If you stroll down the aisle of any large supermarket today, mixed in with the merchandise of well-known national brands is similar merchandise in the store's brand. Next to a major brand-name can of creamed corn, you might also see a can of the house brand of creamed corn.
In the financial supermarkets that house today's large brokerage firms, banks and insurance companies, banks often sell their own investment products and services alongside of those from outside suppliers. And, on the virtual shelves of a large financial company, the mutual funds of major companies—like Fidelity or Franklin—sit side-by-side with the house-brand mutual funds. In this article, we'll show you how to decide between purchasing a house-brand fund over a major-brand fund. (See also: Picking the Right Mutual Fund.)
House-Brand (Proprietary) Funds Vs. Third-Party Funds
A house-brand, or proprietary, mutual fund is created when the bank or brokerage firm that distributes the fund also acts an investment advisor for the fund. The mutual fund business has two components: managing fund assets and distributing (or selling) funds. Each side can be very profitable and the creation of proprietary mutual funds is considered a form of vertical integration—not to mention a profitable way to leverage an existing sales force. Typically, these mutual funds are developed, managed and sold in-house. (See also: An Introduction to Mutual Funds.)
Third-party mutual funds, on the other hand, are managed by outside, independent managers. These include the big brand names of the business such as Vanguard, T. Rowe Price, Franklin and Fidelity. They might be sold directly to the investor or they may be sold by other companies or by an independent advisor. Those who sell the funds are often totally independent from those who manage the funds. In theory, this should result in totally unbiased advice when advisors recommend these funds to their clients.
Sellers of Proprietary Funds
Proprietary funds can normally be found at just about every company that has a large sales force that can sell mutual funds. This includes banks, credit unions, brokerage firms, insurance companies and wealth management companies. In-house mutual funds were developed by companies to be sold by their own distribution networks, and are now part of an overall move into wealth management.
The brokerage industry entered into the proprietary mutual fund business as a means of averaging out their revenues. The fees generated from managing assets tend be smoother and more predictable than the potentially volatile revenues of their traditional lines of business of investment banking, trading and commissions.
Although most sellers of in-house funds will also offer third-party funds, some advisors or firms may only sell and promote their own funds. Companies that have their own sales force may only sell their brand of funds. If an advisor recommends an in-house fund, investors should ask if they sell third-party funds as well, because they may be required to promote internal funds first.
Issues Surrounding Proprietary Funds
Although there are hundreds of mutual fund companies and thousands of mutual funds to choose from, if you are purchasing funds from an advisor or a company that is only offering in-house funds, this narrows your choices considerably. This could be a problem for a number of reasons:
- The investment style they use might currently be out of favor and buying from an in-house fund could result in lagging performances.
- The bank may not offer an international growth fund among its proprietary offerings, which may be needed for diversification. (See also: Introduction to Diversification and The Importance of Diversification.)
- If the bank does offer a growth fund, the foreign assets that have been selected for the fund may be out of favor for the duration of the client's investment horizon. This would be less likely to occur if there was a larger offering of international growth funds available.
- The type of fund or style you desire might not be found within the fund family.
Proprietary funds can be priced differently than third-party funds. The sales commissions and management fees can differ. This will depend on a number of factors:
- First, the in-house funds might be relatively smaller in size to third-party funds. This means they may not enjoy the same economies of scale, resulting in relatively higher costs. (See also: What Are Economies of Scale?)
- Secondly, because the same company manages and distributes the funds, it has more leeway about how to charge. For example, some companies might decide to charge lower fees on their proprietary funds as a means of building market share and keeping more money in-house.
- Thirdly, the company has a captive market, which means it can offer advantageous pricing to catch the "lazy" investors who don't comparison shop and would rather continue to work with only one broker.
Unlike third-party funds, typical proprietary funds may not be transferable from one firm to another. If an investor wants to move his or her account, the units of the in-house funds will have to be sold. This can result in additional fees, commissions and administrative costs. Also, there is some additional market risk between the time the mutual funds are sold and when the proceeds are reinvested. Investors may purchase proprietary funds without appreciating portability restriction and the firms do not necessarily tell their clients that the assets of proprietary funds are not transferable.
Because there is the potential for advisors to steer client money to in-house mutual funds that may not be in the clients' best interest, the Financial Industry Regulatory Authority (FINRA) has outlawed the use of sales incentives for the sale of proprietary funds. The reason FINRA barred this action is because it gives brokers a financial reason to put their interests ahead of those of their clients—which is completely prohibited according to advisor rules
However, some firms may still have incentives in place; although they might meet the letter of the regulations, they do not meet the spirit of the underlying rules. As a result, some advisors and customers have taken the opposite position and will not buy or offer their in-house funds at all in order to avoid any nuance of indiscretion.
Further Buying Considerations
Proprietary funds can be found at almost all large financial institutions. Like third-party funds, they can be excellent investment products. However, before buying these funds, you should make sure you understand what you are buying and how it will fit in with your portfolio. The same due diligence that is necessary for buying mutual funds in general should be carried out when purchasing those developed in-house. Some might argue that even more due diligence is necessary, especially when an in-house fund is recommended over a third-party fund. Advisors should be able to disclose all incentives to the client in writing to ensure they do not offer influenced advice. (See also: Due Diligence in 10 Easy Steps.)
Clients should also check to see if in-house funds can be transferred to other firms and, if so, whether this transfer would involve any costs or fees.
The Bottom Line
If you are careful in your research of these house-brand funds, you may find that you don't need to put your money in with the major brands to experience good growth and a personalized investing experience.