OneSource is in eye of pay-to-play storm

Some advisers take steps to make clients aware of all fees

Mar 1, 2004 @ 12:01 am

By Brooke Southall

Companies such as Charles Schwab & Co. Inc., Fidelity Investments and TD Waterhouse Group Inc., and the independent fee- only advisers that use their no- transaction-fee platforms, may be taking advantage of mutual fund investors, industry observers charge.

"All the heat is going to broker-dealers and national load fund companies for pay-to-play," said Eric Schwartz, president of Cambridge Investment Research Inc., a broker-dealer in Fairfield, Iowa. "The same goes on in the fee-only side, as well through all platforms. [Asset custodians] get paid some amount of money from mutual funds to be on their [NTF] platform."

Morgan Stanley of New York settled with the Securities and Exchange Commission for $50 million because its brokers allegedly had not informed clients of revenue-sharing deals with the mutual fund companies to which they had directed them.

Mr. Schwartz said fee-only advisers have an obvious incentive to put their clients into funds carried on NTF platforms if they contract with customers to pick up commission charges.

Advisers don't have to pay those charges, but they also enjoy a subtle advantage of using the platform when they pass along commissions to clients.

"You don't think clients notice when they get a $50 charge when they've already paid 1%," Mr. Schwartz said.

Pay-for-play

Glen Mathison, a spokesman for San Francisco-based Schwab, disagrees, saying there is no similarity between OneSource - Schwab's NTF platform - and commission-driven, load-driven brokerage companies.

"OneSource is not a list," he said. "It's a group of funds that pay a fee to participate in the marketplace, and the fee is paid for all the work we do for them. There is no recommendation. This is a marketplace, and a huge one with lots of choices."

However, industry analysts and securities lawyers agree that when mutual funds pay about 0.35% of assets to list on NTF platforms, the arrangements need to be called what they are - even though the level of conflict may be different.

"It's pay-for-play," said Stephen C. Winks, principal with SrConsultant .com, an investment management consulting firm in Richmond, Va.

Julie Allecta, partner and vice chairman of the investment management group of Paul Hastings Janofsky & Walker LLP in Washington, says she sees conflicts in the fee-only business.

"Does it go on in the no-load world?" she asked. "Sure it does; it just goes on differently."

Many fee-only financial advisers agree that the NTF platforms set them up for possible conflicts of interest with their clients.

"I think [the contention of these parallels] is right," said Russ Hill, president of Halbert Hargrove Russell LLC of Long Beach, Calif., which has $795 million under management, almost entirely under custody with Boston-based Fidelity. "People always look at fee-based [advisers] as having no conflicts. You're just trying to get conflicts as low as possible."

The degree of conflict is far less than that of the brokerage community, said Roger C. Hewins III, president of Hewins Financial Advisors LLC in Foster City, Calif., which manages $1.3 billion.

"None of these advisers has the conflict where they're selling something they know not to be good," he said. Mr. Hewin's firm keeps its assets primarily at Schwab.

Avoiding conflicts

Certainly, Schwab, Fidelity and TD Waterhouse have a stake in keeping their NTF platforms from being tarred. Those platforms had $102 billion, $77.4 billion and $8.6 billion in assets, respectively, as of Dec. 31.

"Since 1997, clients have invested $7 into OneSource funds for every $1 in transaction fee funds," said Mike Durand, a spokesman for Schwab.

New York-based TD Waterhouse declined an interview request, but spokeswoman Jennifer Olegario submitted a statement by e-mail addressing the issue of this potential conflict.

"Advisers are required to act in the best interests of their clients by choosing the most appropriate investment vehicle for their clients' needs, and cost is only one factor in their decision," she wrote.

Vincent Loporchio, spokesman for Fidelity, said: "The fund companies participating in FundsNetwork have the option of distributing the funds as NTF funds or transaction fee funds. Each fund company decides how they want to distribute based on their own business model."

Meanwhile, Mr. Hewins said he takes extra steps with clients to avoid conflicts when OneSource is thrown into the mix.

"We make clients aware of all the fees," he said. "We point out the obvious - that OneSource funds have substantially higher fees than transaction fee funds."

Mr. Mathison of Schwab said this indeed is where the fee issue needs to be handled.

"It's a situation that could be solved by disclosure to the client," he said.

OneSource-listed funds have an average expense ratio of 1.28%, while funds listed on its traditional retail platform have an expense ratio of 1.16%, according to Chicago-based Morningstar Inc.

Owners of mutual funds say they also must be vigilant not to be accused of conflicts when they use NTF platforms.

Bill White, vice president of client development for Corbyn Investment Management Inc. in Lutherville, Md., says his company put its $116 million Greenspring Fund into Schwab's OneSource last March.

The payoff was immediate and dramatic. Independent fee-only advisers have directed $30 million in assets to his firm. In the previous several years, the Greenspring Fund brought in only $7 million on Schwab's regular transaction fee platform.

"We get a lot more assets because advisers migrate to OneSource," Mr. White said. "That's because they're not paying $69 and $79 a pop."

The results, he said, were no less dramatic at Fidelity, where adviser-derived assets in the Greenspring Fund have doubled since listing on its NTF platform in November.

Mr. White added that he decided not to list Greenspring Fund on the NTF platform of TD Waterhouse, because the firm charges only $24 on its transaction fee platform anyway.

But he says that certain fee-only advisers watch him like a hawk to be sure that no conflicts arise as a result of the less visible OneSource fees of 0.35% that he pays.

"A number of old-school [advisers] said, `You're going onto OneSource, and it's going to drive up my fees,"' Mr. White said. "They don't want to turn around to the clients and say that Greenspring sold out to OneSource."

He said his fund was able to lower its total expenses to 1.14%, from 1.19%, because it could spread its expenses out across more assets. Mr. White said he can service a much larger number of smaller customers because Schwab handles the paperwork and mailings.

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