Good news for investors: Brokerages are leaving the fund business. By Andrew Tanzer, Senior Associate Editor June 21, 2006 Why are the big New York City brokerages abandoning their in-house mutual funds -- and should you, too? In December, management of Citigroup's Smith Barney mutual funds passed to Legg Mason. Soon Merrill Lynch will outsource management of its fund group to BlackRock. If you own shares in these funds, consider holding on because their performance should improve. Before we tell you why, here's a bit of background.The brokerages have turned shy over issues of conflict of interest -- real and imagined. If your Merrill Lynch broker sells you high-load house funds, is it because the funds offer superior performance? Most likely, no. "If you buy any five to seven Merrill funds to diversify, you'll get some dogs," asserts Ray LeVitre, a financial adviser in Utah. So brokers are feeling the heat from both regulators and clients to clean up their acts. In 2003, NASD and the Securities and Exchange Commission fined Morgan Stanley for dubious sales practices, such as encouraging its brokers to promote "preferred" funds. And this March, NASD fined Merrill Lynch $5 million, in part for holding "impermissible sales contests" to push Merrill funds. Customers are getting wiser, demanding more choices and voting with their feet if they don't get them. During 2001-05, the fund groups of Morgan Stanley, Merrill Lynch and American Express all suffered severe net outflows of money, according to Financial Research Corp., in Boston. During the same period, sales of Smith Barney's house funds plummeted, from 46% of total fund sales to 12%. Advertisement If you're a loyal shareholder of Richie Freeman's Smith Barney Aggressive Growth fund -- up an annualized 15% over the past ten years, six points per year better than Standard Poor's 500-stock index -- then you're a contented investor. Trouble is, most of the financial conglomerates can boast only a handful of such funds. Mediocre-to-dreadful performers are much more the norm -- and their returns are generally inferior to those of funds from independent managers, such as Capital Research Management and T. Rowe Price. LeVitre, for example, studied the performance of American Express funds, which were spun off last year and are now run under the RiverSource name. (AmEx holds no equity stake.) The Utah financial planner compared a 75% stock/25% bond portfolio of AmEx funds against the relevant indices from 1994 through 2005. Result: The American Express funds underperformed the indices by more than two percentage points a year. Stepchildren How to explain the undistinguished records of the offspring of these financial behemoths? Investment banks may not be a suitable habitat for entrepreneurial fund managers, who play second fiddle to investment bankers in these sprawling financial supermarkets. Focused fund-management houses, such as Dodge Cox, seem to have an easier time recruiting and retaining talented people. Burt Greenwald, a fund consultant in Philadelphia, notes that it's hard for a huge financial conglomerate to adequately reward a brilliant fund manager who, after all, generates just a trickle in a corporate revenue stream. The split-off broker funds should thrive in their new homes with asset managers, such as Legg Mason, that focus exclusively on funds. Over the past three years and the past five years, nearly 70% of Legg Mason's funds beat the average returns of all funds that specialize in the same types of stocks and bonds, reports Lipper. But you should remain mindful of conflicts of interest: Merrill Lynch will still own nearly 50% of BlackRock, and Citibank retains a small stake in Legg Mason. Advertisement This is also an excellent time to revisit the performance of your broker-sold funds, including those from Morgan Stanley, which, unlike its Wall Street brethren, seems intent on keeping its fund business. If your broker sold you 100% proprietary funds, your portfolio is almost certainly lagging. If he or she insists that house funds can meet all your needs, consider taking your business elsewhere.