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Steering fund investors to surefire lower returns

Times Staff Writer

Using a broker to buy index-based mutual funds could prove hazardous to your wealth.

That was the conclusion of a recent study of S&P; 500 index funds -- those that mimic the Standard & Poor’s 500-stock index.

These “plain vanilla” funds are essentially commodities, holding nearly identical investment portfolios. The variation in performance among such funds depends almost entirely on the annual fee each fund charges. Those fees can vary dramatically, from a low of 0.07% to a high of 1.45%. The lower the fee, the higher the return to investors.

Therefore, investors who pay a fee to a broker to help them choose index funds should expect the broker to steer them to the lowest-cost and thus highest-returning fund, said Mercer Bullard, coauthor of the study and founder and president of Fund Democracy, a shareholder advocacy group that was a sponsor of the study. Yet the opposite happens, he said.

Investors who bought funds that don’t charge fees to pay the salespeople who market them paid an average of $2.15 in fund operating expenses annually for each $1,000 held in the funds.

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Those who bought through a broker ended up in index funds with average annual operating expenses of $7.04 per $1,000 -- more than three times as much -- and paid the broker an additional $1.56 a year per $1,000 invested.

“Although one would expect using a professional advisor to improve an investor’s performance, instead the investor pays a significant penalty,” said Edward O’Neal, assistant professor at Babcock Graduate School of Management at Wake Forest University in Winston-Salem, N.C. “When investors used brokers they paid twice: First, they paid the broker; second, they paid a penalty in the form of higher fund fees.”

The differences may seem small, but the resulting disparities in portfolio size mount over time. With nearly half of all U.S. households owning mutual funds, and with U.S. mutual funds holding $10 trillion in assets, seemingly small differences are too costly to ignore, said O’Neal, the study’s other author.

How costly are they? The broker-bought index fund would cost $29,560 more at the end of 20 years for someone socking away $500 a month, assuming a 10% annual return before fees. After 30 years, the investor in the low-cost fund would have $1,080,845, versus $942,511 if he invested in the higher-cost index fund. That’s a $138,334 difference.

The study’s authors weren’t criticizing the brokers’ fees -- just the fact that the brokers steered investors into higher-cost products.

Though the study looked only at index funds, the authors said the results were probably indicative of broker-sold funds overall.

“It raises some troubling questions about whether brokers are acting in the best interest of their clients,” said J. Christopher Kerckhoff Jr., vice president of Plancorp., a Chesterfield, Mo., advisory firm. Kerckhoff is a member of Zero Alpha Group, a coalition of independent planners, which cosponsored the study.

Tom Holloman, a spokesman for NASD, formerly the National Assn. of Securities Dealers, which licenses and regulates brokers, declined to comment on the study’s results.

The study’s authors said the results pointed to a little-understood risk for investors who deal with financial salespeople.

Some of the salespeople are fiduciaries, bound by regulation to serve in the best interest of their clients. Others are not. The average investor cannot tell the difference between the two -- a problem that’s not limited to the U.S., experts said.

“Investors cannot clearly differentiate between those professional advisors who are acting in a fiduciary capacity and thus must always act in the best interests of their clients and those who are not and thus may make a product recommendation that favors their best interests rather than the client’s,” said Denys Pearce, managing director of Plan B Financial Services in Perth, Australia. “Although there are substantial fee disclosure requirements placed upon Australian financial advisors, we find that investors often don’t read them and frequently are unable to make valid comparisons.”

The Securities and Exchange Commission is conducting a study of whether a distinction should be made between fiduciaries and salespeople but has come to no conclusion, said Robert Plaze, associate director in the SEC’s division of investment management.

This analysis has taken so long, however, that a group of financial planners -- who must act as fiduciaries -- are suing the agency.

The planners allege that the SEC has let salespeople use the term “financial advisor” for too long, without clearly warning investors about the differences.

In the meantime, mutual fund investors may have to do more research when their advisor recommends a product. At a minimum, they need to ask how the product was chosen, how its fees and returns compare with those of similar products and whether the advisor’s recommendation is partly based on a commission he’d earn on a sale.

“Mutual funds have become Americans’ investment of choice, and the overwhelming majority of funds are purchased through brokers,” Bullard said. “If you are paying a broker for advice, it should get you into a better fund, not an unambiguously worse fund.”

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Kathy M. Kristof welcomes your comments but regrets that she cannot respond to every question. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com. For previous columns, visit latimes .com/kristof.


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