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Lindley Estes is a business writer for The Free Lance-Star and This blog is on Fredericksburg-area business. Send an e-mail to Lindley Estes.

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Study shows broker funds may not be best option

MUTUAL funds fall broadly into two categories: those available directly to investors and those sold through stockbrokers or financial advisers.

Investors can often purchase the direct-channel funds for no sales charge, although there is sometimes a back-end sales fee to dissuade people from moving in and out of funds.

On the other hand, mutual funds bought through brokers and advisers typically carry front-end sales charges of several percentage points, often called “loads.”

A common adage is “you pay for what you get.” If that cliche is accurate for mutual funds, investors should get better returns from broker-channel funds.

But that’s not the case, according to a recent study by three economists called “Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry.”

Daniel Bergstresser and Peter Tufano of Harvard Business School, and John Chalmers of the University of Oregon, authored the report. It was the subject of Roger Lowenstein’s column in the January 2008 edition of “Smart Money.”

The study, which used data between 1996 and 2004, found that direct-channel mutual funds tended to outperform broker-sold funds, even before fees were taken into consideration.

The costs of mutual funds with sales charges add up, the study shows. In 2002, fund investors paid a total of about $15 billion in sales charges as well as 12b-1 marketing and distribution fees. That’s compared with the $24 billion paid for funds’ actual operational and management expenses.

The study does list some benefits of broker-channel funds. People who use broker funds are more likely to invest overseas, and the adviser-sold international funds often outperformed their counterpart direct-channel funds.

Further, the study notes the more qualitative potential benefits of broker funds: Advisers may help clients save more than they would, feel comfortable with their investment choices and customize their portfolios based on risk tolerance. Those clients don’t have to spend time studying investments.

Further, the results of the study are purely on an aggregate level–it doesn’t take into consideration the skills of individual advisers.

But on a purely quantitative basis, broker-sold funds underperformed on a number of levels during the study period, the authors found.

On a risk-adjusted basis, funds sold by brokers did worse than direct-channel funds before fees. Investments in broker-sold funds don’t do any better timing the market through asset allocation, and they’re just as likely to chase past returns.

Finally, the study finds that advisers often direct clients into funds that offer them rich commissions. “The more money there is to pay for sales efforts, the greater the flows to these funds,” the authors write.

The second-to-last sentence of the report sums it up and gives investors something to consider:

“This work leaves us with the puzzle of why investors continue to purchase funds that appear to be no better at substantially higher costs,” they write.