In a rather unusual case, the Securities and Exchange Commission sanctioned Kelmoore Investment Co. of Palo Alto, Calif., and fined the company $100,000 for misleading disclosures regarding the investment advisory fees it charged on five proprietary mutual funds, two of which were only available within variable annuity contracts and were liquidated at the end of 2005 due to low asset levels.

The SEC charged that from 1999 to 2005, Kelmoore understated the total fees it charged investors for managing the mutual funds. Although the funds' prospectuses showed an annual advisory fee of 1%, the fund adviser also received substantial brokerage commissions for executing options contract transactions that are a mainstay of the funds' investment strategy.

Those additional commissions boosted the fees paid by fund shareholders to more than 3% during some periods. These total costs were not properly disclosed, preventing investors from comparing other funds' advisory expenses and making informed decisions, the SEC charged.

Kelmoore is a bit unusual in that it is a dually registered entity. It has been registered since 1996 with the SEC as an investment advisor, and has also been registered since 1988 as a broker/dealer. In that dual role, the company acted as advisor to the funds and also executed equity options contract transactions. In some cases, Kelmoore's commission charges were a substantial $5.63 per options contract, the SEC said.

While large firms may have an investment advisory unit as well as a brokerage division, the two are typically separated by a Chinese wall that prevents issues of conflict, experts said.

"Kelmoore's publicly disclosed advisory fee of 1% of assets under management did not include the substantial brokerage commissions that Kelmoore additionally charged for certain services that normally, in the context of providing advice to mutual funds, would be deemed advisory services," noted the SEC in its administrative action.

Under the regulatory settlement agreement announced on Jan. 18, Kelmoore, which neither admitted nor denied the charges, was also required to hire an independent consultant to review the funds' 2006 advisory fees and commissions. Kelmoore also agreed to enhance its explanatory disclosures in fund documents seen by both existing and prospective shareholders, and notify existing shareholders of this regulatory matter.

In a statement released to Money Management Executive, Kelmoore acknowledged the SEC's action as well as the $100,000 fine and required reforms. "Kelmoore is pleased that the matter has been settled," the firm said, also acknowledging that it had fully cooperated with the SEC's investigation and had taken "prompt remedial actions to address the SEC staff's concerns."

Last year, Kelmoore did beef up its funds' prospectus disclosures. A review of the funds' prospectus publicly filed with regulators in May 2006 shows lengthy language that concedes that Kelmoore provides both investment advisory and brokerage services to the funds. The document also provides in-depth detail as to how options contracts are executed and the underlying costs.

Kelmoore is best known for its covered equity option writing strategy on its three funds. The funds' main goal is to realize gains from investing in large-cap or mid-cap stocks with adequate price fluctuations, then sell, also known as "writing," covered-call options on those stocks. Gains are then achieved either through the premiums earned by the fund from the writing of those options, or through the increase in the market value of those stocks that are called away from the funds.

Options contracts are plentiful, as the firm writes options against substantially all of the shares of stock it owns. Kelmoore personnel determine the timing and terms of the options, which include determining duration, price and strike prices, as well as when to hedge downside risk through the use of put options.

Kelmoore is also well-known for devising a series of now four comic books that feature "Kaptain Kelmoore," a fully costumed superhero who reportedly resides in a bunker just beneath Kelmoore's corporate headquarters. The Kaptain Kelmoore character debuted in 2002. His purpose is to educate investors and explain the fund group's complex options strategy, and is marketed by Kelmoore as the "defender of truth, justice and a balanced portfolio."

"Even Kaptain Kelmoore couldn't save them," quipped Jeff Tjornehoj, senior research analyst with Lipper of New York. Kelmoore is a rarity in that it's a fund company that is also registered as a broker/dealer, he said. Moreover, less than crystal-clear disclosure can put investors in a tenuous position in not fully knowing how much they're being charged in advisory fees and brokerage commissions.

Many mutual funds use options, but only a minority rely on a full and steady diet of equity options as their primary strategy. The $3.3 billion Gateway Fund, managed by Gateway Investment Advisers of Cincinnati, is perhaps the largest fund to engage in a full options strategy.

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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