By Martin Wolk Executive business editor
msnbc.com

The scandal embroiling the mutual fund industry has cast a harsh light on the murky world of hidden fees and revenue-sharing arrangements that eat away at investor returns.

Investment fees have not been a prominent issue in most of the cases brought so far against mutual fund companies by state and federal regulators. With few exceptions the allegations have focused on illegal or improper trades that effectively have skimmed profits by raising expenses and reducing returns to ordinary investors.

But legislators and regulators interested in reforming the $7 trillion mutual fund industry are homing in on hidden fees, “soft dollar” payments, revenue sharing and other arrangements that could have a far greater impact on investor returns. These hidden fees widen the scope of the state and federal inquiry beyond the mutual fund industry itself to the broader network of banks, brokers and advisers that market the securities.

“Right now, all the focus is on mutual funds, but the current industry scandal really casts a light on a related problem: investment advisors and other financial professionals who are failing to live up to their obligations as fiduciaries,” said Kimberly Sterling, vice president of Resource Consulting, an investment advisory firm in Orlando, Fla. She spoke in a telephone news conference with other “fee-only” investment advisors who favor low-cost, index-based mutual funds.

A glimpse into the little-understood world of these hidden fees and payments was offered this week when Morgan Stanley agreed to pay $50 million this week to settle a case with federal regulators that focused on how the giant brokerage marketed mutual funds.

In testimony to a Senate committee this week, Securities and Exchange Commission Chairman William Donaldson referred to the Morgan Stanley case when he pledged that the agency would tighten its governance of the fund industry to enhance disclosure of “conflicts that arise as a result of the various arrangements between funds and brokers regarding the sale of fund shares.”

Specifically he commented on the so-called “shelf space” payments made by fund families to Morgan Stanley and other brokerages. In Morgan Stanley’s case, according to the newly required disclosure, the brokerage gives preferential treatment to 16 fund families. In exchange for business being steered their way, the funds pay Morgan Stanley up to 0.2 percent of any investments raised plus an annual retention payment — in addition to commissions paid by the investor to Morgan Stanley.

That previously undisclosed arrangement raises fundamental questions about whether Morgan Stanley brokers offered investors straightforward advice about the most appropriate mutual funds. The issue was further complicated by multiple classes of fund shares that offered different “loads” and different commission structures. The SEC found that Morgan brokers sold Class B shares of certain funds to some investors who were likely to have better returns if they bought Class A shares.

“Few things are more important to investors than receiving unbiased advice from their investment professionals,” Donaldson said in his testimony. “Morgan Stanley’s customers were not informed of the extent to which Morgan Stanley was motivated to sell them a particular fund.”

Donaldson said the SEC is investigating potentially similar practices at 15 additional brokerages and some mutual fund companies.

Although such arrangements may not have been disclosed to investors, they have been fairly well-known in the industry.

Russel Kinnel, senior fund analyst at Morningstar, said such shelf space payments are “ridiculous.”

“The brokerage is supposed to be acting in their clients’ best interests,” he said. “Instead they’re saying, ‘Rather than putting you in the best funds, we’re going to put you in the funds that pay us the most.’”

He also suggested that Congress should ban so-called “soft dollar” payments by funds, such as the overpayment of brokerage commissions in exchange for research or other benefits. A bill that passed the House this week would require only greater disclosure and board oversight of such payments, which are favored by fund managers because they do not show up in funds’ all-important expense ratio.

The problem of multiple share classes is also well-known. In a 1999 paper published by a professional group, finance professor Edward O’Neal found that different commission structures for the different share classes create an inherent conflict of interest for brokers.

“My opinion is that the SEC and anybody else who has a stake in this should seriously reconsider whether multiple share classes are in the best interest of shareholders,” said O’Neal, now a professor at Wake Forest University. “Certainly brokers should not be compensated differently for selling the different share classes.”

If commissions were equal, brokers presumably would make the right decision for investors every time, he said.

“When amateur buyers are pitted against professional sales people, it’s typically not to the advantage of the amateur buyer,” said Tom Muldowney, managing director of Savant Capital Management in Rockford, Ill. He complained about brokers who are “joined at the hip” to specific mutual fund families and are offered incentives like special bonuses and exotic vacations.

In general Muldowney believes that brokers who sell on a commission basis can never offer unbiased advice to their customers, and recommends instead that investors seek advice from fee-only advisers who either charge a onetime consultation fee or take assets under management for an annual percentage.

In assailing the Securities and Exchange Commission’s partial settlement with Putnam Investments last week, New York Attorney General Eliot Spitzer complained that the deal “does not address structural reforms necessary to ensure that investors are charged the lowest possible fees.”

“Up until this point, mutual funds’ fee structure has benefited management companies at the expense of investors,” Spitzer said in a statement.

© 2013 msnbc.com Reprints

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