Step on one of these and your business could get blown to bits.
Mutual funds may seem like a relatively low-risk investment decision, but pick the wrong one and you could cause your client and yourself a lot of problems.
What kind of problems?
In January 2019, the Securities and Exchange Commission settled charges against two New York-based investment advisers and one of their CEOs who had selected mutual fund share classes inconsistent with their disclosures to clients. The firms and the CEO will collectively pay more than $1.8 million, which will be returned to harmed investors.
According to the SEC’s order, the two firms and the CEO invested advisory clients in mutual fund share classes that paid 12b-1 fees to the firms’ investment adviser representatives (IARs), even though less expensive share classes of the same funds were available. The SEC ruled that the firms failed to disclose conflicts of interest, violated their duty to seek best execution, and failed to implement policies and procedures designed to prevent violations of federal securities laws in connection with their mutual fund share class selection practices.
In disclosures to clients, one firm incorrectly stated that its IARs either did not receive 12b-1 fees or only selected the more expensive share classes when less expensive share classes of the same fund were unavailable, while the other incorrectly stated that it selected higher-cost share classes for the “long-term benefit” of clients and only where less expensive share classes of the same fund were unavailable, according to the SEC.
An ongoing crackdown
Before dismissing this as a one-off occurrence, consider that the settlement was just the latest in an SEC crackdown aimed at RIAs mutual fund share class selections launched in 2013.
So, how can RIAs avoid this mistake? A first step is to make sure to disclose any and all conflicts of interest in your firm’s Form ADV along with information about what steps you have taken to mitigate that conflict. A second step is to make sure all your financial advisors read and understand your Form ADV.
“Advisers must be vigilant in disclosing all conflicts of interest arising from compensation received based on investment decisions made for clients,” C. Dabney O’Riordan, Chief of the SEC Enforcement Division’s Asset Management Unit said in a Jan. 21 press release announcing the latest settlement. “The documents these advisers provided to clients were incorrect and investors were harmed. We are continuing our efforts to stop these violations and return money to harmed investors as quickly as possible.”
Being unaware of tax implications
Another common mistake RIAs make is failing to consider the tax implications of a mutual fund’s distribution policy. Distributions may or may not be subject to taxes, depending on the type of distribution, the length of the investment holding, and the overall investment type. Purchase shares in the wrong fund – such as one with a high turnover rate – and you could trigger a tax event.
This due diligence should also be performed when taking over a new client’s portfolio, particularly if the client appears to have done little tax planning or have little understanding of their tax situation. There may be some mines among the mutual funds lingering in their portfolio.
Taxation on mutual funds is complex, and it’s important to make sure that your clients aren’t in the dark. Communication is key, and clients will appreciate up-front discussion about a fund’s tax implications and how you can work with them to minimize the tax burden.
Putting the cart before the horse
A third mistake RIAs make is chasing yield before considering whether a particular fund, or type of fund, fits into a client’s overall portfolio. This poses several risks.
The first, and most obvious, is that past performance is no guarantee of future performance. Beware the 30-something rock stars who have never had to navigate in a bear market, especially this late in an economic recovery. Chasing a hot streak is for amateurs.
Base your decision first and foremost on what’s best for the client and complies with their risk-reward tolerance. While these criteria won’t guarantee performance any more than a fund’s past performance, they could help you retain the client’s trust should the fund not perform as expected.
The bottom line is that while mutual funds provide much greater diversification than individual stocks and bonds, they do present risks. Some could damage your relationship with a client, and some could even end your career or put you or your employer out of business. The good news is that you can mitigate all of these by following the same simple risk management approach we advocate for selecting all investments: select mutual funds based on your clients’ best interests.
Purshe Kaplan Sterling Investments is a full-service broker/dealer that offers two career platforms for established industry professionals via a classic open architecture environment. To learn more contact us today.