Schwab boots funds that have
cheaper share classes elsewhere.
Pick a fund, any fund, at Charles Schwab and you
won't find a cheaper share class anywhere else. If you do, Schwab won't
match the price, like a car dealer or a mattress store would with their
competitors. Instead, it will boot the fund out of the Schwab system,
making it unavailable for new purchases.
This acknowledged Schwab practice is aimed at
keeping things simple for investors, the company says. "We have an
ongoing practice to offer one class of shares to all investors at
Schwab," says Doug Hanson, vice president of asset management and
strategic alliances for the firm. "We want it to be simple, and we
don't want to compromise."
Morningstar, for one, isn't buying the KISS (keep it
simple stupid) defense. "I think it is arguably a mechanism that keeps
fund fees higher than they should be," says Christine Benz, director of
mutual fund analysis at Morningstar.
Hanson acknowledges that he sees how the policy
could be misconstrued, but insists that Morningstar and others who take
issue with it aren't seeing the bigger picture of serving all Schwab
clients, whether investor or advisor, the same.
When asked about it, however, advisors step right up
and complain. "For the last four years I have noticed more of my
favorite funds disappearing from Schwab, or having exorbitant charges
assessed to buy a fund through Schwab. I have had to pull more and more
funds out of Schwab and send it direct to the fund company to get the
best pricing. I feel Schwab is trying to manipulate clients to buy
in-house funds," says Don Martin, a certified financial planner at
Mayflower Capital in Los Altos, Calif.
Hanson denies that charge too, and says he couldn't
point to or think of any fund that has been dropped from its offering
menu because of share class controversy. The use of multiple share
classes has been the subject of an ongoing investigation by the
National Association of Securities Dealers, because of concerns that
investors may have purchased Class B mutual fund shares when it would
have been more cost-effective for them to purchase shares of a
different class.
"Before purchasing Class B mutual fund shares, you
should determine whether this investment is in your interest, and not
just in the interest of your broker or advisor who may receive higher
commissions from the sale of Class B shares than other classes of fund
shares," says an NASD alert. "Class B shares do not impose a front-end
sales charge, but they may charge higher expenses that investors are
assessed over the lifetime of their investment in a fund, as compared
to Class A shares. Class B shares also normally impose a contingent
deferred sales charge (CDSC), which you pay if you sell your shares
within a certain number of years. In addition, investors who purchase
Class B shares cannot take advantage of breakpoint discounts available
on large purchases of Class A shares."
It was this last point that tripped up Merrill
Lynch, Wells Fargo and Linsco/Private Ledger, to name just a few
brokerages. Last December the NASD announced fines against them
totaling $19.4 million for "improper sales of Class B and C mutual fund
shares."
Hanson says this isn't the case with Schwab at all. He says the firm,
which in June said it was cutting prices for equity, option, mutual
fund and bond transactions and eliminating service fees, such as
charges for ATM withdrawals, various checking services and electronic
bill payments, effective July 1, is merely trying to do the right thing
for clients, whether advisors or individuals, by creating a level
playing field for fees. "We don't want to disadvantage our customers,"
he says.
But Benz says this is exactly what Schwab's policy
does. She says smaller mutual funds are afraid they will get shut out
of the Schwab program and lose assets, so they keep a higher-priced
share class on the books even though they could offer direct investors
a lower price. Moreover, some fund companies complain that the cost of
participating in Schwab OneSource, typically 40 basis points per year,
can consume more than 50% of a bond fund's revenues.
Small fund groups also are convinced their largest
competitors can wield their clout with Schwab and negotiate deals well
below the annual 40 basis points charge. "You know Pimco isn't paying
Schwab 40 basis points on its bond funds," says the marketing chief at
one small fund boutique.
Davis Selected Funds, the highly regarded Tucson, Ariz.-based fund
family, is the only firm she knows of that is allowed to offer two
share classes in the Schwab system. Hanson explained that Davis is
allowed two share-class offerings because its Selected or "S" class has
been in the Schwab program for a long time and it "has a fantastic
record." Still, he says, the new "D" class, offered as a no-load with
no 12b-1 fees, is the only share class available to new investors.
Existing "S" class investors can accumulate more shares through Schwab,
however.
Davis is a big, widely respected firm, Benz notes. A
smaller firm may not garner the attention or the accommodation that big
"product" firms get. Indeed, in other circumstances, large mutual fund
complexes pay big dollars to get wider exposure, gain more assets and
rake in fees.
"I don't think this is just a Schwab issue but is a problem with many
B-Ds. One of the reasons I left my former firm was due to this issue.
My former B-D would not allow certain share classes in their selling
agreements because they said they felt there were potential regulatory
problems. Speaking with some of my friends on the inside, I found out
anonymously that there was no 'sponsorship' provided by these
distributors and therefore selling the cheaper share class cut their
profits," says Allen Bronton, at Wealth Preservers LLC in Crystal Lake,
Ill.
Meanwhile, Schwab execs hold a steady line. "We work
with funds to determine if the share class available is right for our
investors," Hanson says. Another Schwab spokesman says there is no
discrimination among its vendors.
Schwab says this is how the fund universe is winnowed: 6,000 are made
available through Schwab, but only 2,500 are available through
OneSource, its "no transaction fee" program. Another 1,500 or so are
available for $49.95 per trade.
"Schwab's Mutual Fund OneSource service gives you
access to a wide selection of funds from America's most prominent fund
companies, all available without transaction fees," firm literature
says. "Transaction fees may apply to certain no-load and low-load funds
which do not participate in our Mutual Fund OneSource service. Such
funds are subject to Schwab's standard transaction fees in addition to
any redemption fees imposed by the fund."
In certain circumstances, Schwab notes, transaction fees are waived for
certain high-load funds. It doesn't explain why. However, it goes on to
say, "Schwab receives remuneration from participating fund companies."
Advisors access Schwab's menu of mutual funds
through its institutional division. The division has grown, over almost
two decades, to service more than 5,000 registered investment advisors
representing almost a half trillion dollars in assets. Many, if not
most, of those assets under management are in mutual funds.
The Investment Company Institute, the mutual fund
trade association in Washington, D.C., reports in its 2006 ICI Fact
Book that "more than half of all mutual funds offer two or more share
classes." That puts a big dent in Schwab's offering capability, given
its "one share class" mandate.
Some advisors aren't bothered by this. "We utilize Schwab Institutional
and we seldom come across funds we would like to access but that are
not available," says Shannon A. King at SilverOak Wealth Management LLC
in Minneapolis.
Others are. "I discovered years ago, in my year on
Schwab's inaugural advisory board, that the company is a one-way,
heavy-handed bully and not to be trusted. I subsequently transferred
every dime of AUM to Fidelity and Waterhouse," says Gene Balliett at
Balliett Financial Services Inc. in Winter Park, Fla.
Fidelity, Schwab's biggest competitor, offers
multiple share classes for mutual funds, and it has its own famous
brand of mutual funds. TD Ameritrade, yet another Schwab competitor,
also offers multiple share classes for the same funds.
To be sure, offering multiple share classes poses
its own problems. As the NASD found in its investigation of the issue,
some mutual fund investors weren't aware that shares could be purchased
more cheaply via other distribution routes, such as buying directly
from the company, while others were left in the dark about breakpoints
afforded to certain institutional share classes if they made larger
investments.
Mutual fund expenses have been on the decline,
according to the ICI, falling in 2005 to their lowest levels in more
than 25 years. The decline is being driven primarily by continued
investor migration to lower-cost funds and by cuts in expense ratios by
funds, ICI research shows. It says wider availability of lower-cost
funds is "slightly more important" in driving this trend. What the ICI
fails to mention is that much of the reduction in expenses was driven
by the mutual fund scandal after which many fund complexes agreed to
lower fees as part of their settlements with regulators.
Other factor come into play as well. "As a rule,
asset growth tends to reduce the advisory fees of a given mutual fund,
whether that fund is a stock, bond or money market fund. Some mutual
funds have 'breakpoints' in their advisory contracts that automatically
lower their advisory fees as fund assets grow. Even if a fund's
advisory contract does not have breakpoints, the fund's advisor (in
conjunction with the fund's board) may cut a fund's advisory fee as its
assets grow. Moreover, regardless of asset growth, advisors may cut
their fees for competitive reasons or may institute fee waivers, both
of which lower a fund's expense ratio. All of these factors helped to
lower the expense ratios of stock funds in 2005," ICI reports
The Schwab philosophy helps keep things clean and avoids
investor/advisor ignorance and/or ineptitude with regard to purchasing
the proper share class. But at the same time, Schwab may be keeping
mutual funds from lowering their shareholder fees to attract more
assets: Why give up a sure thing and a gorilla distributor
to-maybe-find assets somewhere else?
The ICI notes funds "that sell through financial
advisors offer more than one share class to provide investors with
several ways to pay for the services of financial advisors." In
Schwab's world there is only one way; it's their way.