This Awful Investment Should Just Die

In general, government regulation of the financial industry scares the heebie-jeebies out of me, as unintended consequences can easily outweigh any benefit that comes from increased regulation. But if a new law that more closely regulates the relationship between brokers and their clients has the peripheral effect of killing off one particularly costly investment, then more regulation might be worth it.

A broker by any other name
Part of the controversy in the financial community lately comes from the question of how to define the relationship that brokers have with their clients. Those who work as "investment advisors" have what's known as a fiduciary duty to their customers to act in their customers' best interest.

If you work with someone who's called a "broker," though, you historically haven't had that level of protection. As long as a particular investment meets what's known as the suitability test, a broker can sell it to you -- regardless of whether it's the best thing out there.

That disparity could go away if the Investor Protection Act of 2009 successfully passes through Congress and becomes law. One thing the law would do would be to put brokers and other investment professionals on an even playing field, forcing all to bear fiduciary duties to their clients.

An end to alphabet soup?
One market commentator has suggested that the Investor Protection Act could force brokers to stop selling a particular class of mutual funds. Known as "C" shares, these investments steadily siphon off investment returns for as long as you own them.

As background, broker-sold mutual funds often come in a number of different varieties. "A" shares typically charge a front-end sales load. "B" shares come with no load on the front-end but charge a deferred sales load if you sell them within a certain period of time. In contrast, C shares don't charge a load on either end -- but their annual expense ratios are typically higher by as much as a full percentage point.

Under a fiduciary duty standard, C shares suddenly look completely inappropriate for long-term investors. As painful as a front-end load can be, paying even 5% or 6% upfront is better than paying an extra 1% per year for 20 to 30 years. Unless a customer expresses an interest in short-term trading, then C shares could become a thing of the past.

Why deal with load funds at all?
But I'd take that logic a bit further, arguing that a true fiduciary duty would require financial professionals not to sell load-bearing funds at all. After all, sales loads are designed specifically for the benefit of the salesperson selling them; the proceeds don't go to the fund itself or even the fund company when you buy a fund from a broker. If that salesperson has a responsibility to act in my best interest, then it's hard to justify selling me an investment that clearly works for the salesperson.

In addition, funds with loads are among the worst performers out there. Just take a look at some of these terrible-performing large-cap funds, according to Morningstar:

Fund

Maximum Load

10-Year Avg. Annual Return

Holdings Include:

Saratoga Large Cap Value B (SLVZX)

5%*

(3.2%)

Transocean (NYSE: RIG  ) , Chicago Bridge & Iron (NYSE: CBI  )

Virtus Capital Growth A (PHGRX)

5.75%

(6.3%)

Oracle (Nasdaq: ORCL  ) , Apple (Nasdaq: AAPL  ) , Google (Nasdaq: GOOG  )

Eaton Vance Tax-Managed Int'l Equity A (ETIGX)

5.75%

(2.7%)

Total SA (NYSE: TOT  ) , Novartis (NYSE: NVS  )

Source: Morningstar. *Deferred load.

Research has shown that no-load funds with reasonable expense ratios tend to perform far better than funds with loads. Given that, anyone with a fiduciary responsibility should clearly go with the no-load option.

It'll never happen
Given the political strength of the financial industry, I'm confident that even if the Investor Protection Act becomes law, mutual funds with sales loads aren't going to go away entirely. But there's no reason for them to take away your hard-earned money. Steer clear of load funds and go with proven no-load funds that do a better job at a cheaper cost.

There's a bubble brewing in the mutual-fund world, and you don't want to be in it when it bursts. Amanda Kish has all the details here.

Fool contributor Dan Caplinger doesn't need regulation to tell him when it's smart to save a buck. He doesn't own shares of the companies mentioned in this article. Google is a Motley Fool Rule Breakers pick. Apple is a Motley Fool Stock Advisor selection. Total SA is a Motley Fool Income Investor recommendation. Chicago Bridge & Iron and Novartis are Motley Fool Global Gains picks. The Fool owns shares of Oracle. Try any of our Foolish newsletters today, free for 30 days. With a little luck, the Fool's disclosure policy will live forever.


Read/Post Comments (2) | Recommend This Article (17)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 11, 2009, at 7:29 PM, xetn wrote:

    Perhaps the best regulator is the individual consumer. Every day, we make decisions regarding dealing with all kinds of services and products. We us United Labs for ideas on all kinds of products, we talk to friends, we do research on the internet, like Fool, etc.

    Just why do you think, after all of the above seems to work very well for most, we would need any government regulation? After all, there is ample evidence that what we have now (although very expensive) does not really offer any protection. Witness the case of Bernie Madoff, people even called the SEC and various other arms of government regulators and they did not do anything. Besides that, there were rating services that were warning their customers against Madoff's offerings. With government regulators in place, nobody bothered to "pay" for those services. Kind of like now, with the Fed as lender of last resort (at least for its largest bank members) and FDIC, nobody seems to care what condition our banks are in. That is called moral hazard and encourages the kind of risk taking that resulted in the credit meltdown.

    Government cannot do anything effective or efficient!

    As a matter of fact, we currently have over 70000 pages of government regulation affecting virtually every area of the economy (and your private life as well) resulting in companies having to add lots of analysts, CPAs and attorneys for compliance. This greatly adds to the cost of business, and drives companies off shore (along with their jobs).

  • Report this Comment On November 12, 2009, at 12:47 PM, switchingtoguns wrote:

    I'm sure I'll get flamed for this but what purpose does a investment broker or adviser serve other than to perpetuate their own existence? If 75% of mutual fund managers fail to beat the market indices in the long term what is the ROR for these brokers and advisors after factoring in sales loads?

    I am very skeptical about anyone who would call themselves an investment "expert". At the end of the day one could argue that you are paying for an opinion when you seek a financial advisor and nothing more. I have read articles here on the Fool about fee only financial advisors and can see value in that but again your asking for an opinion.

    I still have lots of time before my retirement and have only recently taken a more acute interest in preserving the meager capital I have collected so far. In the past year I have been reading Fool and doing some research.I nvesting is not that complicated if you stick with the basics. Roth, 401k with reasonable expense ratios. And maybe sink a little into a blue chip dividend stock. Not that hard to do.

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