Directed Brokerage Vs. Mutual Funds

A directed brokerage is a practice in which mutual fund companies steer trades to brokers as a reward for selling their funds to retail clients.

Many in the industry felt that directed brokerage could be detrimental to mutual fund shareholders, since it had the potential to create incentives for fund managers to direct fund transactions to brokers who were encouraging sales of their funds rather than to the firms that could provide the best execution, or price, on fund transactions. Fees are not going down, because a big part of it is that the middlemen have become very good at extracting more money from fund investors and fund companies alike.

The SEC (Securities and Exchange Commission) recently banned directed brokerage because it could create conflicts of interest for mutual fund managers. In directed brokerage arrangements, fund managers would direct portfolio transactions to particular brokerage firms in exchange for promoting their funds. Mutual funds are required by law to seek the best execution for their stock and bond trades. Still, to win limited “shelf space” for their funds at brokerage firms, fund shops often reward broker-dealers by sending them trading business. Ending directed brokerage practices could save investors money on commissions.

Until the SEC banned the practice outright in 2003, directed brokerage was legal as long as all parties complied with certain provisions. The commission is sifting through every aspect of mutual-fund management and behavior – fees, governance, advertising and sales.

Because of this, directed brokerage firms’ resolution – current directed brokerage practices to place the interests of the fund manager first and that of the investor second.  They provided directed brokerage arrangements that aim to reward the broker for sales of fund shares while guaranteeing funds greater shelf space and overlook the fundamental precept that fund brokerage belongs to shareholders. Accompanying the directed brokerage statement, the Trade Breakdown provides detailed information about the transactions executed on behalf of the client each month. Such information is beneficial to those clients who have multiple investment managers directing activity to the firm. This enables these clients to quickly determine manager participation.

Donaldson & Co., a directed brokerage firm and leader in providing directed commission and soft dollar programs to season and start-up funds alike, has the ability to recapture 12b-1 fees. The 12b-1-fee charge is the distribution cost component of a mutual fund’s expense ratio, and is typically paid to a designated ‘broker of record’. The 12b-1 payments are for the broker's sales and marketing efforts on behalf of the mutual fund, and are usually paid quarterly as a percentage of the account's asset value.
While a directed commission program is simple to implement, a directed brokerage firm should be carefully selected.