From the November 2004 issue of Investment Advisor • Subscribe!

November 1, 2004

Fund Cop

He may dress like a Keystone Kop, but Jerry Wade's not kidding.

Jerry Wade is fed up with mutual funds. He's become so leery of the scandal-ridden fund industry that he recently launched a Web site, www.fundpolice.com, to give investors a heads-up on which mutual funds have been "busted" or are being investigated by regulators. He's now urging his clients to invest in ETFs and folios instead of mutual funds.

Wade, president of Wade Financial Group in Minneapolis (he also likes to be called the commissioner of Fundpolice.com), says investors are clueless "as to the ongoing conflicts of interest in the fund business, and are almost completely unaware of alternatives, such as ETFs and 'stock basket' trading," also known as folios. He recently created a batch of folios available at www.wadefolios.com. "ETFs are a fantastic investment that investors haven't really heard about," he says. Wade's firm has created 15 different folios, some comprising ETFs, others individual securities.

After New York Attorney General Eliot Spitzer exposed the after-hours trading activities of some funds last fall, Wade and his colleagues started keeping track of wrongdoers by clipping newspaper and magazine articles, Morningstar e-mail alerts, and by printing information found on the SEC's and Spitzer's Web sites. "We were tracking the problems for our clients, so that we knew which funds were doing the shenanigans and we could keep our clients' money out of them," Wade says. Soon, Wade was knee-deep in clippings on more than 90 financial institutions. So he hired a Web firm to design Fundpolice.com and appointed an in-house staffer to run it. "The heart and soul" of the site is its "Who's Busted" database, Wade says. Updated weekly, it provides information on fund companies "that have gotten into trouble or have settled with the SEC."

The database has three categories: Red light funds that investors should "steer clear" of, yellow light funds that require investors to use caution when considering them as an investment, and green light funds that have won Wade's seal of approval. Don't confuse Fundpolice.com with another popular Web site, FundAlarm.com, which tells investors to avoid what it calls "three-alarm" funds that have bad performance. Fundpolice doesn't "pontificate about performance," Wade says. "We tell people about funds that have been screwing them, so they can move their money out."

The Fundpolice.com home page shouts: "Wake up America. Your financial future is at stake. You need to care." Wade says he created Fundpolice.com for investors, but it's also a great educational tool for advisors. They can log on to the site while meeting with a client, he says, to see whether any of the client's mutual funds have been reined in by the SEC.

Fundpolice.com also exposes shenanigans in the 401(k), insurance, and annuity industries, and educates investors on what Wade says are the 12 sins of mutual funds. These include undisclosed brokerage costs, soft dollars, directed brokerage, and shelf space payments. The SEC in August banned directed brokerage, a quid pro quo arrangement under which brokerage firms received extra dough for selling certain funds. But Wade, like other advisors and analysts, believes the SEC's ban won't end the practice. "Most mutual funds will pass along the expense [of distributing their funds] to the investor in some buried form that will be lost in the prospectus," Wade says.

Matthew Beinfang, a senior analyst at TowerGroup's retail brokerage and investing unit, agrees that investors will get stuck with the bill now that directed brokerage has been outlawed. "In whatever new form or shape directed brokerage takes, if 100% of the cost is not borne by the fund companies, TowerGroup predicts that the $475 million that was spent each year on directed brokerage could be cut by as much as 50%," Beinfang says in a recent report. Beingfang says that with fund companies' margins being squeezed and pricing pressure increasing, directed brokerage payments will likely become "marketing assistance" payments or "training reimbursements."

Most brokerage firms used the money they received from directed brokerage arrangements to pay for research. Beinfang predicts the new rule will have little effect on larger brokerage firms, since they have "robust research and capital markets capabilities." The rule may actually have a positive effect on wirehouses, he says. "Orders once handled on a 'step out' basis, where the brokerage gave credit for the trade and a portion of the commission to another firm, may still be executed through the wirehouse as a normal course of business, with the credit for the trade remaining with the executing broker," Beinfang says. "Even though these trades are likely to be executed at a lower-commission level, high-margin operators will be able to absorb the loss of revenue from directed brokerage more readily, offsetting that loss with the added trading volume."

The independent broker/dealers will suffer the most, Beinfang says, because their operating margins are the lowest of all segments of the retail brokerage industry. "For many independent firms, directed brokerage represented a revenue stream that was not shared with the distribution force but instead dropped to the bottom line," he says. "As a consequence, a good or bad year in fund sales could make or break profitability for the year. For many small, independent firms, the [SEC] rule banning directed brokerage may push margins even lower, forcing them to reevaluate the business model and...their compensation grids."

Independent investment advisors, too, could be hurt by the SEC rule. Some of the services that a custodian offers to an advisor--like desktop tools, financial planning tools, and calculators--are "subsidized by these directed order flow payments," Beinfang says. "If a custodian is not receiving $50 million per year from all of the fund companies that would represent the directed order flow for shelf space, where is that money going to come from?"

Planner Wade says the SEC's rule requiring advisors and mutual funds to have a chief compliance officer is also wreaking financial havoc on these firms, causing some small mutual funds to fold. "I think that's bad for the small investor," he says. Moreover, mutual fund expense ratios continue to rise, Wade says, adding that regulatory reform won't fix this. "The mutual fund industry predicted a decade ago that as the industry grew and funds grew in size, expense ratios should go down," he says. "The exact opposite happened in the last 10 years--expense ratios went up, and that was without regulatory reform."

In Wade's mind, the mutual fund industry is a "dinosaur" that "hasn't been reinvented since the 1940s." He says it's up to advisors to create alternatives for their clients. With his folios, "we're bringing diversified investing and individual securities to the mass affluent," he says. His 15 folios--which include a value portfolio called The Dividend Advantage, another called The Growth Advantage, plus The Total Return folio--are meant to serve the mass affluent with $100,000 to $500,000 to invest. "With the average mutual fund investor having $130,000, we think we have a nice market to go after," Wade says. The folios are investment-only products, he says, so there's no financial planning involved. The folios are "price competitive, offer lower cost, better tax advantages, and better performance" than mutual funds, Wade says, and, there are no hidden fees. "The client is only charged two fees--one from us and a brokerage fee."

But are ETFs and folios really a threat to mutual funds? "It's still David versus Goliath, but at the end Goliath will fall," Wade maintains. Mutual funds' demise will occur only when "several large financial firms--like a large brokerage firm or Schwab--embrace an alternative investment concept like ETFs or folios," he says. An unlikely scenario for the foreseeable future, as loss of mutual fund sales would take a big chunk out of a large firm's bottom line.

Wade also takes to the airwaves to expose scandals in the fund industry. The Jerry Wade Show airs every Saturday on KYCR, a radio station in Minneapolis. Wade provides callers with all sorts of investing advice, including a weekly "fund scandal update." He is so committed to uncovering the ills in the mutual fund industry that he's doubled the size of his office space and hired new employees to handle Fundpolice.com. Not every advisor has the financial resources to expand office space and add staff, but they still can be as vigilant as Wade when it comes to insuring their clients' money is being invested correctly.

Washington Bureau Chief Melanie Waddell can be reached at mwaddell@ia-mag.com.

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