TCS Daily


The SEC and the Desire For Continued Relations

By John E. Tamny - August 27, 2004 12:00 AM

The Wall Street Journal recently reported that the SEC will ban a practice by which mutual fund companies direct trades to brokerage firms in return for promotion of their funds. By making it even more difficult for new mutual funds to gain "shelf space" in the marketplace, the ban will help established mutual fund firms at the expense of the small investor.

The apparent rationale behind the SEC vote appears to be the incentives created by trading commissions, and the worry that investment firms will be swayed by them in such a way that they'll recommend less than stellar (but high paying) funds to their customers. Only in the land of regulators could an idea this silly merit a vote.

In fairness to the SEC, its argument might briefly make intuitive sense. The profit motive is one of the central tenets of capitalism, and wouldn't that motive cause brokerage firms to sell customers not the best mutual funds, but the funds that in return send a lot of trading volume their way? I said briefly.

By the SEC's shortsighted logic, restaurant owners would buy only the cheapest ingredients, hairdressers would cut hair with an eye on volume instead of quality, and doctors, instead of correctly diagnosing patient ailments, would simply make diseases up so as to move on to the next paying patient. It's not a stretch to see that at least in other industries, failure to give the customer what he wants is a recipe for unemployment.

Is the brokerage industry somehow different? Notwithstanding Eliot Spitzer's broad character assassination of Wall Street in recent years, the reality is that reputation is everything there. The companies and people that prosper in the extremely competitive investment world do so because they fulfill customer wants and needs, and in taking care of their customers, gain referrals along with repeat business.

Cato Institute Chairman William Niskanen refers to the above as the desire for "continued relations." The self-interested desire to repeatedly sell to and serve hard-to-get clients means that the successful salesman and company will sublimate any short-term and dishonest instincts in favor of honest ones that insure more sales in the future.

The ban of directed brokerage practices totally ignores the incentives that drive profits on Wall Street, and anywhere else for that matter. Worse, it insures that small investors will in the future see less competition for their investment dollars, not to mention the higher fees that will result from the aforementioned lack of competition.

For the ban does not outlaw paying for "shelf space" at brokerages altogether. Mutual funds will be allowed to make direct payments to brokerages; the problem there being that the funds most in need of shelf space won't have the budgets of larger fund companies necessary to buy space. Directed trades are presently an inexpensive way for small-budgeted funds to market themselves, and to get the attention of firms that will help them expand their asset base.

Ironically, three studies (including one by the SEC) have shown that the greatest fee reductions have occurred among mutual funds that have grown the most. A vote against directed trades will stunt the growth of tomorrow's big competitors, and in doing so, will make established mutual fund firms less vulnerable to the kind of competition that improves service, and lowers costs for the small investor.

In the year since the news broke about market timing among mutual funds, many rules and regulations have been passed to presumably create the appearance of corrective action. Importantly, looks can be deceiving, and while outlawing directed brokerage efforts might look good, there's no evidence that the ban will be good for the investor class.

John Tamny lives in Washington, DC and can be reached at jtamny@yahoo.com


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