Grocery shoppers can choose between name brands and the house versions of a product. The latter is generally less expensive than the former, but the quality is supposedly similar. Proprietary vs. nonproprietary mutual funds work in the much the same way, with proprietary mutual funds serving as the house brand – in many cases, the brokerage house – and nonproprietary mutual funds consisting of the national name brands.
Understanding Mutual Funds
Mutual fund companies pool money from investors to purchase securities. Stock mutual funds invest in securities, while bond mutual funds invest in bonds, and some mutual funds invest in stocks, bonds and short-term debt, according to the United States Securities and Exchange Commission.
Investors purchase shares in mutual funds, buying and selling the shares at the present net asset value. Money is earned in several ways. The shares' worth may grow or the shares may pay dividend, and capital gains may come into play when the mutual fund company sells securities whose price has increased. Of course, mutual funds also lose money when share prices drop.
Proprietary Mutual Funds
Proprietary mutual funds are those funds owned and managed by your brokerage house. As with all mutual funds, proprietary funds charge fees for money management. However, the amount charged annually depends on the mutual fund. With proprietary mutual funds, these fees go directly into the brokerage house coffers, and such fees are very profitable endeavors.
Proprietary mutual funds are usually much smaller than nonproprietary mutual funds. Because they do not approach the holdings of larger, nonproprietary mutual funds, they don’t benefit from economies of scale and must charge higher fees. However, some brokers or banks may charge less for proprietary mutual funds, in order to boost market share.
Proprietary vs. Nonproprietary Mutual Funds
A nonproprietary mutual fund is also known as a third-party fund. You probably recognize the names of many the major fund brands, such as Fidelity, T.Rowe Price and Vanguard. Proprietary funds are managed by either the brokerage, bank or credit union creating the fund, and these financial institutions play a dual role. Wealth management and insurance companies may also develop and sell proprietary mutual funds. Not only did these entities establish and manage the funds, but the only way to purchase proprietary mutual funds is via the parent bank, brokerage or insurance company.
Management of nonproprietary mutual funds falls to third parties, hence the name. Investors may purchase shares in these funds directly from the mutual fund company, or through an independent advisor or other financial institutions. Managers and sellers are completely independent, so the idea is that investors receive straightforward advice when making fund purchases. With a proprietary mutual fund, it’s not always clear whether such advice is unbiased.
Proprietary mutual funds usually charge higher, often much higher, fees than nonproprietary mutual funds. You can find the fees charged by any fund in its mutual fund prospectus. Overall, proprietary mutual funds do not tend to perform as well as their nonproprietary counterparts.
The investor’s choice of proprietary mutual funds may also prove limited. For example, in an increasingly global economy, many banks do not offer international growth funds. Diversification is critical when making long-term mutual fund investments.
Not Necessarily Transferable
There’s another issue with proprietary vs. nonproprietary mutual funds. If you aren’t satisfied with your brokerage and want to do business with another firm, transferring your old brokerage’s proprietary mutual funds to your new brokerage isn’t always possible. Instead, you would need to sell your proprietary mutual fund shares. Along with additional commissions and fees, there’s a time lag between selling your proprietary mutual fund shares and the reinvestment of the monies in your new brokerage account. You could end up selling low and buying high, the exact opposite of wise investment timing.
Because some proprietary mutual funds are good investments, there’s another step to take while performing your due diligence concerning the fund. Don’t assume the fund is transferable if you leave the brokerage, and find out from your broker whether it is transferable before purchasing shares. Along with transferability, ask about any administrative costs associated with a transfer. If such costs are excessive, think twice about your investment.
Employer-Sponsored Retirement Plans
For people of a certain age, their biggest asset isn’t necessarily their house. It is likely their employer-sponsored retirement plan, such as a 401(k). Over the years, regular contributions, employer matches, growth and reinvested dividends can mean an employee’s retirement fund is worth hundreds of thousands, or even millions, of dollars.
Perhaps you always do your homework in your personal investing and avoid proprietary mutual funds sold by brokers. That may not mean you don’t have considerable investments in such funds, as your 401(k) or similar retirement plan may hold proprietary mutual funds. How can you tell if the financial institution managing your retirement account has proprietary mutual funds in your portfolio? All you need to do is look for either your broker or your custodian’s name on your mutual funds. Find them, and that’s a proprietary fund.
If the proprietary mutual fund in your retirement fund performs well, you may not want to act. If the results are less than stellar, and certainly if they don’t keep up with the index for the fund type, you will want to get out of the proprietary fund. Your retirement plan likely has alternative, nonproprietary funds, so do your research and find lower fee funds with a good track record.
Proprietary Mutual Funds and Advisors
If you are seeking a financial advisor, you want to ensure they are giving you the best advice possible for your situation and not just trying to sell you mutual funds or life insurance policies earning them a commission.
When searching for a financial advisor, asking the right questions is critical. As long as you understand how they are paid, you can make an informed decision. Look for an independent, fee-only registered investment advisor who is not earning a commission on the products sold. You must also ask if the person is a fiduciary, which means they must always act in the best interests of the client. Just because a person is a financial advisor, which covers various categories carrying different certifications, does not necessarily mean they must act in a fiduciary capacity.
The Financial Industry Regulatory Authority (FINRA) does not permit financial advisors to receive sales incentives for selling proprietary mutual funds. That regulation was promulgated so advisors can’t put clients' money in mutual funds that don’t serve the clients' best interests. That doesn’t mean there aren’t brokerage firms taking a “wink, wink” approach to FINRA’s rule. The incentives may still exist, but they aren’t as obvious as they were previously.
You want a financial advisor whose fund recommendations are based on the right choices for your situation, not for the fees he or she might rack up selling these funds to you. While you should always ask for an advisor’s track record, that is doubly true if the advisor sells proprietary mutual funds. An advisor who won’t sell their firm’s proprietary mutual funds to avoid even the slightest appearance of bias is worth considering when it comes to taking care of your money and your financial future.
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- CFA Institute: Ethics in Practice: Firm’s Funds Are Best Investment, Right? Case for Week of 20 November
- Wealth Pilgrim: What is a Proprietary Fund?
- Vanguard: Vanguard Again Leads Pack Among Managers of DC Mutual Funds
- SEC: What Are Mutual Funds?