Next Scandal: Brokers?

Can the discount brokerage industry stay clean in the growing fund scandal?

Doubtful. It's highly likely that hedge funds called on discount brokers in recent years for special arrangements to use brokers' trading platforms to actively trade funds. Why? Think of the brokers' popular fund supermarket trading platforms -- the grand fund bazaars where customers can buy and sell thousands of funds in one place -- as a high-speed Internet connection with no firewall.

Years ago, things were simple. Investors owned shares directly. They called up a fund, ordered a prospectus and application, filled it out and mailed in a check. The fund company knew who its customers were and could police bad behavior directly. In the last decade, however, third-party distribution has become the fastest-growing area for new fund assets. Fund companies seeking extra distribution have partnered with brokers that want to offer mutual fund investing alongside stocks, bonds and options.

How It Works

Schwab(SCH) pioneered the mutual fund supermarket and is the Wal-Mart of no-load fund distribution. Schwab OneSource allows millions of Schwab customers access to thousands of mutual funds. Fund investors love the convenience of buying and selling all their funds in one place.

Schwab and some other discount brokers maintain a giant house account at each no-load fund in their fund supermarket. The broker does its own subaccounting, keeping track of all its clients who buy and sell the XYZ growth fund, and makes one big trade each day in its house account to reflect the net shareholder flows.

If a broker's customers place $10 million in buy orders for the XYZ growth fund and $5 million in sell orders, at the end of the day the broker does one trade and buys $5 million in its house account with the fund. These house accounts are enormous; the Schwab house is usually the single-largest account at most no-load funds.

This is known as the Omnibus structure, and is the alternative to maintaining multiple individual accounts at the fund for each shareholder, which some brokers do. It's a good system; most fund companies prefer one Omnibus account over many individual accounts because it keeps their own accounting costs down. Whether it has $200 or $2 million, each individual account costs a fund around $15 per year in administration costs to maintain.