panel, as did famed investor Warren Buffett, Harvard Business School Prof. Samuel Hayes and Thomas O’Hara, chairman of the National Assn. of Investors Corp., an investment club group.

For mutual fund investors, the implications of the panel’s findings should be clear: Ask questions, be skeptical about certain products and gain an understanding of financial matters.

Some practices, such as pitching funds promoted in a contest, are very difficult for investors to learn about on their own. But other red flags are easier to spot.

Jerome Bruni, a former Smith Barney broker who now runs his own investment firm in Colorado Springs, Colo., suggests that investors be wary of brokers who mostly recommend their own company’s line of mutual funds.

“It strains anybody’s imagination to believe that the best growth, international or whatever type of fund happens to be that [firm’s] products,” he says.

In recent months, three large brokerages--Merrill Lynch, PaineWebber and Prudential Securities--have decided to eliminate extra payouts to brokers who sell proprietary products, Schlein says.

Although not covered in the panel’s report, investors should also be wary of “churning,” or excessive trading of funds or other holdings, says Stephen Adams, managing director of brokerage Van Kasper & Co. in San Francisco.

“If somebody pays a load, they shouldn’t be taken out of that fund any time soon--it’s a long-term investment,” said Adams, who recently chaired a regional enforcement arm of the National Assn. of Securities Dealers.

Among other questions, the panel recommended that investors ask about a broker’s training, experience and disciplinary record, along with the suitability, risks and costs of specific investments.