By Pam Martens: May 11, 2017
For as long as we have been observing Wall Street sleaze (three decades and counting) we have been reading about illegal sales contests and mutual fund abuses at Morgan Stanley and its 1997 merger partner, the retail brokerage firm Dean Witter. Given that history, when we read last week that Morgan Stanley was going to gut one of the all-time best families of mutual funds from its client offerings (Vanguard Funds), we felt our readers deserved a fuller understanding of the facts than they were getting from corporate media.
Incredibly, a number of corporate media outlets tried to pass this off as Morgan Stanley attempting to “close out under-performing and less popular funds.” Before we get to the nitty-gritty of why Morgan Stanley is freaking out about the respected Vanguard Funds, some necessary background is in order.
Our earliest recollection of the mutual fund outrages at Dean Witter came courtesy of BusinessWeek reporters Leah Nathans Spiro and Michael Schroeder in a February 1995 article. (Bloomberg L.P. purchased BusinessWeek from McGraw-Hill in 2009. The Bloomberg brand now shows on the online article.)
Nathans Spiro and Schroeder explain in the article why Dean Witter was pushing its own internal mutual funds on its brokers and the brokers were not pushing back. The authors write:
“But the greatest incentives are usually for selling investments created by the firm. The reason for favoring its own products, especially mutual funds, is simple: much higher profit margins. The firm reaps a fee for managing its own funds. It gets no management fee for an outside fund…
“The firm that’s most vulnerable on this issue is Dean Witter. It says that more than 75% of the mutual funds it sells are the house brand, probably the highest ratio in the industry. Customers who invest in Dean Witter funds pay a sales load that ostensibly compensates the broker for unbiased advice in helping them pick the best fund. Yet three times out of four, clients are simply ushered into Dean Witter funds. One reason: Brokers receive 5% to 15% more for selling Dean Witter funds than for outside funds. ‘It’s like calling yourself a car consultant when you sell Fords,’ says Don Phillips, publisher of Morningstar Mutual Funds.”
Seven months after the BusinessWeek article appeared, the Washington Post stunned Wall Street by publishing an insider’s allegations against Dean Witter. Les Silverstone was a respected, retired broker from Dean Witter. He blew the whistle on the lavish prizes brokers were getting for selling select products. The Washington Post reported:
“Over the last few years, Silverstone said, Dean Witter has given brokers televisions, home computers, stereo systems, clothing, sports and lottery tickets and other prizes for selling selected financial products during contests. Investors are unaware that many brokers’ recommendations are influenced by contests, Silverstone said…
“Silverstone said Dean Witter also has sponsored holiday contests. In one Dean Witter Valentine’s Day contest, brokers were encouraged to submit their ‘sweetheart’s name and address’ when they phoned in orders so the firm could send flowers and Godiva chocolate…
“Silverstone said contests distort the advice that brokers give customers. ‘Would you want to go to a doctor who was trying to win a contest by writing certain prescriptions? The contests create a certain culture and it is detrimental to the consumer. What you need from your broker — his best thinking about how to achieve your long-run financial goals — is exactly what the contest is forcing the broker not to give you.’ ”
By 2000, long after Dean Witter had merged with Morgan Stanley, the brokerage firm was still running afoul of regulators. In November 2000, the National Association of Securities Dealers’ regulatory arm charged Dean Witter with selling over $2 billion of Term Trusts to more than 100,000 customers by using an internal marketing campaign that characterized the investments as safe and low-risk. The NASD Regulation complaint said that Dean Witter targeted “certificate of deposit holders and other conservative investors, many of whom were elderly with moderate, fixed incomes…” The risky Term Trusts at one point had lost over 30 percent of their value and were forced to reduce their dividends by nearly a third.
The NASD Regulation complaint noted that “Dean Witter’s marketing effort for the Term Trusts also included high-pressure sales efforts at the regional and branch levels, include the use of sales contests and sales quotas.”
In 2003, Morgan Stanley was fined $50 million by the Securities and Exchange Commission for improper mutual fund sales practices. The SEC said the firm had set up a “Partners Program” in which a “select group of mutual fund complexes paid Morgan Stanley substantial fees for preferred marketing of their funds.” The firm further incentivized its brokers to recommend the purchase of the “preferred” funds by paying them increased compensation. The SEC said Morgan Stanley also failed to disclose the higher fees imposed on Class B shares of its proprietary funds versus sales of Class A shares.
While Morgan Stanley now sells a broad range of outside mutual funds to clients, it continues to sell its own proprietary mutual funds as well. Last year a former participant in its 401(k) Plan for employees filed a $150 million lawsuit against the firm for including in the $8 billion 401(k) Plan Morgan Stanley’s own proprietary mutual funds that were “tainted either by poor relative performance, high relative fees, or both,” according to the lawsuit.
Against this backdrop comes the news that Morgan Stanley is eliminating the ability of its brokers to continue to sell the low-fee, passively managed and widely respected funds offered by the Vanguard Group.
Wall Street On Parade took a hard look at Vanguard after Frontline correspondent Martin Smith stunned PBS viewers in a 2013 bombshell report, explaining what mutual fund fees were doing to the average worker’s 401(k) plan. We reported the following at the time and confirmed the math:
“If you work for 50 years and receive the typical long-term return of 7 percent on your 401(k) plan and your fees are 2 percent, almost two-thirds of your account will go to Wall Street.”
This is how we double-checked the math:
“Take an account with a $100,000 balance and compound it at 7 percent for 50 years. That gives you a return of $3,278,041.36. Now change the calculation to a 5 percent return (reduced by the 2 percent annual fee) for the same $100,000 over the same 50 years. That delivers a return of $1,211,938.32. That’s a difference of $2,066,103.04 – the same 63 percent reduction in value that Smith’s example showed.”
There is likely one more insidious aspect to this story. On April 16 New York Times reporter Landon Thomas dropped his own bombshell on Wall Street. Thomas reported the following:
“In the last three calendar years, investors sank $823 billion into Vanguard funds, the company says. The scale of that inflow becomes clear when it is compared with the rest of the mutual fund industry — more than 4,000 firms in total. All of them combined took in just a net $97 billion during that period, Morningstar data shows. Vanguard, in other words, scooped up about 8.5 times as much money as all of its competitors.”
Big Wall Street banks have a problem when somebody else eats their lunch. Passive investing in indexed mutual funds like Vanguard’s popular 500 Index Fund poses not only the risk of sucking fees away from the big Wall Street banks’ asset management operations but it further poses the risk of making their controversial practice of putting out buy and hold recommendations on individual stocks an unproductive exercise. Morgan Stanley has a retail broker force of approximately 15,800. (That force grew dramatically with Morgan Stanley merging the brokers formerly with Citigroup’s Smith Barney.)
There was a time when Morgan Stanley’s equity research department, along with its Wall Street peers, could start a broker stampede and levitate a stock by issuing a new buy rating. But as Vanguard mutual funds and passive index investing consume more and more investment dollars, when Wall Street speaks fewer ears are listening.