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:

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.