Why a Brokerage Giant PushesSome Mediocre Mutual Funds
Jones & Co. Gets PaymentsFrom 'Preferred' Vendors
By LAURA JOHANNES and JOHN HECHINGER Staff Reporters of THE WALL STREET JOURNAL
Like many who bought poorly performing Putnam mutual funds in recent years, Nancy Wessels lost big. One of her investments, Putnam Vista fund, dropped 40% from when she bought it in April 2000, near the stock-market peak, until she sold it in May 2002. That performance was worse than 80% of similar stock funds.
What the 80-year-old widow's broker, Edward D. Jones & Co., never told her was that it had a strong incentive to sell Putnam funds instead of rivals that performed better. Jones receives hefty payments -- one estimate tops $100 million a year -- from Putnam and six other fund companies in exchange for favoring those companies' funds at Jones's 8,131 U.S. sales offices, the largest brokerage network in the nation.
When training its brokers in fund sales, Jones gives them information almost exclusively about the seven "preferred" fund companies, according to former Jones brokers. Bonuses for brokers depend in part on selling the preferred funds, and Jones generally discourages contact between brokers and sales representatives from rival funds. But while revenue sharing and related incentives are familiar to industry insiders, Jones typically doesn't tell customers about any of these arrangements.
The situation "gives you the feeling of being violated," says Mrs. Wessels's son, DuWayne, a Waterloo, Iowa, real-estate broker. He says he found out about the fund-company payments to Jones from his mother's new broker when the son moved her $300,000 account to another firm in 2002.
Jones, whose storefront offices are common across much of the country, is one of the nation's largest distributors of mutual funds, with 5.3 million individual customers who hold more that $115 billion in fund shares. The firm has earned respect for its advocacy of conservative, buy-and-hold investing, and it hasn't been tarnished by the scandals sweeping the mutual fund and brokerage industries.
But Jones, based in St. Louis, is also among the nation's leading practitioners of a little-understood fund-sales practice now under scrutiny by federal securities regulators. In the industry it's known by the bland name of "revenue sharing": Fund companies give brokers a cut of their management fees to induce them to sell their products. Critics call it "pay to play."
"The deception is that the broker seems to give objective advice," says Tamar Frankel, a law professor at Boston University who specializes in mutual-fund regulation. "In fact, he is paid more for pushing only certain funds."
If properly disclosed, revenue sharing is legal. But the practice has come under increasing scrutiny as part of the current mutual-fund scandal, and it is now unclear precisely what disclosure is required. In November, Morgan Stanley agreed to pay $50 million to settle Securities and Exchange Commission allegations that its brokers didn't inform customers about revenue-sharing deals and other incentives to sell certain funds. Morgan Stanley didn't admit or deny wrongdoing. The money will be distributed to fund investors. The SEC also accused Morgan Stanley of steering customers to the funds of companies that gave Morgan lucrative stock-trading business; Jones doesn't engage in that practice.
Douglas Hill, Jones's managing partner, this week referred all questions to firm spokesman John Boul, who repeatedly declined to comment. On its Web site, Jones says it favors a handful of funds to help investors sort through the thousands of available offerings. "We focus on seven preferred mutual fund families that share our same commitment to service, long-term investment objectives, and long-term performance," Jones says.
The funds Jones favors are a mixed bag. Some recently have exceeded average performance in their category, while others, like Putnam, have offered inferior returns.
The fund companies on the preferred list also pay for Caribbean cruises and African-wildlife tours for Jones brokers, according to former brokers. During these excursions, fund-company representatives make sales pitches to a captive audience of Jones employees, current and former brokers say. More than half of the firm's brokers are invited on the twice-a-year trips, based on meeting certain overall sales targets.
Fund-company payments to encourage broker favoritism began in the mid-1980s and grew more common during the 1990s stock-market boom, Ms. Frankel says. The practice proliferated as the number of funds rose sharply, to 8,200 from fewer than 570 in 1980, in an industry that now has $7 trillion in assets. Brokers and other intermediaries today account for more than 80% of fund sales, up from about 50% in the early 1980s.
The nation's 50 largest mutual-fund groups quietly dole out $1.5 billion annually in revenue-sharing payments to brokers, according to an estimate by Financial Research Corp., a Boston fund-tracking firm. Fidelity Investments, the largest fund firm, says it makes such payments for its broker-sold funds, but declines to elaborate. No. 2 Vanguard says it doesn't share revenue with brokerage firms.
Payments similar to mutual-fund revenue sharing are common in other industries. Food companies routinely pay supermarkets for shelf space, and travel companies "spiff" agents for plugging cruises or tours.
But under securities laws, brokers are held to the high standard of trusted financial advisors -- not just salespeople -- and must either offer objective advice or properly disclose any serious conflicts.
Revenue-sharing arrangements are generally referred to in prospectuses fund companies distribute to customers. But prospectus language can be vague and hard to find. In the Morgan Stanley case, disclosure by its favored funds wasn't enough to prevent SEC action.
With roots dating to 1871, closely held Edward Jones caters to investors in suburbs and small towns. In his 2002 book "Take on the Street," former SEC Chairman Arthur Levitt praised Jones, which avoids most investment banking for corporate clients, and thus can recommend stocks without the conflicts of interest that have tainted some Wall Street firms. He also noted that Jones doesn't push its own line of funds.
Mr. Levitt says in an interview that "all of the things Jones did right outweighed any potential negative on revenue sharing." He adds, however, that if brokers accept such payments, they should disclose them prominently in sales materials. "I think it is a bad practice, and I think it should be abandoned, and if not abandoned, fully disclosed," Mr. Levitt says.
Jones has promoted its clean reputation, which has helped propel its growth. Revenues have doubled since 1997, to $2.3 billion in 2002. On Nov. 6, as the mutual-fund scandal unfolded, Jones bought full-page ads in major newspapers condemning what it called the "anything goes" mentality in the industry.
The letter didn't mention revenue-sharing, a practice that has raised concerns within the firm's sales force. Former Jones brokers, some of whom are now competitors of their ex-employer, say that Jones employees who happily sell only the favored funds are referred to within the firm as "drinking the corporate Kool Aid." Eighteen current and former Jones brokers were interviewed for this article.
Jones has postponed a planned $150 million limited-partnership offering -- in which brokers can invest in their firm -- due to concerns about possible regulatory scrutiny, according to people familiar with the matter. The offering had been scheduled to close at the end of 2003. In a Nov. 10, 2003, SEC filing, the firm's parent disclosed that state and federal regulators are "likely" to restrict revenue sharing and that brokers will be required to disclose it. Such changes "could negatively affect" Jones, the filing said.
Mutual-fund companies are eager to sell their funds through Jones because it has more than 9,000 brokers, the fourth-largest such group in the nation. The firm is also a sought-after distributor because its seven-member preferred list is relatively short. The seven are: American Funds, Federated Investors Inc., Goldman Sachs Group Inc., Hartford Mutual Funds Inc., Lord Abbett & Co., Marsh & McLennan Cos.'s Putnam Investments, and Van Kampen Investments.
Capital Research & Management Co.'s American Funds, the nation's third-largest fund company, confirms that it makes payments to Jones. American values being on the Jones list because it "gets us access" to the firm's brokers, American spokesman Chuck Freadhoff says. "We have the ability to meet with the individual financial advisors, [so] we can explain our products and our funds," he adds. American discloses the practice in its prospectus in a manner "consistent with" industry and SEC rules, the spokesman says. American says Jones is the top seller of its funds.
Goldman Sachs spokeswoman Andrea Raphael says it has "robust disclosure" of its revenue-sharing practices in its fund prospectuses. But Goldman is "not aware" of incentives Jones provides to its brokers, she says.
Spokespeople for Putnam, Federated, Lord Abbett and Van Kampen all declined to comment. A Hartford spokesperson discussed its fund performance but declined to comment on revenue sharing.
Jones has selling agreements with about 100 mutual funds, but 90% to 95% of its fund sales come from the seven preferred companies who engage in revenue sharing, according to Boston financial consultants Cerulli Associates. Jones customers are viewed as desirable in the fund industry because many are loyal "buy and hold" investors. On average, Jones has said, they stay invested in a mutual fund for about 20 years, reliably paying management fees. Financial-services veterans say the industry-wide average is about four years.
The funds to which Jones brokers steer those customers are an uneven lot. American Funds has a good record. All of its stock funds beat industry-wide peer-group averages in 2002, and 59% did so again last year, according to fund researcher Morningstar Inc.
But others -- including Federated, Goldman Sachs and Van Kampen, a unit of Morgan Stanley -- have been underperformers. Just over half of Federated's stock funds, for example, beat their peers last year, after only 44% did so in 2002, according to Morningstar. Only a quarter topped their peers in 2001. Federated has said it allowed improper fund trading, but hasn't been charged.
Putnam tanked after a strong showing in the 1990s, when it bet heavily on the stocks of technology firms and other fast-growing companies. When the Internet bubble burst in 2000, many Putnam investors got hurt. Only about a third of Putnam's stock funds beat similar offerings last year and in 2002, Morningstar says. Only 19% did so in 2001.
Jones has maintained Putnam as a preferred fund provider even as Putnam was charged by federal and Massachusetts regulators with civil fraud in October and saw its assets drop $32 billion, or almost 12%, in November, as investors fled the scandal. Putnam had disclosed that six of its money managers engaged in short-term trading of Putnam funds that regulators said hurt long-term shareholders. Putnam has partially settled SEC allegations without admitting or denying wrongdoing. The company, which has pledged an unspecified amount of restitution to investors and replaced its top management, has said it instituted new controls and fees to discourage improper trading.
The amount fund companies pay Jones to get favored treatment varies from .05% of the fund assets investors hold through Jones to .2%, calculated on an annual basis, former brokers say. That can be a big chunk of a mutual fund's management fee, which averages .61% of assets for stock and bond funds, according to Lipper Inc., a research firm.
The Nov. 10 SEC filing says Jones received $335.6 million in "asset fees," which included revenue sharing and other items, for the first nine months of 2003. Based on Jones's disclosed mutual-fund assets, among other information, Neil Bathon, president of Financial Research, estimates that Jones receives between $100 million and $140 million a year in revenue sharing from fund companies.
The payments go to Jones corporate headquarters. Firm profits are divided among 235 general partners, with some 5,000 limited partners receiving relatively small amounts, former brokers say. As an illustration: If a broker sells $10 million a year of mutual funds, Jones could gain up to an additional $20,000 in revenue sharing.
That is in addition to the standard, disclosed sales charge, or load, the customer pays when buying a fund. Sales charges can be as high as 5.75%, the bulk of which are split 60-40 between Jones and brokers. But unlike the one-time sales load, payments from fund companies are made each year an investor holds shares in the funds.
Individual brokers have a strong financial incentive to pitch favored funds. The revenue-sharing payments are credited as income to the profit-and-loss statements of brokerage branches. Those statements are a significant factor in determining the size of brokers' bonuses, generally awarded three times a year, according to former brokers. The bonuses can add up to $80,000 or $90,000 for a good producer, and often average about a third of total compensation.
"I sold no outside funds," says former broker Eddie Hatch, who worked at Jones in North Carolina for 13 years, until he left in 2000 to work for another brokerage firm. "You took a reduced payout" if you sold funds not on the preferred list, he adds.
Jones floods its brokers with literature from its preferred funds, former brokers say. "I didn't take the blinders off for nine years," says Scott Maxwell of Cary, N.C., a broker who left Jones for another firm in March of last year. He switched jobs, he says, largely because he was uncomfortable with the limited fund selection. Mr. Maxwell says he wanted to be freer to offer clients funds with better investment performance and lower fees.
Jeff Davis says he was "young and wet behind the ears" when he was hired at Jones in 1993 after a stint as a White House intern. Even before he fully understood the financial incentives, he says he sold the seven funds almost exclusively. "I was afraid not to," he adds. Mr. Davis, who left Jones in 2001 and started his own business, also says he was uncomfortable with the incentives and wanted more leeway to sell other funds.
Within the preferred list, Jones makes some funds more attractive to sell than others. Strong-performing American pays by far the least amount of revenue-sharing fees, former brokers say. At a gathering of brokers in North Carolina about three years ago, Jones regional leader Jim Barber -- a liaison between headquarters and branch offices -- "stood up and told everyone, do not sell American Funds. You need to be selling Putnam funds and other funds because their revenue sharing is higher," says Mr. Hatch.
Mr. Barber, who is a general partner at Jones, says he "never made that comment." He adds that Jones receives payments from fund companies because its customers hold funds far longer than average -- a big plus for both the clients and the funds. "There's a long line of funds that want to be" on the preferred list, he says.
Customers are likely to hear much more about revenue sharing in coming months. Regulators who have focused so far on mutual-fund trading practices that hurt smaller and long-term investors say they are now turning their attention to other practices, including revenue sharing.
The SEC says it is considering rules that would require disclosure of revenue sharing in the confirmation slips that brokers give clients after they buy a fund. SEC officials also are examining whether fund companies inflate their management fees to pay for revenue sharing. "We recognize there is a conflict of interest between the broker and the mutual-fund investor," says Robert Plaze, associate director for the SEC's division of investment management. "That client needs to understand the recommendation of their broker is being affected by these payments."
Under existing SEC rules, brokers technically are required to disclose revenue-sharing payments. But industry lawyers have maintained that this disclosure requirement can be satisfied if a revenue-sharing arrangement is mentioned in a fund's prospectus. That document is supposed to describe the fund's fees, risks and financial arrangements.
But in November, the SEC charged Morgan Stanley with fraud for not itself disclosing revenue sharing and other incentives its brokers had to sell its list of 16 "partner" funds. The SEC said at the time that vaguely worded fund-prospectus language referring to the practice was insufficient because it didn't make clear that Morgan Stanley brokers had a conflict of interest in the arrangement.
As an example of such language, Putnam, one of the 16 on Morgan's list, as well as one of Jones's preferred funds, typically discloses in its prospectuses that it may "pay concessions to dealers that satisfy certain criteria established from time to time by Putnam Retail Management relating to increasing net sales of shares of the Putnam funds over prior periods, and certain other factors."
In addition to agreeing to the $50 million settlement payment, Morgan Stanley disclosed its revenue-sharing practices on its Web site. The SEC has said that Morgan Stanley's favored fund companies are currently under investigation concerning the adequacy of their own disclosure.
You can sell American Funds all you want, but dont try to say that the pref fund system at Jones is good for clients.