Directed commissions dropped by Putnam

The informal practice by mutual fund companies of directing trading commissions to brokerage houses as a reward for selling their products may be on its way out.

That’s the conclusion many industry experts reached in the wake of a decision by Putnam Funds’ board of trustees to drop directed commissions at the beginning of next year. The funds are offered by Putnam Investments LLC in Boston, which supports the change.

The move came after a published report said MFS Investment Management in Boston had suspended the practice of directing brokerage business to securities firms that sell its funds or bring in new clients. A spokesman for MFS declined to comment on the report.

Fund watchers say Putnam’s announcement may force the rest of the fund industry to follow suit.

They say the industry, reeling from allegations of late trading and market timing at many fund firms, can’t afford to seem unwilling to discontinue a practice that may not be in the best interest of shareholders.

“I would guess there are other firms which, at the very least, will reduce” their use of directed commissions, says Jeff Keil, Denver-based vice president of global fiduciary review at Lipper Inc. of New York.

If that’s the case, it could change the way many fund companies do business.

Fund companies are reticent about directed commissions. In fact, fund companies and brokers barely acknowledge the practice, let alone provide information on it. But Mr. Keil says he believes it’s fairly widespread.

Still, some fund experts say putting an end to directed commissions means little to investors. Directed commissions may appear ethically suspect, but they’re rather innocent, they say.

The issue of whether they are innocent has to do with whether a broker provides a fund company with “best execution” of trades.

“As long as they are getting the best prices, I don’t understand what the problem is with the practice itself,” says Neil Bathon, president of Financial Research Corp. in Boston.

He says there isn’t a conflict of interest, because brokers don’t feel pressured to push certain funds in the hope of getting commissions.

“By and large, the individual reps don’t get any benefit,” Mr. Bathon says.

While individual brokers may not benefit, the brokerage industry benefits because the practice of directed commissions helps obscure what best execution actually costs, says Louis Harvey, president of Dalbar Inc., a Boston-based research company.

As a result, funds are paying more than retail investors to buy and sell stock, he says. A retail investor had to pay about $100 in fees 10 years ago to buy 100 shares of a stock but today can do it for about $5, he says.

Funds, which buy stock on a cents-per-share basis, paid about 8 cents a share to buy a stock 10 years ago but pay about 6 cents today, Mr. Harvey says.

“If the practice [of directed commissions] is done away with, it will be replaced by competitive forces,” he says.

Not necessarily, says Burton Greenwald, a mutual fund consultant in Philadelphia. Mutual fund trades have always been predicated on best execution, he says, and there is no evidence that brokerage houses will say they can provide best execution for less if directed commissions are discontinued.

If they are abandoned – and Mr. Greenwald says he thinks companies will have to consider this step in the wake of Putnam’s announcement – the result may help fund investors in other ways.

For example, the fund itself, and its shareholders, will not be tapped to supplement the distribution cost of the fund. Currently, a fund company pays cash for brokerage shelf space but can supplement that with directed commissions, which are paid by the fund.

However, fund watchdogs such as Mercer Bullard, founder and chief executive of Fund Democracy Inc., a fund shareholder advocacy group in Oxford, Miss., argue that the practice is illegal. The fund itself is not supposed to bear the cost of distribution, he says.

But fund companies have argued that as long as they receive best execution of trades, the practice is legal.

That the practice falls into a legal gray area, however, could provide fund companies with added impetus to do away with directed commissions. That’s because in the wake of Putnam’s announcement, regulators will no longer be able to ignore it, says Mr. Harvey.

“I would say the regulators would be forced to scrutinize every other company,” he says.

As a result, companies may do away with the practice as a pre-emptive measure, says Matt McGinness, a senior analyst with Cerulli Associates Inc. in Boston.