The Fund Industry's Best-Kept Secret (Hint: It's Not Good for You)

If your broker is pitching a PaineWebber, Oppenheimer or Kemper mutual fund to buy before year-end, you might want to ask if he or she is fired up about the fund or its payout.

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Right now, the distributors of PaineWebber, Oppenheimer and Kemper funds are offering one or more brokerage firms a boosted commission to sell certain funds by year-end, when fund sales often dip. It's a fairly common promotional practice, called full-dealer reallowance, that doesn't cost investors more money but might cause a few less scrupulous brokers to put their own paychecks ahead of a client's long-term needs. It also might be one of the fund industry's best-kept secrets, since it's only disclosed in little-read fund documents.

Here's how it works. When you buy shares of a broker-sold fund and pay a sales charge or load, a portion of that money pays the brokerage firm and the selling broker's commission. The rest, usually between 0.25% and 0.5% of the amount invested, goes to the fund company. But when a fund company offers a full reallowance promotion, it pays its share to participating brokerage firms on sales of specified funds for a specified time. Often, this extra payout is shared to greater or lesser degrees with selling brokers -- though not always.

Usually, a reallowance promotion focuses on Class A shares, those that carry a front-end or upfront sales charge. For instance, from Oct. 1 through Dec. 31, Kemper Funds is paying full reallowance to PaineWebber on Class A share sales on more than 40 stock and bond funds, according to filings with the Securities and Exchange Commission. And from Sept. 25 through Dec. 31, the firm is paying the full reallowance on Class A shares in addition to an extra 0.5% commission on Class B and Class C shares to the brokerage arm of First Union, according to other filings.

How much does a 0.5% bonus add up to? For every $50,000 worth of fund shares sold, that's an additional $250 -- not a bad bonus around the holidays.

Promo Time These firms are currently running full dealer reallowance promotions.
Fund Firm	Funds	Promotional Period
PaineWebber	(PWKAX Quote)Strategy (PWTAX Quote)Tactical Allocation Enhanced S&P 500 (PWNAX Quote)Enhanced Nasdaq-100 (PGRAX Quote)Financial Services Growth (PSPIX Quote)S&P 500 Index	Nov. 13 to Dec. 29
Kemper	More than 40 stock and bond funds	Oct. 1 to Dec. 31
Oppenheimer	(OIGAX Quote)International Growth (ODMAX Quote)Developing Markets	Sept. 18 to Dec. 31
Source: SEC filings.

For fund companies, reallowance is a way to help a fund or group of funds stand out in a crowded market, but the practice always has its critics.

"I think it's very questionable," says Scott Cooley, a senior analyst at Morningstar. "It's a pretty objectionable practice. Especially if you're a broker without a big book of business, it's pretty tempting to put your interest ahead of your clients."

After all, boosted commissions do create a potential conflict of interest and it does so quietly. Investors don't pay a higher commission, and the practice is only required to be disclosed in a fund's prospectus or statement of additional information, so few have any idea it's in effect. The only way to know if a fund is offering a firm and its brokers a higher payout than usual is to ask your broker point blank or comb through the fund's paperwork.

"The average investor simply doesn't understand that this happens," says Harold Evensky, a financial planner at Evensky Brown & Katz in Coral Gables, Fla.

Despite its critics and potential conflicts, reallowance is hardly uncommon. It's difficult to turn up the practice in the veritable sea of funds' regulatory filings since most standard filings for broker-sold funds give them leeway to make these offers. But even an unscientific ramble through the seemingly bottomless trough of paperwork turns up some other similar promotions from this year.

The Full Story These are probably just a few of this year's full dealer reallowance promotions. Click on a firm's name to check out TheStreet.com's story on the offer.
MFS	(MRSAX Quote)Research International (MFEGX Quote)Emerging Growth (MCOFX Quote)Capital Opportunities (MITTX Quote)Massachusetts Investors Trust (MIGFX Quote)Massachusetts Growth Stock	July 3 to July 31
Pioneer	24 stock and bond funds	June 1 to Aug. 31
MFS	(MTCAX Quote)Technology	May
MFS	(MGTAX Quote)Global Telecommunications	June
Kemper	39 funds	Jan. 1 to April 30
Source: SEC filings.

There are usually a few scenarios where fund firms use reallowance. Perhaps the most common is when rolling out a new fund, since it's often tough to get brokers to look at a new or untested fund. Two examples are MFS' reallowance promotion with various firms for its recently launched MFS Technology and MFS Global Telecommunications funds.

ING Funds did the same thing last year when it offered several brokerages a boosted payout on sales of its fledgling (INGAX Quote)ING Internet fund.

And reallowance can work well. PaineWebber raised a record $2.1 billion in a six-week subscription period through its own brokers for the (PWKAX Quote)PaineWebber Strategy fund, which essentially holds the favorite picks of the firm's popular strategist Ed Kerschner. While Kerschner's name probably drummed up significant interest, the boosted commission offered during the fund's subscription period probably didn't hurt, either.

"When we see a fund launched with $1 billion and no track record, we speculate that there might have been some incentive," says Morningstar's Cooley, not commenting specifically on the PaineWebber Strategy fund. He likens the situation to that where a firm's brokers are paid higher commissions for selling the firm's own family own of mutual funds.

Since Nov. 13 PaineWebber, which declined to comment on reallowance, is offering a higher payout on the Strategy fund and a handful of other funds in a promotion that ends on Dec. 29, according to regulatory filings.

The first four months of the year are also a key time for reallowance because many investors make their tax-deductible IRA contributions to reduce their tax bills by April 15. IRA investments aren't huge but they can lead to big rollover accounts from 401(k) plans when investors' change jobs and they're typically held for the long term, which makes them highly attractive to fund shops. Both MFS and Kemper offered boosted commissions on IRA sales early this year.

These are hardly the only fund shops practicing reallowance, and it's probably a good idea to throw some water on some instinctive conclusions you might jump to.

First, fund shops don't offer reallowance on funds because they're too weak to sell on their own merit. While the ING Internet fund, down 66.2% since Jan. 1, and the PaineWebber Strategy fund, down some 31% this year, have lagged more than 90% of their peers since Jan. 1, according to Morningstar, others have fared better. The MFS Technology fund and (OIGAX Quote)Oppenheimer International Growth funds, for instance, have both fared better than their peers during this tough year.

Second, it's far from a given that brokers selling funds during a reallowance promotion are putting their interests before their clients'. In my past life as a fund marketer, I found the vast majority of brokers had little interest in these types of promotions. In fact, many brokerages now refrain from participating.

That said, brokers' and brokerages' growing reluctance to participate in reallowance, combined with my own discomfort with the technique have convinced me that it's probably something the fund world should shed.

The Junk Pile

Once again we're seeing that fund investors aren't the only ones who chase hot performance. Health care sector funds, riding a wave of hot biotech stocks, are up more than 50% this year, according to Morningstar. That makes health funds far and away the top fund category this year, more than doubling current runner-up real-estate funds.

While investors' cash flows to the sector have picked up in this tough year for stocks, fund companies' interest has been far more remarkable. Fund shops have launched some 17 health funds this year, not even counting a slew of exchange-traded funds, according to fund-tracking Web site MaxFunds.com. The previous record for health fund launches in any year was six in 1999 and 1998, and more than half the health funds out there don't have a three-year track record.

As we pointed out before, a record number of funds focused on a sector often presages a downturn for that sector the following year. For a look at some solid funds in the sector, check out this recent Big Screen.