Subject: File No. S7-15-10
From: Chaz Hart, CFP

November 5, 2010

I want to start by saying I am all for transparency of fees for investors and revising fund director oversight duties. I do want to touch on the topic of protecting investors by limiting fund sales charges and encourage retail price competition. I want to make sure that we first understand the various ways investors can invest their money. I think the interpretation of what investment professionals see 12b-1 fees as and what the rest of the market see them as is not fully understood.
Let me start with a brief overview of the various ways investors can invest their money.
The first way for clients to invest money is to go and purchase their own stocks or bonds and build their own investment portfolio. They could go to a low cost transactional platform or website like E-Trade and purchase various stocks and bonds. Alternatively, they could use a system to help them pick the various investments. There are no internal costs associated with the holding of the various positions, as the client is the only manager (overseer) of the investments. The only fees the client pays is when they sell or buy and investment.
The second way to manage assets is for an investor to buy no-load funds, index funds or exchange traded funds (ETFs) on their own. When client buys these positions without the assistance of an investment professional these investors are considers do-it-yourself investors. They can go to providers such as Vanguard or Fidelity and pick the mutual funds they want to invest in and purchase them online and monitor the account themselves and make adjustments as needed. They will pay the internal management cost associated with no load fund, index fund or exchange traded fund. These funds usually do not have transactional costs like the above option 1. No-load funds, exchange traded funds and index funds usually make their money by the internal charge sometimes referred to as the expense ratio, management fee, or administrative fee. The investor receives the net return after the internal fee has been taken. So for example if the investor receives a 10% return the investment, then the investment probably had a return of 10.5% but the .5% was kept by the investment firm who charges the internal fee. This is how the investment firm offering the fund makes their money.
The third way for and investor to manage assets is for clients who want to work with an investment professional and pay fee to that advisor to help them manage the investments. The client will pay a fee of some sort. This is the focus of this proposal. Let me first go over the various investment methods for advisors to help clients manage their investments.
The first method is for the clients to purchase a front loaded mutual fund or also called a front-end sales charge mutual fund. A front-end sales charge mutual fund charges an upfront charge to the investor to get into the investment. A majority of this front-end sales charge is given to the advisor as a commission taken from the clients starting investment amount. Let me give an example. A client puts $100,000 into a front-end sales charge mutual fund that has an upfront sales charge of 5%. $5,000 (5%) would be taken off the top of the clients investment and paid to the advisor as a commission (the advisor would receive $5,000 in commissions) and the clients investment portfolio would then start with a value of $95,000. Remember the advisor usually receives a lower amount than the $5,000 as the advisors company they work for usually keeps a portion of this money. The percentage the advisor receives on average can be between 35% to 90% depending on if they are an independent advisor or not. So on the $5,000 they could receive .35 x $5,000 = $1,750 to .90 x $5,000 = $4,500. This upfront charge is one of the topics in question on the proposal. The 12b-1 fee, which is the second fee in question on the proposal, pays the advisor on average 0.25% per year on the value of total assets on a Front End Sales Charge mutual fund. This 0.25% of the assets is paid each quarter. So for example above if the $95,000 investment grew back to $100,000 (just to make the numbers easy) due to the market and the investment fund stayed at $100,000 for the entire year the advisor would receive ongoing compensation of $100,000 x 0.0025 = $250 per year. Again, this is the total and the advisor receives between 35% to 90% of this value or $87.50 to $225. Let me make sure we are being realistic when looking at this investment method. In my opinion, this is the worst type of investment for multiple reasons. First, the clients investment starts off with less money than they started with to invest. This means if the market goes up they will have less growth then other investments due to starting with the lower starting value because their investment has had the upfront sales charge taken off the top. If the market goes down, they then will lose money on top of staring off with the lower investment amount due to the upfront sales charge. Second is the way the advisor is compensated. Let us really examine this. An advisor has an incentive to get an investor to invest with them because they receive a large commission upfront. The goal is for the advisor pick a good investment portfolio. After the upfront sales charge of $5,000 in my example, the advisor receives $250 ongoing. As an advisor, I want everyone to understand that no advisor is going to put in a lot of attention to a portfolio that they are making 0.25% on (or $250 on this $100,000 example). To give you an example the other day I paid my plumber $250 for 2 hours of work. As a client if I have $100,000 invested, I want to make sure I am paying enough for an advisor to review it. I do not want to be neglected. I want to know what I am paying which I agree need to be disclosed. For a client to think their advisor is going to put in hours and hours to make sure the investment is properly allocated and continues to be the best investment when they are making $250 a year is not reality. The third reason in my opinion that this is a bad investment is if the client or the advisor determines the investment they are in is a poor investment and they feel they should go into another investment then the client wasted 5% of their money to pay another 5% to get into a new investment. This is what the investment market calls an A share asset class. In my opinion if anything needs to be addressed, this is the one. I have no idea why someone would allow their money to be invested in an A share or upfront sales charge investment when they have a very high chance of being neglected after the advisor receives his up front commission. If I understand the proposal right, they are trying to limit the upfront sales charge, which I agree with. I believe they are also trying to eliminate the 0.25% ongoing 12b-1 fee paid to the advisor. This is even a worse idea. If the advisor only is paid upfront on a clients portfolio then the clients portfolio will never be reviewed or looked at. The client will be neglected. If they move to another advisor because they feel they are being neglected then they face the chance of getting charged the upfront sales charge again and could go through the same experience.
The second type of investment a client can work with an advisor on is an asset-based sales charge. An asset-based sales charge pays the advisor on the investment based on the value of the investment. So let me go back to the example. If a client invests a $100,000 the advisor would on average receive $1,000 but the clients full $100,000 is invested. If the advisor does well for the client and the clients portfolio makes money and in year 2 the clients account is now worth $110,000 for example then the advisor would receive 1% of the $110,000. So if the portfolio value was worth $110,000 and stayed at that value for the entire year then the advisor would receive $110,000 x 1% = $1,100. This type of investment puts the advisor on the same side as the client. If the client makes money the advisor makes more money if the client losses money then the advisor losses money. In the proposal, they are trying to limit the compensation paid to the advisor to amount equal to the upfront sales charge limit. Therefore, from our example above if the maximum up front sales charge of 5% then the maximum asset-based sales charge would be equal to 5%. Therefore, if the asset-based sales charge was 1% per year the 5% would be reached by year 5. After year 5, the advisor would receive $0 in compensation.
My question to whoever is behind this proposal is what happens after year 5 or when the maximum upfront sales charge is met on a level asset based compensation method? The client will still need ongoing assistance with their investments. What advisor is going to review a portfolio when they making no money. The answer is no one. I do not know how people think this is going to help the clients. In the industry, this is known as a C share asset class. There are other similar types of investment accounts usually called wrap accounts, which work the same way. They charge an ongoing percentage of assets under management to assist the client in managing the investment. Most firms have this type of account. Fidelity calls it the PAS account or Portfolio Advisory Services, Vanguard has the Vanguard Asset Management Services program. All these programs work very similar to a C share or what the proposal is calling an asset-based sales charge. For client who do not want invest their money on their own I personally think this is the best way for a client to invest their money when working with an advisor. With this type of asset management program if the investment underperforms you can switch to another investment with minimal to zero costs to the client. I believe this is how all assets should be managed if you work with an advisor. There is no big incentive up front, the client can evaluate you over time, and if they do not like your performance, they can move to another advisor with minimal cost. If they like your performance then they continue to invest with you and pay you the asset-based charge to for the continued assistance with their investments. If you only pay the advisor for 4 or 5 years, which I believe is what the proposal is stating then what do all these clients do after that. No advisor is going to work for free. This topic is very important to my clients and me. This really needs to be examined properly because if it is changed clients will potentially be neglected and smaller clients will never get a good advisor because a good advisor will work only with client who have enough money where they get paid in a wrap program. The difference on a C or asset based sales charge vs. a wrap account is the asset based sales charge is already built into the fund. With websites like clients can easily look up their funds and see the funds expenses. The other thing is ranks investments on their net return. So if you take a index fund charging 0.20% internal charge and a asset based sales charge position charging 2% then Morningstar looks at the net return. So if the index fund has a return of 9% and the asset based sales charge fund has a return of 10% net then the asset based sales charge fund would receive a higher ranking then the index fund. This information is all transparent on websites like