Skip to main content

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.

Since fund companies (or rather fund shareholders) pay the broker for distribution on a no-transaction-fee supermarket, they would rather deal with an Omnibus account, or they wind up paying twice -- once to the broker, and again to maintain the separate accounts the broker sets up.

The Big Negative

While the Omnibus structure has many benefits, it could have one big negative in the war against active fund timers and net asset value gamers: It can be used to hide questionable trades. (NAV gaming involves trading in and out of a fund specifically to take advantage of a fund price, or NAV, that is off from what the underlying securities are likely worth. Exploiting fund prices that don't properly reflect recent events is a form of stealing, as profits come directly from other fund investors.)

At your typical no-load fund company that participates in Schwab's no-transaction-fee network, somewhere between a third and a half of the fund's total assets are in the Schwab house account. Other fund supermarkets run by

Fidelity

,

TD Waterhouse

and

TheStreet Recommends

E*trade

(ET) - Get Energy Transfer, L.P. Report

can mean more than half of a fund's assets are from brokers.

This means a $1 billion fund may have a few house accounts with $500 million in assets. That's $500 million in client assets that a fund company knows very little about in terms of actual shareholder makeup or individual trading behavior.

With a $500 million dollar house account, how would a fund know if a discount broker allowed a client with $20 million to actively trade the fund? All the fund would see is a change in assets of $20 million every so often to the account, an amount that could represent the flows of hundreds of smaller investors making routine buys and sells and following the fund's trading rules.

Discount brokers like Schwab honor a fund company's redemption fee schedule. This means that if an investor withdraws money a few weeks after buying a fund that has a short-term redemption fee, the broker will deduct the fund company's redemption fee, as stated in the fund's prospectus. This fee would get passed on to the fund for the benefit of all other shareholders who bear the costs of the trading.

In addition, discount brokers like Schwab charge their own short-term trading fees, fees that deter short-term trading even when a fund's own redemption fees are in place to prevent that behavior.

Discount brokers don't really care about the cost and performance implications of active trading to the fund -- they just want to lessen their own costs in handling trades and profit from the trading activity.

Active fund trading at a discount broker should be even lower than with investors who buy the fund directly from the fund family, because the penalties for trading are greater -- you get hit twice, once by the fund's short-term redemption fees, again by the discount broker's short-term trading fees.

While to date there have been no allegations of this behavior at retail discount brokers, it would be possible to use a fund Omnibus account to actively trade a mutual fund. This could mean everyday market-timing using funds, or more costly (to other shareholders) NAV gaming by taking advantage of stale prices on foreign funds.

Possible Misdoings

Could a discount broker behind the fund platform waive its own quoted short-term trading fees in exchange for other benefits? Could the discount broker "forget" to collect a fund's short-term redemption fee as stated in the fund's prospectus? Could a broker allow select clients to hop into the daily house account trade -- a trade that doesn't go to the fund immediately after the market close -- after late news breaks?

The recent inquiries into

Bear Stearns

(BSC)

and

Security Trust Company

show how a third-party platform can be used to run a secretive fund speakeasy allowing trades few fund companies would willingly allow (at least without a kickback). In both cases regulators alleged that the firms used their clearing and custody platforms to help disguise illicit fund trades from fund companies for a piece of the skimming profits.

Schwab's recently announced troubles with fund timing are more related to the conflicts of interest from owning

U.S. Trust

, a company that manages high-net-worth client assets, and managing its own retail mutual funds at the same time. Schwab has its own Schwab mutual funds, and its recent acquisition of U.S. Trust brought Schwab the U.S. Trust-managed Excelsior funds.

We have yet to see Schwab, or the dozens of other discount brokers that run fund supermarkets like

Ameritrade

(AMTD) - Get TD Ameritrade Holding Corporation Report

, E*Trade, TD Waterhouse,

Fidelity

,

J.P. Morgan's

(JPM) - Get JPMorgan Chase & Co. Report

Brown & Co.

,

Muriel Seibert

,

Scottrade

and others, abuse the privilege that allows them to sell fund shares to their brokerage customers.

The question is: Did brokers turn down the temptation for a big money account? The potential for discount brokers to profit is sizable. Omnibus accounts offer interesting ways to cloak illicit trades from a fund, including matching retail buys and sells against big-money accounts taking the opposite trade at opportune times.

Several discount brokers were contacted for this article, but none had any comments about their fund supermarkets. A National Association of Securities Dealers representative said the NASD last Wednesday "agreed to requests by

Securities and Exchange Commission Chairman William Donaldson to form an Omnibus account task force." They remained hush-hush about which firms will be questioned by the new task force.

Discount brokers may not have fallen prey to temptation. They've been known to call a fund and ask if it wants certain large clients' large and active trades, actually helping to highlight questionable accounts.

But discount brokerage fund platforms also certainly offer a way to actively trade a mutual fund. They offer a way to make illicit or just questionable trades without a fund company's being the wiser.

As details of the fund scandal unfold, it seems where there is a way, there is often a will.

Jonas Max Ferris is co-founder of

MAXfunds.com, a fund research and analysis company, and partner in an investment advisor offering managed accounts in mutual funds. He welcomes column critiques, comments or baseless accusations at

jferris@maxfunds.com.