Commission Practice Has Fund Investors on Lookout for Conflicts

A practice called reallowance offers brokerage firms extra incentive to push a new or slow-selling fund.
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As recently as a few months ago, the

ING Internet

fund would have been a surefire attention-getter just because of its focus on Internet stocks.

But Net stocks have cooled, the number of Internet funds has mushroomed and ING's funds group, a division of

ING Groep

(ING) - Get Report

of the Netherlands, has neither a well-known brand name nor a high-profile manager to make its broker-sold fund stand out from the crowd.

But it does have a weapon: ING is offering to boost the normal industry commission to brokers who sell the fund to their clients.

This higher payout is known in the industry as a full-dealer reallowance. And as of July 15, the ING Internet fund had signed up 25 brokerage firms to participate, according to documents filed with the

Securities and Exchange Commission

. For a list of those companies, click

here.

Other companies offer reallowance as well, though it's impossible to say how many because regulators don't keep track. But an unscientific search of documents filed with the SEC indicates that reallowance programs have been offered in the past three years on funds sold by

Goldman Sachs

(GS) - Get Report

, the

Dreyfus

unit of

Mellon Bank

(MEL)

,

Federated

(FII) - Get Report

and

Alliance

(AC) - Get Report

, among others.

Critics say this marketing technique creates an inherent conflict because it encourages brokers to focus on a fund's commission rather than its suitability for customers' portfolios.

"It makes me want to throw up," says Frank Armstrong, a fee-based planner and president of

Managed Account Services

in Miami. "It's why I left the brokerage business, and it almost made me leave the industry because it creates a gross conflict of interest."

Dealer reallowance has been around since the early 1980s, though it remains one of the fund world's best-kept secrets. In fact, investors often have no idea when it is in effect. Fund companies must disclose the practice, but they typically do it in a document that few investors ever see.

Here's how it works: Ordinarily, when you buy a fund with a sales charge or load, the fund company keeps a portion of that money, usually around 0.75%. The rest of the load goes to the brokerage firm, which pays the broker who sold the fund.

When a fund company offers full dealer reallowance, it agrees to hand its portion of the load back to the brokerage firm. The firm then typically passes on at least a portion of that extra money to brokers who put clients in the fund.

The promotion lasts for a specific period, usually one to three months. But because clients pay the same load as usual, they're unaware of the broker's increased payout.

"It is a common practice. We've disclosed it in the fund's Statement of Additional Information in compliance with SEC rules and referenced it in the fund's prospectus," says ING spokeswoman Cindy Schauss. The added payout does not allow brokers to stray from requirements that they only put clients' money in suitable investments, she adds.

But the Statement of Additional Information, or SAI, is a legal document that is provided to fund investors only upon request. If reallowance is mentioned in the prospectus, the more commonly distributed document, it is usually only to say that further details can be found in the SAI.

Could this higher payout lead some brokers to pitch an inappropriate product to their clients? Indeed it can, say some former brokers who've become fee-based planners.

"It's simply a way to get someone to sell the fund just for the payout, rather than the product's quality," says Harold Evensky, a planner in Coral Gables, Fla.

But in the crowded broker-sold fund business, fund firms that are small, unheralded or new in the marketplace will otherwise have a hard time getting brokers to consider their funds.

ING's new Internet fund is a good example. To begin with, the Net-fund category is getting crowded. A year ago, there were only three Internet funds, and only one was broker-sold. But for 1999, Internet-fund sales have topped $3 billion, and more companies have launched funds to grab a piece of that pie. Today, there are eight Internet funds, and 14 more have filed registration papers with the SEC.

Compounding its difficulty, ING is a rookie brand in the U.S. fund market. Although the company manages more than $70 billion in assets, it jumped into the U.S. fund business with 14 funds just last December. The obscurity of the Internet fund's manager, Guy Uding, who is based in The Hague, won't help get brokers' attention. And as a broker-sold fund, ING Internet will have to compete directly with the $2.5 billion

(MNNAX) - Get Report

Munder NetNet fund, the category's behemoth.

Although ING has pledged to close its fund at $500 million, the reallowance shows it's not too confident that investor dollars will flood in.

Despite -- or maybe because of -- the practice's low profile, reallowance is a proven tactic for boosting a fund's sales, says one veteran fund marketer who has used it.

"The idea is that it gives the broker incentive to learn your fund's story. Once the broker knows the story, it might stay in the broker's book of business after the promotional period is over," says the fund marketer, who asked not to be named. "I know it works because I'd see sales on funds offering reallowance spike up during the promotion."

How do you know if a fund you're being pitched is offering reallowance? Your only options appear to be asking your broker or poring over a fund's SAI.

Steve Gibson, chief executive of

Liberty Funds Group

, which has used full dealer reallowance in the past, doesn't think investors should be too concerned because the practice is becoming less effective, particularly at larger brokerage houses.

"Today many large distributors take the money but don't really pass it on to their brokers, so it's really most effective with smaller firms," he says.

But one Virginia broker affiliated with a major firm says his firm's practice of not passing on the extra payouts to brokers has become a point of contention.

"When they do take the money from fund companies, they don't tell us, we don't see it and we have a problem with that," he says. He wants to receive the payout, but claims it wouldn't create a conflict of interest.

Viewed from a certain angle, reallowance can be the trademark of a solid fund, Gibson says. "If a company is putting reallowance on a fund, they probably really believe in it. It's a vote of confidence," he adds.

The

National Association of Securities Dealers

, the regulatory body for brokers, plans to look at the issue sometime in the future, a spokesman says. Meanwhile, the industry should do its own re-examination of brokers' work and pay structure, Evensky says.

"Most brokers are competent and honest, but we're all human. As long as there are carrots like this out there, there is the potential for conflict of interest," Evensky says.

Time will tell if ING's reallowance will pay off for the company. Sales figures for the new Internet fund won't be released until next month.