"Ask Paul": The Next Big Mutual Fund Scandal | Print |  E-mail
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Mutual fund investors may think they've been betrayed by scandals at several big fund companies. But I believe that many investors who sell their Putnam funds are about to be fleeced once again -- and not by the mutual funds they own.

The losses from this second round could total hundreds of millions of dollars, dwarfing those that the regulators and reformers are howling about. What's worse, the investors who incur these losses could easily avoid them -- but they probably won't.

Last week I spoke with a longtime friend, I'll call him Max, a broker with a large national brokerage house. I consider him to be a thoroughly ethical broker who cares about his clients.

But through this conversation I realized that the brokerage industry is eager to reap a huge one-time windfall from sales commissions as investors bail out of Putnam and put their money in other load funds.

This broker says he has heard of at least one employer encouraging its brokers to get clients' money into other load funds by the end of this year in order to meet sales goals and fatten bonuses.

In other words, Wall Street has decided to turn Putnam's ill fortune into a profit center. And that conflict gives Wall Street a huge incentive to play up Putnam's problems.

In Max's case, the majority of his clients' money is invested in Putnam funds, reflecting the fact that Putnam was the most popular load fund family when Max went into the business.

Max said he felt a little bit guilty about encouraging clients to buy funds that will require them to pay new commissions. But he believes he is off the hook ethically because of the government investigations.

I asked Max what funds he is recommending to exiting Putnam investors.

I expected him to tell me he is recommending American funds, a family that's very popular among brokers and advisors who promote load funds. American funds particularly stand out for their relatively low expenses. Max and I agree that low expenses are the most reliable guide to future performance -- and that's what investors want.

So I was a bit surprised to hear that Max is recommending funds offered by Franklin Templeton and Oppenheimer, not American.

I asked why. Max admitted that his clients would likely do better with American funds, but said his employer charges him $50 for every purchase he makes in American funds. Max is not willing to pay that $50 charge.

Better deals

I wondered how other load funds would stack up against Putnam and American funds. To make a comparison, I looked at the Class A shares of four large-cap load funds from four families. For each fund, here's the annualized return for the 10 years ended Oct. 31 along with the annual expense ratio:

The future performance of these funds can't be known. But whatever returns an ex-Putnam investor makes in a new load-fund family will be made on a lower asset base because of the sales commission. (And it might be lower still if the Putnam sale results in taxable capital gains.)

Despite these facts, Max is recommending Franklin Templeton and Oppenheimer funds.

This is a striking example of the conflicts of interest that pop up when advisers are compensated through sales commissions. If a client with $40,000 in Putnam funds reinvests that money in Franklin Growth, for instance, the client would pay $2,300 in a sales commission (at 5.75 percent). Most of that money would go to Max.

Max and other brokers may recommend Class B or Class C shares, which have no upfront sales load. Many investors will take such recommendations, not realizing that the funds they're buying will more than make up the difference by padding their expense ratios.

Max's clients are likely to take his recommendations without knowing a critical piece of information: That Max is recommending what he believes will be an inferior investment because he can earn $50 more by doing so.

What do you suppose the client would do if Max laid out the facts like this: "Look, there are two choices: American funds or Franklin funds. Each one will cost you exactly the same sales commission. American funds is likely to make you more money because of its lower expenses. But I'm recommending Franklin because it would cost me $50 to put you into American funds."

The client would be better off simply paying Max $50 directly. But without this important information, the client never gets that choice and never sees the conflict of interest.

Just say no to loads

The monkey business at Putnam may cost shareholders as much as 0.1 percent of their returns annually. Reacting to that, many shareholders are about to take advice from their brokers, which will cost them much more -- in many cases a whopping 5.75 percent of their entire fund balances.

Investors could avoid those losses by simply saying "No!" to load funds. Those who are willing to take the trouble to invest in no-load index funds could avoid paying those sales commissions. But instead, most of them will rely on their brokers for advice, not realizing they are being taken advantage of.

This secondary scandal may exploit Putnam's problems in a perfectly legal racket that fattens the coffers of Wall Street.

Unfortunately, the industry's windfall will be financed by investors who put their trust in brokers who don't deserve that trust.

Why aren't the regulators and the financial media outraged about this?