Just When You Thought It Was Safe…

October 27, 2006

Regulators uncover a new way that mutual fund companies are ripping off shareholders.

Just when you thought it was safe to go back in the mutual fund waters, the Securities and Exchange Commission (SEC) has uncovered a new way that fund companies are ripping off shareholders.

According to The Wall Street Journal, the SEC has launched an investigation into 27 mutual fund companies that are accused of accepting hundred of millions of dollars of kickbacks at shareholder expense in recent years. 

The investigation builds on a $21.4 million settlement reached last month Bisys Fund Services, a company that provides various services to mutual funds, including jobs like printing shareholder reports and prospectuses.  According to the SEC, Bisys paid over $230 million in kickbacks to the mutual fund industry between July 1999 and June 2004 to win lucrative contracts.  The SEC has now sent letters to the 27 firms involved asking for more information.

Although the details are still emerging, the SEC gave one example of how the scam works:

 "Adviser A," rumored to be AmSouth Funds, paid Bisys 0.20 percent of total assets annually for a variety of services.  Bisys only kept one-quarter of that amount, however.  An additional one-third was paid back to the Adviser in an "above-board" contract, and the remainder - about 8 basis points - was kicked back to the fund company under the table as a "marketing budget."

Funds typically cover marketing expenses out of their own pockets, or in the case of certain exchange-traded funds (ETFs), through line-item amounts identified in the prospectus. Sucking off extra dollars for marketing expenses is a no go. 

As with most scandals, however, things get ... juicier ... as you dig down into the specifics.  In this case, the best detail is that Adviser A used part of the money to purchase a country club membership for the firm. I'm sure they can explain the value that gave to shareholders.  Maybe everyone with $10,000 invested got a free round of golf.

The SEC isn't naming names, so there's no real way to know if any index fund managers are implicated in this scandal.  But I'd give you good odds that the answer is no.  For starters, the 20 basis points that "Adviser A" paid to Bisys is higher than the total expense ratio for many index funds.

The net impact to shareholders of these kickbacks is negligible, amounting to a few pennies on most investments. But the damage to the industry's reputation is immeasurable.  If mutual funds keep ending up in the news alongside the words "scandal," "kickbacks" and "bribes," eventually shareholders are going to sour on the whole deal.

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