The US Securities Exchange Commission (SEC) has gathered evidence and is investigating mutual fund companies that pay kickbacks to brokerage firms, Reuters reports.

This news may not come as much of a surprise to financial industry insiders, but everyday investors are largely unaware that millions of dollars are paid every year by mutual fund companies to brokerage firms to encourage the sale of certain mutual funds that may not be of the highest quality.

The SEC review began 18 months ago and attempts to uncover a complex web of pay-to-play practices. Some of the practices, such as brokerage firms inviting wholesalers from mutual fund companies to make presentations to broker-advisers, have been going on for years. But some brokerage firms have expanded into paid presentations where the wholesalers make payments to market their funds to advisers.

The core of the problem lies with the brokerage firms’ lack of clearly communicating disclosures to investors that mutual fund companies make payments that promise prime shelf space to their funds.

How to Avoid the Potential Pitfall of Payola Practices

The funds that are most heavily marketed by the mutual fund company wholesalers are those with revenue sharing 12b-1 fees that are paid to brokers out of fund assets, and these are primarily actively-managed funds.

This partially explains why actively-managed funds dominate the brokerage firms’ recommended lists and thus their respective client portfolios: The most expensive funds tend to be the most lucrative for mutual fund companies and, thanks to these payola practices, the sale of the funds add to the bottom line for the brokerage firms.

But where does this leave the investor? There are a few primary points for individual investors to keep in mind to avoid the potential pitfalls of buying the heavily marketed actively-managed funds, which may or may not be of superior quality compared to other funds:

• Use a fee-based adviser: The traditional brokerage firms and their stock brokers get paid for selling products. While there is nothing inherently wrong with this pay structure, and there are certainly honest and competent brokers that exist, there is little incentive to sell the highest quality, lowest-cost funds. However, fee-only advisers, registered investment advisers and other fiduciary level, fee-based advisers get paid only by the client and no other entity. In different words, brokers are product-centered and fee-based advisers are client-centered.
• Use only “true” no-load funds: If you are not using a commissioned-based adviser, there is no reason to pay unnecessary expenses, even if you want to use actively-managed funds. Therefore, if you’re a do-it-yourself investor and you want to use actively-managed funds, be sure to avoid funds that charge a front-load or back-load. Also, to be sure you are using a true no-load fund; there shouldn’t be a 12b-1 fee either.
• Use passively-managed funds: Index funds and ETFs have gained in popularity in recent years for a good reason — they are low-cost investment vehicles that mirror the performance of an index, which enable an investor to build a diversified portfolio of funds without concern about fund manager mistakes, asset bloat or style drift.
  

Later this year, when the SEC is due to finish its review of mutual fund companies and revenue sharing with brokerage firms, it will likely succeed only in making disclosures about their relationship more clear to investors. It won’t make high-cost, low quality funds go away.

Therefore, investors using advisers will need to be aware of how their advisers get paid and the do-it-yourself crowd will need to avoid unnecessary expenses, such as 12b-1 fees, and consider the use index funds and ETFs for their portfolios.