Investors may be getting a raw deal when investing in index mutual funds through their broker, as they pay a steep "broker penalty." The extra operating costs paid over time for broker-sold load index funds are triple those paid by investors in true no-load mutual funds, according to a study by Zero Alpha Group and Fund Democracy, released during a conference call last week.

The study analyzed 141 retail mutual funds that track the Standard & Poor's 500 index. Data was gathered from Morningstar's Principia Pro Plus for Mutual Funds database.

"One would expect using a professional adviser to improve an investor's performance, but instead, the investor pays a significantly higher penalty," said Edward O'Neal, assistant professor at Babcock Graduate School of Management at Wake Forest University.

Index funds are essentially commodities that hold identical or almost identical sets of securities. Although funds that track a particular index deliver almost identical performance, their fees vary widely, O'Neal said.

The study found that the expense ratios of the S&P 500 index funds ranged from seven basis points to 145 basis points.

True no-load fund investors pay no distribution expenses and an average of 21.5 basis points in operating expenses. While no-load fund investors pay no broker commissions, they pay 12b-1 fees, which average 12.6 basis points, and their operating expenses average 70.4 basis points. Finally, load fund investors pay 15.6 basis points in distribution expenses and 70.4 basis points in operating expenses.

Essentially, that means in return for an additional 15.6 basis points worth of distribution services, load investors pay an extra 48.9 basis points for operating services over the amount true no-load investors pay, O'Neal said. Operating expenses incurred by investors in load funds are 3.3 times greater than those incurred by investors in true no-load funds.

Brokers may not always be acting in the best interest of their client and not fulfilling their fiduciary duties, panelists agreed. Brokers presumably are compensated for acting as agents for investors, but the only way to explain their index fund recommendation is to view them as agents for the fund companies that manage the higher-cost index funds, the report states.

The problem is that investors pay the brokers, not the fund companies, and investors expect that their broker will recommend the best funds for their needs. Investors' payments to brokers are effectively used by fund companies to find investors for their funds, Zero Alpha Group said.

"These findings show that brokers are serving as agents of fund companies, not in the best interest of their investor clients," said J. Christopher Kerckhoff, Jr., vice president of Plancorp of Chesterfield, Mo. "We would fully expect such investors to incur distribution costs associated with compensating their broker. However, there is no valid reason for investors to have to foot the bill over and above what true no-load investors do for other, non-distribution services."

Currently, a broker gets paid through the funds in which their clients invest, so, therefore, brokers are putting their clients in funds where they can get compensated the most. The one solution could be if brokers get paid a flat commission, as they do when they buy and sell stocks, regardless of which stock they select for their clients, said Mercer Bullard, a professor of business law at the University of Mississippi in Oxford, Miss., and founder of shareholder advocacy group Fund Democracy.

"Brokers are supposed to work for their clients, but when recommending a generic product such as an index fund, they refer their clients to more expensive funds and then collect sales charges to boot," Bullard said. "Federal law requires that brokers charge the commissions that funds tell them to charge. It is time to end price fixing in the industry and cut the cord between mutual funds and the brokers who sell them."

The study does note some differences in index fund attributes that may explain why investors in load funds may be willing to pay more for operating expenses. Funds with low turnover, a low minimum investment amount and low tracking error relative to the index, may charge higher operating expenses.

However, there are regulatory actions that can be taken to rectify the problem, according to Zero Alpha. While the Securities and Exchange Commission currently relieves brokers of the same standards that apply to financial advisers, there is a lawsuit pending to get the rule overturned, Bullard noted. The SEC could move the issue along, but it would take legislation from Congress to pass the laws, experts said.

Educating investors is also key. "Investors need to realize that brokers are not held to the same fiduciary responsibilities that registered financial advisers must follow," Kerckhoff said.

"Investors dealing with commissioned salespeople need to find a fiduciary," said Richard Bennett, a principal and financial adviser at Savant Capital Management of Rockford, Ill.

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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