It is 9:15 in the morning on a snowy day in the winter of 2003, and I haven’t had my coffee just yet. Or I did but I’m cranky anyway. I am working in the Helmsley Building on Park Avenue and 45th Street in Manhattan. It has been designated a “landmark building,” which really means that you’ll have to pardon the building for the arctic office temps in the winter and the equatorial humidity in the summer. As I sit there dialing the phone, in the shadow of the gargantuan MetLife Building, which we all expect to be bombed any minute, I see an incoming call from a 617 area code. Boston. Here we go …
“Hi Josh, Bill O’Shaughnessey from Fidelity.* How’s yah day going?”
“Ya know, it’s kinda just starting. Is there any way I can call you back?”
“Josh, I just wanted to touch base about our Select Biotechnology fund. Mahningstar has it ranked in the top decile for the last two quahters, and I really think it’s worth a look for your clients.”
“Yeah, I’m sure it’s great, but I really gotta get my day going, the market’s about to open up and …”
“No problem, Josh. Tell you what. My external sales rep James MacDougall’s gonna be in Midtown on Mahch the 21st through the twenty-fawth. Can we put something on the calendah so I can get him in there to see you guys?”
“See which guys?”
“You and the rest of the brokers.”
“They’re all nitwit stock jockeys. They don’t want to meet anyone except Gordon Gekko, and I’m pretty sure he’s a fictional character. Your external James would be wasting his time here.”
“How about if Fidelity buys you guys lunch. They’ll sit through a few slides for that, right?”
“Now you’re talking. Pizza from Naples 45 buys you 20 minutes. Anything longer than that, and we’re talking sandwiches from Cucina.”
“Tell ya what. Let’s do that Wednesday. We’ll make the catering arrangements the day before.”
“Fine, thanks, Bill. I gotta hop …”
“Great! Before you go, let me just confirm your e-mail, fax number, mailing address …”
“Yeah, guy, I have clients to call back …”
“OK, no worries. I’ll just give you a buzz this afternoon to check in. We can go over the fact sheet on that New York municipal select I sent you last week …”
“Oh my god, please. I’ll buy any fund you want, I swear, just make it stop.”
If brokers are the most aggressive and tenacious salespeople on the planet, then imagine the guys and gals responsible for selling stuff to the brokers themselves. You have no idea. The call I’ve just narrated is a pretty faithful amalgam of a few hundred just like it I’ve been on over the years.
Every broker-sold mutual fund family has a pretty serious and regimented sales apparatus to make sure the brokers in each territory are hearing their “stories.” On The Street, brokers call stocks “stories,” but the wholesalers call themes and individual funds “stories.” “Fairy tales” would be a more apt term as I would come to learn, but we’ll get there in a few moments.
So here is how the wholesaler-broker connection works. Pay attention here, because if you have a 401(k) with load funds in it or an IRA at a brokerage firm, this will go a long way toward explaining how your current fund portfolio has come to be.
The wholesalers work for the fund family. Their job is to speak with the brokerage firms in their territories as often as possible without pissing anyone off (mission unaccomplished). There is both an internal wholesaler and an external wholesaler who cover the brokers in each territory or region.
Internals are the ones making the phone calls and sending the e-mails. They are distributing the literature on the various fund offerings and also those “think” pieces that justify never selling anything. The funds don’t get paid their fees when investors go to cash, and so almost every investment company produces the infamous “10 Best Days” brochure. This brochure will say something like “The S&P 500 has returned 300 percent in the last 15 years—but if you were out of the market during the 10 best days, you only saw an 80 percent return.” I’m exaggerating, but you know what I mean. My partner Barry Ritholtz has actually done the math on this most specious of marketing myths. It turns out that if you missed the 10 worst days, you did even better than the chumps who were worried about being fully invested the whole way through. Anyway, that’s the kind of stuff the internals pump out all day.
They also take incoming calls from the brokers they cover and tend to be extremely knowledgeable about their products and very helpful. Over the years, I’ve had great working relationships with many of them from BlackRock to Fidelity to Pimco. The trouble is, they all have phone extensions off the 800 number with six digits, and they tend to get rotated to different territories a lot. You call up one day, and the person who answers is all like, “Oh yeah, Patrick is covering the greater Delaware area, but my name’s Marissa. Can I help you?” And I’m all like, “Not really. I kind of want my dear, sweet Patrick to walk me through something.” Oh, well.
The external wholesaler is the internal’s sidekick. Or vice versa. I actually believe that externals get paid more, and to me they have the much more arduous job of the two. The internal is constantly setting up appointments for his or her external partner to go out and see brokers who should be selling more of their funds to clients. The external has to have a much more extensive and snazzy wardrobe than the internal, because he or she is banging through different brokerages and banks all day long. The external is the person doing the talking while the brokers chow down on whatever catering was brought in for the due diligence meeting.
Often a giant cardboard box full of literature and sales material will be shipped over to the branch a day or two prior to the external’s arrival. I used to jokingly warn the brokers not to open up the box until the sales rep from the fund company got there or else the rep would put the dreaded wholesaler’s curse on us, and it would be seven years of bad luck. The brokers would look at me with blank stares like I was some kind of an idiot and then they’d get back to their phones. Anyway, the external comes in and does the usual dog and pony show. The brokers ask a handful of questions just to be polite, a few of them sleep through it behind sunglasses, and I usually squirt Dijon mustard out of a packet onto my tie. The whole thing is a waste of time if the guys don’t drop at least $100,000 worth of tickets on the fund within a day or so. They almost never did.
And if this all sounds futile to you, keep in mind that it’s only gotten worse with the advent of exchange-traded funds and the growing realization that active management is a farce anyway. And I’ve only been describing the scene at a small or regional broker-dealer; the draconian process of getting in to see a large wirehouse sales force is unimaginable. A Midtown Manhattan branch of a Smith Barney or a Merrill Lynch could have seven or eight of these externals in their offices every day of the week. They all sit in the waiting room with their attaché cases on their laps, pretending to scroll through e-mails on their BlackBerries as they await the precious 15 minutes they may be granted by the Thundering Herd. It all sounds horrible until they crack in. And then it’s absolute nirvana for the wholesaler, who will be paid on tens of millions, even hundreds of millions, in assets coming his way. The thing about wirehouse guys is that they’re resistant to change of any kind; once they start using a product, it tends to stay in their repertoire forever. When you get your fund into that regular rotation, the steam shovel of incoming cash is unstoppable.
The fund family is regulated under the Investment Company Act of 1940. Either the fund families are managing your money themselves using in-house research (like Janus or T. Rowe Price), or they are simply marketing a fund under their own name but using subadvisors to actually handle the investing (like John Hancock, the insurance broker, tends to do).
Either way, the name of the game is assets under management, and the fund families usually offer several share classes in order to entice different brokers to sell their funds to you. I’ll give you a very basic description of the major share classes and how they work:
A shares. A full commission is charged up front, beginning at as high as 5.75 percent and sliding down, based on how much you put in (a breakpoint discount). The broker is paid that day by the fund family. The negative is that you start off 5 percent in the hole on day one. The positive (and I use that term loosely) is that your shares are free and clear to be sold immediately with no penalty and there are no trailing commissions eating into your ongoing returns above and beyond the fund’s internal expense ratio.
B shares. These are basically the devil. A broker who sells you B shares is either a dirtbag or he just hates you or he truly doesn’t know any better. B shares offer the broker a similar commission percentage as A shares, but instead of the commission being deducted from your principal on day one, it is surreptitiously paid to the broker from the fund company itself so that you start out with 100 percent of your money invested from Jump Street. Sounds great, right? OK, but if you sell within the first couple of years, you get nailed for that commission on the way out. Plus, the returns are dampened by ongoing 12b-1 fees used for marketing expenses so the fund can bring in more investors. It’s not until six years have passed that your B shares convert into A shares and you’re able to sell with no penalty. As if any of us will even be alive in six years once the nuclear war between Google and Facebook turns the country into a war-ravaged apocalypse. Anyway, the B-share class has become so demonized that many brokerage firms are no longer allowing employees to sell them, and the fund companies themselves have actually ceased offering them. A well-deserved extinction to be sure.
C shares. The C-share fund is as close as you get to having a broker try to get paid and still do the right thing by the client. C shares are far from perfect, but they do align the broker’s compensation a bit more with the client’s success. The C share pays the broker a 1 percent fee the day he or she buys the fund for you and then a 1 percent trailing commission for each year you hold onto it until infinity. This arrangement does dampen performance over time (as any fee will), but the broker is betting on a long-term relationship with you and will have more upside based on the success of the fund (the higher your assets climb, the more his or her 1 percent trailer will translate into). Before leaving the brokerage business, I was doing C-share business almost exclusively whenever using open-end mutual funds. It was the most like an advisor I was able to be at the time even though I was, in the words of my broker colleagues, “leaving mad gross on the table.” Those assholes are probably waiting tables these days, so whatever.
Now there are also things like I-class shares (the lowest-cost class, for large institutional purchasers) and T-class shares (some convoluted hybrid between the A and the C), but we won’t get carried away here.
The point I’d like to leave you with is that, other than the brokers, no one has the slightest idea how these things are actually charging them. Nobody has a clue how much the salesperson is making from each class or what the true cost to the clients is over time. And we’re not just talking about brokerage clients either. If you work at a company where the 401(k) plan was pitched to the owners by a brokerage firm, you likely have A or C shares as your sole options. This means you are paying the brokers who set the company plan up with a cooperating fund family; they are carving up the fees from your fund elections each month despite the fact that you’ve never met any of them. The funny part is, the brokers have really only selected the plan’s choices at the very beginning; in many cases, there is no ongoing maintenance from that point, merely the collection of trailing fees.
And before we move on, there’s one other thing you may want to be aware of when looking at the composition of your brokerage account and the fund choices in it. There’s a very good chance that the fund family has actually paid your broker just to be on the platform. One of the most insidious and unknown practices on The Street is called the revenue-sharing agreement. Rather than take pains to explain it, I’ll give it to you directly from the horse’s mouth. The following appears on the Web site of one of the largest brokerage firms in the country on a page called “Revenue-Sharing Fund Families,” I’ve redacted the name and edited it down to make my point:
The following revenue-sharing information pertains to mutual fund purchases in commission-based brokerage accounts …
From each fund family offered, [Redacted Brokerage Firm Name] seeks to collect a mutual fund support fee, or what has come to be called a revenue-sharing payment. These revenue-sharing payments are in addition to the sales charges, annual distribution and service fees (referred to as “12b-1 fees”), applicable redemption fees and deferred sales charges, and other fees and expenses disclosed in the fund’s prospectus fee table …
Set forth below is a listing of the fund families from which we received revenue-sharing payments in 2009. Fund families are listed in descending order based upon the total amount of revenue-sharing payments we recognized from each fund family for 2009 …
In other words, this is a classic pay-to-play racket. “You want access to our client cash, you gotta sweeten the pot, boys.” The firms have to disclose this stuff somewhere, and I’m certain it’s not located in the “Dear Investor” welcome letter!
Brokers and fund wholesalers are forever engaged in an ongoing dance, with your retirement assets as the music playing in the background. As of 2010, 54 percent of all 401(k) and 403(b) retirement assets were invested in mutual funds, as were 47 percent of all IRA assets. I thought you’d like to know how they got there.