Is American Funds Un-American?

Man, I'm tired of writing about scandals and improprieties relating to Wall Street. Yet Foolish duty calls. So, here's the latest: Yesterday, the National Association of Securities Dealers (NASD) sued American Funds, the largest seller of mutual funds in the U.S. since 2002, for allegedly kicking back $100 million in commissions to brokers in exchange for touting the firm's funds. In other words, American Funds allegedly cheated.

This despicable practice actually has a name: directed brokerage. Last May, American Express Financial Advisors, a unit of American Express (NYSE: AXP  ) , was implicated in a similar case for allegedly accepting directed brokerage fees. But, in my book, American Funds' alleged scheme appears much worse. That's because, according to the NASD, American didn't stop with the kickbacks. Technically, commission revenue sharing between funds and brokerages isn't illegal. Instead, American allegedly created target commission levels based on expected sales to 75 different firms with which it has revenue-sharing agreements. In creating the arrangements, American allegedly told brokerages it expected its funds to be among the "preferred" or "recommended" offerings. And that's where it went wrong, breaking the NASD's anti-reciprocal rule that is supposed to keep brokers from favoring products that line their pockets with cash.

What's most troubling about this development is that American's funds are hugely popular. According to researcher Strategic Insight, American Funds accounted for 84% of net U.S. mutual fund sales through brokers last year. Also, according to a Bloomberg News report, the company managed six of last year's 10 top-selling U.S. funds.

If nothing else, this incident ought to convince investors once and for all that buying funds through a full-service broker or advisor is usually a miserable idea. I mean, really, how can you trust that you're buying the best product for your portfolio when your broker is being paid to recommend the so-called top products to you? Isn't that a little like walking into a used car dealership and getting a non-stop pitch from Rocco, the fast-talking and overly caffeinated sales manager, on the bumper-to-bumper extended warranty that pays him a massive bonus? Yep.

But don't despair; there is something you can do. In fact, all it requires is a moderate shift in your thinking. From now on, recognize that your broker and advisor are often salespeople first. The next time you get a call from either of them touting a fund that's supposedly good for your portfolio, stop and ask these two questions: "How much money will you make from the sale?" And: "Are there similar, highly rated funds that would cost me less? I'd like to research the entire list, please." If they try to sidestep these legitimate inquiries, hang up. Fast. Your portfolio will thank you for it.

For related Foolishness:

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Fool contributor Tim Beyers wonders whether Wall Street will ever work in the interests of individual investors. He's also waiting for it to rain frogs. What's your take? Discuss the ins and outs of the Street's wise men at the Discount Brokers and Full Service Brokers discussion boards. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. You can find out what's in his portfolio by checking Tim's Fool profile. The Motley Fool has a disclosure policy.


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