In the broadest terms, aside from 401(k) and similar plans there are two ways you can buy mutual funds. You can seek the recommendations of brokers or other salespeople. Or you can pick them yourself after doing research and reading.

The first way is easier. But is it better? That question is the focus of this article.

Three business professors conducted a study on this very issue, comparing what happens in real life when investors choose funds themselves vs. relying on brokers to choose them. The research was based on a variety of industry data from 1996 through 2004, representing trillions of dollars invested in mutual funds.

The professors found some striking differences when they looked at the funds that were purchased by two groups of investors.

One group, those who chose funds on their own, were called customers of the “direct channel.” The second group, who paid brokers for fund selection and advice, were called customers of the “broker channel.” This channel includes commissioned advisors and salespeople who may work for banks, brokerages and insurance companies.

For the record, this study was done by Daniel Bergstresser of Harvard Business School, John M.R. Chalmers of the University of Oregon and Peter Tufano of Harvard Business School and the National Bureau of Economic Research.

They began with the premise that investors inevitably pay higher costs for using the broker channel. They wanted to know what benefits investors received in return for those higher costs.

Specifically, they asked: Do broker-channel investors get help choosing funds that are harder to find or harder to evaluate? Do they get access to funds with lower costs? Do they get access to funds with higher performance?

In the end, the study failed to find compelling evidence to support any of those hypotheses.

All mutual fund investors pay for hiring managers to select securities and for operating expenses. But many investors choose to pay substantial additional fees to brokers and salespeople. How much is “substantial?”   

The study found that the industry collects more than twice as much in total fees and expenses on broker-channel funds as it does on direct-channel funds.

To understand this, it’s important to know the difference between marketing costs (called distribution expenses in this study) and the normal fund expenses for management, administration, custody, transfer, audit, agency, legal and board functions. Collectively these expenses are referred to in the study as non-distribution expenses, and all shareholders pay them. (I’ll refer to these costs as operating expenses).

Distribution expenses, on the other hand, are optional depending on which channel investors use to buy funds. Make no mistake about this: distribution charges are big business. The professors estimated that in 2002, mutual fund investors paid $8.8 billion in 12b-1 fees. (A recent report by an industry consultant estimated total 12b-1 fees were $11.8 billion in 2006).

In addition, the professors estimated that broker-channel investors paid another $3.6 billion in front-end loads (sales commissions) and $2.8 billion in back-end loads. That’s more than $15 billion in a single year in charges that investors could easily avoid.

As a group, the investors who pay all these billions of dollars in distribution charges should get something valuable in return. But do they?

To find out, the professors compared funds’ costs and performances before any distribution charges. Summing up what they found, the professors said:

•    Brokers are not directing investors to less-expensive funds than those bought directly from fund companies.
•    The funds that investors bought through brokers have lower reported returns than direct-channel funds.
•    There is no evidence that broker-channel investors wind up with the higher risk-adjusted returns that would be expected if those investors had superior asset allocation.
•    Investors pay about $15 billion a year in unnecessary distribution charges, which directly reduce their returns by that amount.
•    Equity and bond funds bought by broker-channel investors deliver substantially lower performance that costs investors about $9 billion a year.   

Financial arrangements

Direct-channel investors have fairly straightforward financial relationships with mutual funds. The broker channel involves more complex arrangements and incentives to brokers that often are not clearly disclosed.

In the direct channel, Vanguard funds are often cited as the epitome of no-load funds that attract new customers through advertising and word of mouth. These funds don’t normally charge any distribution expenses, and their operating expenses (commonly expressed as an annual expense ratio) are legendarily low.

Many no-load funds charge an annual fee, known as a 12b-1 fee and typically 0.25 percent, for distribution expenses. Because Vanguard and other “pure” no-load funds don’t charge this fee, the three professors regard it as unnecessary and avoidable. In a bit, we’ll look at the effect of this seemingly small fee on a long-term investor.

The professors attempted to measure some of the things that brokers might do in order to earn the extra money that investors pay in distribution costs.

Finding and analyzing funds

Left to their own devices, most investors would choose funds that are relatively easy to find and analyze. That means funds that are bigger, older, tracked by financial rating services and well covered in the media. And in fact the direct channel is dominated by a small number of very large, established and well-known funds. (Three examples: Vanguard 500 Index, Fidelity Magellan and Fidelity Contrafund.)

Such funds are easy to find and easy to choose. But many investors may want help with sorting through the thousands of available funds. Some funds are harder than average to find and analyze. Examples include new funds, small funds and funds not covered by Morningstar Inc. Do brokers help investors by specializing in such funds?

The professors found that brokers do offer funds that are considerably smaller in asset size and more likely to be less than three years old. It may be that this is one place brokers and salespeople believe they can add obvious value. After all, who wants to pay a broker to recommend something that everybody else is buying?   

But do these harder-to-find funds produce higher returns? The professors found no evidence that they do.
Finding less expensive funds

It’s no secret that lower expenses lead to higher net returns. An industry survey in 2004 found that more than 93 percent of fund investors said limiting investment expenses was an important reason for owning mutual funds. As the professors’ study points out, “Inserting a paid broker into the fund selection process seems to potentially increase the total costs” paid by investors. Because brokers cannot change the performance of the funds they sell, these extra costs must inevitably reduce performance.

Many direct-channel investors pay modest distribution expenses in the form of 12b-1 fees that are usually capped at 0.25 percent. But the study found that the industry collects five times as much in distribution charges from investors who buy funds from brokers than it collects from investors who buy through the direct channel.

Do brokers overcome this cost disadvantage by helping their clients find funds with lower operating costs?
Weighted by assets, the professors found that broker-channel equity funds charged operating expenses that were two basis points (0.02 percent) higher than direct-channel equity funds. Broker-channel bond funds charged 23 more basis points.

This latter figure is particularly disturbing, because keeping costs down is considered to be of paramount importance when choosing a bond fund.

The study’s conclusion: Investors in the broker channel tend to pay not only much higher distribution costs but higher operating costs as well.

Steering investors to higher-performing funds

In the end, performance is what investors want most. So it’s very reasonable to ask: Do brokers steer investors to funds with performance that’s higher, before distribution expenses, than that of the direct-channel funds that investors buy?

The professors say that as far as they can tell, the answer is no. Citing “remarkably consistent” results, they say they found “no evidence that funds sold by brokers outperform those sold through the direct channel.” On the contrary, they said brokers steer investors toward equity and bond funds that deliver “substantially inferior performance,” even before considering 12b-1 fees, front-end loads and back-end loads.

This underperformance costs investors approximately $9 billion a year, the study concluded.

The $9 billion question

If investors who buy through brokers aren’t getting lower-cost funds or higher-performance funds, you might wonder: Just what are they getting? The professors wondered about this, too.

Having concluded that “it is unlikely that the benefits of brokers lie in their superior mutual fund choices, asset allocation decisions or superior cost management for the investor,” they surmised that any benefit from the broker channel must be less tangible. “For example, brokers may help investors save more, better customize their portfolios to risk tolerances” or achieve higher levels of comfort with their choices.

In the end, the professors were unable to measure those things.

However, it is very easy to measure the real-world cost of paying distribution expenses. So let’s turn our attention to that.

A benchmark

To tackle this issue, I began by setting a relatively simple benchmark to represent what a direct-channel investor might easily do: Create a balanced portfolio made up of two high-quality, low-cost pure-no-load funds, one in stocks and one in bonds.  

Two funds that meet that description are readily at hand: Vanguard’s Total Stock Market Index and Total Bond Market Index funds (VTSMX and VBMFX). The stock fund’s annual expenses are 0.19 percent, the bond fund’s are 0.20 percent. Over the 10 years ended May 31, 2007, the stock fund had an annualized return of 8.25 percent, the bond fund 5.9 percent.

To keep things very simple, I computed the hypothetical results for an investor who started with $6,000 in the stock fund and $4,000 in the bond fund (representing a 60/40 portfolio) and who made no additions or withdrawals for 10 years. With those assumptions, the portfolio would slightly more than double to $20,353.

Next, I wondered what the effect would be of increasing those funds’ operating expenses by the amounts cited in this study: 23 basis points for the bond fund and two basis points for the stock fund. That would mean reducing returns by those amounts respectively, to 8.23 percent for the stock fund and to 5.67 percent for the bond fund. Over 10 years, that would result in a portfolio worth $20,176.

That difference isn’t much. But it is unrealistic because it ignores distribution expenses, an inevitable drag on performance. So I recalculated this result assuming additional expenses of 0.25 percent (a typical 12b-1) fee for each fund. That would reduce annualized performance to 7.98 percent for the stock fund and to 5.42 percent for the bond fund. Over 10 years, that would result in a portfolio worth $19,711.

These calculations are fairly straightforward, based on two extremely low-cost index funds that many brokers are unlikely to favor. To seek a more real-world result, I decided to look under the hood of a single equity fund so I could examine what it costs to own a fund portfolio on a no-load basis vs. what it costs to own that same portfolio in shares that charge a front-end load and those that charge a back-end load.  

Share class warfare

The $7.7 billion Putnam Voyager Fund (a U.S. large-cap growth fund) turned out to be a good one for this comparison. Putnam doesn’t market no-load shares of this fund to the public, but its Class Y shares impose neither a sales charge nor a 12b-1 fee. These shares are available to institutions and might show up in a 401(k) plan, for example.

The same fund has Class A shares that impose a front-end load of 5.25 percent and Class B shares with a maximum back-end load of 5 percent. The underlying portfolio is identical for each of these variations; the difference in performance should all be explained by fees and expenses.

My first question: What are the standard expense ratios of these three funds? Class Y expenses are 0.79 percent, representing operating costs of management, administration, legal, audit and so forth. Class A expenses are 1.04 percent, explained by the addition of a 0.25 percent 12b-1 fee. Class B expenses are 1.79 percent, explained by the addition of a 1 percent 12b-1 fee.

Figuring out the effect of these differences in real life is not tough, though it requires two more steps each for the Class A and Class B shares.

For the Class Y shares, Morningstar reports an annualized 10-year return of 5.49 percent through May 31. That is the result of gaining access to the portfolio and portfolio managers after paying only operating costs – but no distribution costs.

Assuming an initial investment of $10,000 held without additions or withdrawals for 10 years (not likely to be possible in a 401(k) plan but theoretically valuable for this comparison), that would compound to $17,065. That’s the return of the fund’s portfolio when the investor does not have to pay any distribution costs.

For the Class A shares, the reported 10-year return is 5.23 percent, reflecting the effect of the 12b-1 fee. Over 10 years, that would compound to $16,649. The 12b-1 fee thus cost the investor $416. (This number overstates this return by ignoring the effect of the front-end sales load, which we’ll look at presently.)

For Class B shares, the reported 10-year return is 4.44 percent, reflecting the effect of the much higher 12b-1 fee. Over 10 years, a $10,000 initial investment would compound to $15,441.

However, neither of the last two calculations is entirely accurate. Here’s why:

Investing $10,000 in the Class A shares requires paying a 5.25 percent load at the start. That means only $9,475 would be invested in the fund’s portfolio. Compounding at 5.23 percent for 10 years, that $9,475 would grow to $15,805. Compared with the Class Y shares, this means the investor would have effectively paid $1,260 in distribution costs over the 10 years – nearly 13 percent of the initial outlay – to get into this fund.

In the case of the Class B shares, they automatically revert to Class A shares after eight years. That means the investor would pay lower 12b-1 fees for the second half of the 10-year holding period. I calculated that this would result in a holding worth $15,675 after 10 years. That reduces the effective distribution cost expense to $1,390 – nearly 14 percent of the investor’s initial outlay.

Over a 10-year period, these differences may not seem monumental. But if an investor held these funds for 30 years, the differences become quite striking.

Assuming the same rates of return, Class Y shares would grow in 30 years to $49,698. Class A shares would grow to $43,729. Class B shares, again assuming they converted to Class A after eight years, would grow to $43,452. Over this period, the distribution costs in this fund would amount to $5,969 in the Class A shares or $6,246 in the Class B shares. In each case, that is well over half the investor’s initial outlay.

Advice

I believe this is an unreasonably high price to pay for somebody to help an investor with the initial selection of a mutual fund. Of course many brokers and other advisors provide additional valuable services, and they should be paid for those services.

But investors will usually do better to pay separately for the services they need and receive. And they will usually do better if they pay directly instead of indirectly through commissions and incentives that create potential and real conflicts of interest.

This is an issue to which investors pay too little attention. Jeff Merriman-Cohen, chief executive officer of Merriman Berkman Next, likes to discuss this in terms of a simple question: Who writes the check?

His point is that whoever pays an advisor or broker is the one the advisor or broker is really working for. If you pay an advisor directly for advice or other help, you are (or should be) the real client, the one in the driver’s seat. But if the advisor is being paid by a mutual fund company, then that company may be the one in the driver’s seat, even though the money ultimately comes out of your pocket.

I sometimes say this more bluntly. From the point of view of the advisor, if you buy a mutual fund on commission, the mutual fund is the paying client and you are the tool that the advisor uses to get the fund to pay the commission.

But if you pay the advisor to solve a problem for you by obtaining a no-load fund, you are the client; the mutual fund is the tool. This is much better for you.

It’s not that tough to do the right thing when it comes to buying mutual funds. Just say no to any fund that charges any sales load or a 12b-1 fee greater than 0.25 percent. Better yet, buy “pure” no-load funds that don’t charge any 12b-1 fees. If you need help to determine the best funds to buy, pay for that help separately from somebody who can be objective about what to recommend.

If you take this advice, it should put more dollars in your pocket and more peace of mind in your head.