It is hard to believe it has been almost 20 years since I left Invesco and co-founded Iron Capital with my then-partner Larry Gray in 2003. Almost immediately after we launched, the industry from which I hailed handed us a gift in the way of what was simply known as “the mutual fund scandal.”
I left Invesco because I was bothered by two things in the investment industry. First: the industry is rife with conflicts of interest, which is self-evident. Second: the investor increasingly has no access to actual investment counsel – meaning the industry evolved to put layers of middle-people between the investor and the actual investment professional. Today the investment professionals – analysts and portfolio managers – do their work in relative isolation, and support staff share information to heads of sales (who now go by myriad names other than sales), who distribute that information to brokers (now referred to as financial advisers), and then to clients. A lot gets lost on the way.
We wanted to build a firm that was truly independent and gave investors direct access to the investment professionals who actually make the investment decisions. As we launched the firm, New York attorney general Anthony Weiner announced an investigation into the practices of mutual fund companies who were allowing short-term traders to go into and out of their funds rapidly, hurting long-term investors. To sum up the gist of the scandal, these firms had given preferential treatment to large brokers and hedge funds at the cost of everyday clients.
This actually helped our business, first because we were preaching an end to conflicts of interest, and second because coming from the mutual fund world helped us have a better understanding of what was actually happening. Iron Capital got off to a great start and we successfully built a nice business; quickly we made the decision to be satisfied with doing just that. Having come from a very large firm and knowing all that goes with that, we decided that Iron Capital would remain a boutique. We ended all business development efforts and focused solely on serving our existing clients. Our clients’ referrals are our only source of new business.
Along the way we felt that the industry had improved, as firms like ours led to more independence and fewer conflicts. But I was naive. Yes, many brokers have left their traditional role to become fee-based, but as the old expression goes, “Just because a cat has kittens in the oven, that don’t make ‘em biscuits.” Just this past week I have learned of a practice that should make the first mutual fund scandal seem petty and small.
Multiple mutual fund giants, including but not limited to T. Rowe Price, Fidelity, and yes my old employer Invesco, have made deals with supposedly independent pension consultants to charge their clients less than they charge everyone else. They are doing so by aggregating the total assets of these consultants and charging them as if they were one very large client. What is wrong with that?
Let us count the ways. Traditionally many of the consultants who work with retirement plans followed Iron Capital’s model and remained boutiques. I may be biased, but in my opinion, this is what the best consultants have done… yes that includes us, but not just us. Boutiques have been able to compete because pricing in this business was always based on the client, not whom the client chose to hire as a consultant.
It works the same way for retail investors. Charles Schwab in all likelihood has billions of dollars with these various mutual fund firms. Still, if you go to Schwab and open an IRA and choose one of these mutual funds, what you pay for the fund is based on your account alone. Otherwise, Charles Schwab wouldn’t exist, because they could have never competed with the Merrill Lynch’s of the world who were huge long before anyone “talked to Chuck” as their commercials used to say.
If pricing is based on the size of the consulting firm, then boutique firms will no longer exist. This is problem number one. Problem number two is that independence will no longer exist. Once there is a business relationship between the consultant and the mutual fund company, all independence is lost. One simply cannot serve two masters, so if we build a cost-reduction relationship with T. Rowe Price for their target retirement date funds, but then come to believe that someone else’s product is better, we now have a conflict: Do we go with the best option, or do we go with bulk purchasing power? One cannot serve two masters.
Finally, and most importantly: Small plans, small firms and their employees end up subsidizing these large relationships by paying more for the same fund. Scaling pricing based on the client, whether an individual or a retirement plan, makes sense as there is some fixed cost to having a client. That cost does not increase with the size of the portfolio, so reducing the percentage charge as assets grow makes sense. However, basing that not on the client but on the consultant the client chooses to hire means a small client who hires the preferred consultant may end up paying less than a large one who chooses another path. The only way the mutual fund company can make that work is by keeping prices higher for everyone else.
The original mutual fund scandal boiled down to large brokers getting preferential treatment at the expense of small investors. This 2.0 version boils down to the same thing: Large consulting firms are receiving preferential treatment at the expense of smaller firms and investors. Iron Capital could play this game too. We never dreamed of it because it is unethical. Unfortunately, we have no choice; we have a fiduciary responsibility to look out for our clients. That doesn’t mean we can’t simultaneously work to stop this practice.
I left the mutual fund industry to start Iron Capital because I was tired of feeling dirty when I came home from work. I wanted to look into a mirror without shame. It sickens me that I have to get dirty again to protect my clients. This time I can do it in the light of day. Light is a great disinfectant, at least that is my perspective. This will not be the last time you read about the Mutual Fund Scandal 2.0.
Chuck Osborne, CFA