Pay-for-Promotion Deal Gives Some Funds Higher Profile in Schwab Supermarket

The Charles Schwab(SCH) Web site boldly promises financial services "without sales pressure or conflict of interest."

Join the discussion on our message boards.

But the discount broker is promoting a new Hambrecht & Quist (HQ) mutual fund to financial advisers and its own customers in exchange for a cash payment. Such an arrangement, which Schwab says has been made in the past with other mutual fund firms, gives the untested fund extra visibility among the more than 1,650 funds in Schwab's OneSource, the Web's largest mutual fund supermarket.

Critics say such deals could tarnish Schwab's reputation for objectivity, and that the firm is starting to resemble its nemesis and favorite whipping boy, the traditional full-service broker. Load-fund companies often use financial incentives, such as boosted commissions, to promote their funds through full-service brokers.

According to filings for H&Q's IPO and Emerging Company fund, H&Q will pay Schwab a bonus determined by the amount of assets Schwab raises for the fund during its subscription period, Sept. 23 through Oct. 28.

During the subscription period, investors can reserve shares at $10 each through full-commission H&Q brokers or Schwab's no-load OneSource. At the end of the subscription period, H&Q will use investors' dollars to build the portfolio and commence operations.

Not Bad for a Month's Work Schwab's commission schedule for sales of H&Q's IPO fund
Sales through Schwab	Commission	H&Q pays Schwab
Up to $25 million	0.5%	$100,000 - $125,000
25 - 50 million	0.3	125,000 - 200,000
50 - 75 million	0.25	200,000 - 262,500
75 million and Up	0.2	262,500 and up
Source: Supplement to the IPO fund's prospectus, filed with the SEC

Schwab typically charges mutual funds an annual distribution fee of 0.25% to 0.35% of assets of funds included in OneSource. But the promotional fee on the H&Q IPO fund's subscription sales is a bonus to Schwab, above and beyond the fund's annual 0.25% distribution charge.

A successful launch might be worth Schwab's steep fees, says Dave Krimm, H&Q's top marketing officer. Launching a fund through subscription allows a fund manager to start a new fund with investors' money rather than its own. Today, new funds are typically seeded with $1 million from the fund company and incubated, or managed internally, for a year or two before being offered to the public. That way, investors can see how a fund's strategy has performed before they invest. Fund executives say subscription launches, popular 10 years ago among broker-sold funds, are not as common nowadays because few investors are willing to invest in a fund that has no track record.

But early reports suggest investor interest is high in the H&Q IPO fund due to intense interest in initial public offerings and Schwab's aggressive promotion, which has a solid track record of its own.

"Other fund families have done this through Schwab, and both Schwab and the fund firms have enjoyed it," H&Q's Krimm says. Those other firms include Janus, Warburg Pincus and Stein Roe, according to Karen Riley, Schwab's director of fund marketing.

Bill Beldon, head of product development at Stein Roe, says his firm had great success using Schwab to launch its (SRMGX)Mid-Cap Growth fund in June 1997 and (SRLFX)Large Company Focus fund in June 1998.

"Both launches were deemed successful from both our perspective and Schwab's," he says. Stein Roe is currently pursuing another subscription offering through Schwab.

To raise assets in these new funds, Schwab gives them heavy promotion during their subscription period. For example, the H&Q IPO fund is the only non-Schwab fund featured on Schwab's main and OneSource home pages.

H&Q's new fund is the only non-Schwab fund featured on Schwab's home page

Schwab also touts the fund in emails to clients and financial advisers. Later this month, an investor Q&A about the fund will run on Schwab's site, and there will be a conference call for Schwab-affiliated advisers. H&Q is currently mailing postcards about the fund to 200,000 Schwab clients with accounts of more than $100,000.

Riley says she's not aware of any other online brokerages that offer a similar promotional program to mutual fund marketers.

The Schwab-H&Q agreement is disclosed on Schwab's site and in promotional materials. Full details are available in a supplement to the fund's prospectus that investors can order online from Schwab or from H&Q.

Schwab's Riley admits that the H&Q fund is getting more extensive marketing than other funds in its OneSource supermarket but doesn't concede that it's a conflict of interest. "I think that's one point of view. You can advertise different funds in different ways," she says.

But financial planners say consumers could mistakenly believe Schwab is promoting a fund because of its quality, rather than because of a financial arrangement with the fund's adviser.

"I've been a Schwab loyalist, but this begs some questions. At an absolute minimum, it raises serious concerns, and it's disturbing to see them doing something that could hurt their reputation," says Harold Evensky, a planner based in Coral Gables, Fla.

"Now that they have an enhanced interest in selling some products, you can no longer can rely on their integrity as you used to," says Frank Armstrong, a Miami-based financial planner with Managed Account Services.

But Jim Folwell, an analyst at Boston fund-researcher Cerulli Associates, thinks the practice should come as a surprise to no one. "Schwab is a distributor of financial products and that's how they're being compensated. From Schwab's point of view, it makes sense, " he says.

Indeed, the practice could become more prevalent as falling trade commissions force online brokers to find other ways to make money. If Schwab raises $50 million in assets for the H&Q IPO fund, it could double its usual distribution earnings from a fund of that size.

But the promotional payment ironically makes Schwab resemble a traditional full-service brokerage, where bonus payouts and sales contests are common methods of pumping sales.

"What Schwab is doing here is akin to what the full-service brokers have done for years -- pushing a product that pays more," says Dan Burke, an online brokerage analyst at think tank Gomez Advisors in Lincoln, Mass. "Schwab is just -- in the traditional sense -- brokering the sale."

"Schwab is slowly morphing themselves into the things [traditional brokers] they used to hate," Armstrong says.

>To order reprints of this article, click here: Reprints