Tricks of the Trade. Sales tricks, investment abuses.

[Guest]

Switching (or being switched) from DSC to FEL?

One of the oldest games in the business is for an unscrupulous adviser to switch clients into a FEL fund after expiry of the DSC early redemption penalty period. If and only if the MER in the FEL or F class fund is lower, you’re ahead of the game. BUT note your adviser will now receive double the annual trailer commissions for really no particular reason. Don’t expect twice the service though. This higher commission rate is of course funded by the hapless investors in the fund you just bought into. Ultimately you too will be funding future switchers. A sad commentary on industry business practices.

As far as tax on the switch goes, it appears that such a switch between series of the same fund is not considered by the CRA as a disposition for tax purposes (most prospectuses reflect that view). The rationale is that the basic economic bundle owned by an investor has not changed, i.e. they own the same value of units, in the same fund, which represents exactly the same proportion of the same underlying portfolio, so there has not been any real disposition. It's similar in concept to the different share classes of a mutual fund corporation. Not every firm has its own tax ruling on the issue, but there have been rulings from the CRA upon which the industry has relied.

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I know of an "advisor" who charged his clients the DSC on their money market funds, even when he knew they were short term investors. Yup-he was OK with hitting the clients with a 5% redemption charge on a fund with barely a chance to earn more than 3% or 4% in annual earnings. He explained it to clients as simply the "way it was".

Truth was he enjoyed being paid the up front DSC commission of 5%, and he did not give one thought to the well being of the client. Management at the largest bank owened brokerage in Canada looked the other way and willingly shared in the revenues he generated.

[Guest]

Not all fundcos have different MER’s for DSC and front-load funds

Fidelity Canada definitely does. Fidelity offers a different management fee between front-end load (FEL) and back-end units (DSC), across the Board. On their equity funds, Series A units (which are DSC) have a management fee of 2.00%, whereas Series B units (which are ISC) have a management fee of 1.85%. On so-called Fixed Income Funds, the difference is 0.25% (e.g. 1.25% on A vs. 1.00% on B for Cdn Bond Fund or 0.95% vs. 0.70% on Cdn Money Mkt Fund). Even this small difference adds up over time especially in interest rate sensitive funds operating in a low interest rate environment. NOTE that trailer commissions on FEL funds are generally much higher than DSC sold funds. We can’t help but ask why on earth anyone would buy a m/m fund on a DSC basis –only investors know for sure. Maybe not.

[Guest]

A reminder of the old DSC switcheroo trick
Rob Carrick reminds us once again that fund “advisers” can sometimes act in a self-serving manner. His article DEFERRED SALES CHARGES: Trick of the trade for fund advisers bears scrutiny shows how a fund that has passed its DSC penalty period can be switched into a front –end load (FEL) fund. The controversy comes from the fact that DSC conversions allow “advisers” to make more money in fees off a client's account while doing nothing extra to warrant the pay increase. Fundcos have a self-interest here as well in that they've got a nice incentive for advisers to keep client money in the same fee-earning funds once the DSC schedule has expired, rather than moving to a different fund company. Front-end load funds bring in an upfront sales commission ranging from 0- 2 % or more, while DSC funds generate a lucrative 5% commission at the time of sale that advisers share with their firm. In the rare case where the FEL fund has a lower MER than it’s DSC relative a switch may be to the investor’s advantage. But, even here the question of deemed disposition comes up. The MFDA says it's possible that a switch from a DSC fund to a FEL fund could be considered a sale, which means income taxes would apply in non-registered accounts. Advance tax rulings however suggest that a switch to substantially the same fund is NOT a disposition, but the MFDA, an SRO, says there's been no definitive word.
Front-load funds also compensate advisers by paying so-called trailer commissions of about 1 % in most cases. Because they offer a big commission at the beginning, DSC funds pay about half the trailers that front-load funds do, typically 0.5%. Thus, Carrick points out, the adviser gets the best of both worlds with a DSC conversion. There's the upfront commission of up to 5 % and, after the conversion, there's the 1 % ongoing trailer commission of the FEL fund. Source: R. Carrick, Globe and Mail, Oct. 4, 2005 pg B21.If the investment fund industry truly had investor’s interests at heart they’d set up a monitoring system to detect and manage the switching and it’s corrosive effects.

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Ken Kivenko’s column is all about investor protection. Ken fights for investors’ rights and exposes violations and malpractices. He also runs an advisory business, FundBuster Analytics, assisting investors obtain restitution due to sales or broker abuses.

Trailer Fees: A Vitamin or Toxin?

By Ken Kivenko | Thursday, September 29, 2005

Our investor advocate explains all about trailer comissions
Trailer fees, sometimes called service fees/commissions are “fees” the mutual fund manager claims to pay to the individual and/or organization that sold the fund for providing ongoing services such as investment advice, performance statements and tax guidance to investors. Industry critics label these trailers as commissions to better reflect their actual application--to keep you invested in the mutual fund. In the view of many it’s just another example of a sales-based industry trying to borrow the credibility of professionalism by using their lingo (e.g. “fees”). Investor advocate Joe Killoran has labeled trailers as “tied advice / tied sale” under his disclosure thesis and provides a suite of checklists to aid in adviser-client communications on his website http://www.investorism.com. The OSC’s Fair Dealing Model had three core principles that attempted to address the asymmetric information issue:

There must be a clear, documented allocation of roles and responsibilities among the investor, the adviser and the firm.
All dealings with the investor must be transparent including fees. Transparency is disclosure that is understandable and meaningful to an investor and communicated at the time and in the manner most useful to the investor.
Any conflicts-of-interest the adviser has must be appropriately disclosed and managed to avoid self-serving outcomes.
Regrettably, the FDM seems to have fallen into a CSA swamp

Prospectuses generally refer to this ongoing charge as trailing commissions and do not identify precisely the charges related to a particular fund but use vague terms such as “up to” or “may pay”. Lawyers have worked their magic here for sure. Trailer fees are opaque to say the least. You can get a sense of the magnitude by reading a fund’s Simplified Prospectus, available on-line from your adviser, the fund company or via http://www.sedar.com. Trailer commissions are not an item on fund client statements showing the cost in dollars and cents of the “advice” supposedly provided. Strangely, regulators have not required prominent plain language disclosure at the point of sale or even standard terminology but truly professional advisers are making use of Engagement Letters and Investment Policy Statements to make the costs of advisory services more transparent.

Proponents of trailer commissions argue that the ongoing services are valuable benefits to investors and salespeople must be compensated for their work. For anyone who’s received a crummy client statement and tried to make sense of it, the words ring hollow. Many fund salespersons are not even qualified to provide tax advice. Wisely, most don’t even try to provide it.

Trailer fees are usually in the range of 0.25 % to 0.50 % per annum for DSC sold funds but can exceed 1 %. Equity funds sold with a front-end load typically pay advisors 1% annually. Proprietary funds may offer the highest trailers but are often the highest cost for investors. All the money comes out of the manager’s management fee. Most Index ETF MERs are less than this, e.g. the i60 MER is just 0.17 %. Trailers vary from Company to Company, fund category and load classification with money market funds paying the least. Typically, financial advisors obtain 50% of the annual trailer fee commission when their sales transaction is DSC or Front-end load (high load); they receive 100% of the annual trailer fee commission when their sales transaction is ZERO load, No-Load or Low-load (2% or less). When a DSC fund “matures” advisors often want to convert the position to front-end load on the basis that it makes no difference to the client. In reality the trailer typically doubles from 50 to 100 bp. The extra 50 bp was originally used to “amortize” the advisor’s DSC sales commission. Once that’s paid off, there is no longer any justification for the fund company to charge it. It should be rebated back to the client -- it’s their money after all -- not paid as a bonus to the advisor. Indeed, the fund should automatically convert to a front-end load where the MER should be, but isn’t lower.

The management fee, which includes the embedded trailer, is extracted from the fund’s assets so it’s the investor that’s paying the bill, albeit obliquely. On a $ 300,000 mutual fund account that’s typically about $1,500 p.a. for every year you hold the fund, escalated by any growth in the account. Over an extended time, the decompounding effect of trailer commissions can be hazardous to your financial health if you’re not getting the appropriate advice.

Trailer commissions paid are not an isolable item you’ll find articulated on fund client statements or fund Annual Reports. As with so many other fees and expenses, trailers are subtracted from a fund’s assets so all investors get to see is the Net Asset Value upon which return calculations are made. Critics believe there is a heavy bias towards putting investors into higher risk equity funds where trailer commissions are often highest. It’s also strange that advisers rarely recommend stripped coupon bonds or straight bonds where there are no trailers instead of bond funds with lucrative trailers. Authors John DeGoey (the Professional Adviser) and John Reynolds (the Naked Investor) have documented cases illustrating the process .A Small Investor Protection article located at http://www.sipa.to/investorsCorner/cornerMain.htm warns:

“… Since the sellers are generally commission-driven and some managers push the salespeople to generate more commission there is a natural impulsion to employ strategies that maximize commissions. This can result in churning of accounts, or excessive trading. The mutual fund sellers will often employ the tactic of selling 10% of your mutual funds each year and then reinvesting in other funds to generate new commissions which are greater than the trailer fees they would receive if you held your funds…”

Even David Brown, former OSC Chair, told a May Toronto CFA Society meeting expressed his concerns about embedded commissions in the context of the Portus hedge fund scandal. He said that:

"When considering the extent of the distribution of these products, it is important to keep in mind that this was not a case of early investment successes fueling explosive demand. And the promoter was a relatively unknown individual, with no proven track record and no market reputation. So what could have accounted for the firm’s tremendous sales record? Perhaps there is only one particular feature to speak of – high up front fees and trailer fees for referrals. The potential earnings for agents were high....

Cynical critics also believe that trailers produce a powerful conflict-of-interest for the salespeople who could encourage investors to stay in the fund even when market conditions might indicate that they should redeem their units and keep the money in cash, GIC’s or bonds. Since advice should also include when to SELL as well as when and what to buy, you’d think this actually happens. With few exceptions, don’t count on it unless it’s to churn the account into another fund which may result in a renewed sales commission and continuing flow of trailer dollars to the adviser. In most cases, the sale has nothing to do with market conditions, a change in objectives or suitability.

Critics of the ongoing trailer commissions also argue that investors who hold funds for the long-term end up paying higher overall fees than they would if they had paid a onetime front or back end load. The most outspoken of the critics label the trailer fee as a poorly disclosed inducement or more politely as a “facilitating payment”. Also, trailer commissions are paid from fund assets to whoever sells a mutual fund-even an on-line discount broker, who isn’t even allowed to provide advice. This is controversial because on-line brokers provide no on-going service, other than statements and record keeping. Some exchange traded funds also pay trailers with the same degree of illogic .The only possible reason the payments are made are to keep you invested in the fund so that the fund Company can continue to earn fees each year off your investment.

In too few cases is the existence of trailers highlighted to investors by their advisers. A 2002 paper Out of Sight, Out of Mind: The Effects of Expenses on Mutual Fund Flows [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=496315] by Brad Barber, Terrance Odean and Lu Zheng concluded that:

“..We report evidence that mutual fund marketing does work. On average, any negative effect of expense fees on fund flows is more than offset when that money is spent on marketing; non-marketing expenses, however, reduce fund flows. Though load fees are also spent on marketing, the positive effect of marketing on flows does not appear to be sufficient to offset investors growing awareness of and aversion to loads…”

Fund companies usually watch every nickle they spend, but in the case of trailers they just send out the cheques without regard to the quality of service, frequency of service or even if the service is provided at all. There is rarely if ever, a follow up with investors to determine the level of satisfaction with the so-called trailer services provided. This fact alone suggests that trailers are seen as commissions by industry participants rather than a real advisory service for investors. Indeed, some theorize they are commissions to make up for the 8% front sales load charges that prevailed in the late eighties i.e. 5 % sales commission (paid out of the management fee of DSC funds) + 6 (could be 7) yrs DSC period x 0.5% = 8 % (or 8.5%). The numbers seem to validate the theory.

A wonderful article on how to avoid trailer commissions located at http://www.asldirect.com/ASLDirect%5CAS ... ancialPost states:

“..Have you ever wondered where mutual fund salespeople invest their own money? Many believe in the products they sell but most are only too aware of the long-term impact of annual trailer fees of 0.5% to 1% on their performance. Some have the best of both worlds by putting their personal portfolios with ASLDirect.com, a firm created in 1999 by Mr. ASL himself: Adrian Samuel Leemhuis. ASL rebates trailer fees to customers. As noted the last time ASL was mentioned here -- two years ago -- the firm makes its money charging a flat $29.95/month subscription. That makes it cost effective for portfolios of $50,000 or more…”

Conclusion

Most investors don’t understand trailer commissions and the inherent conflicts-of-interest they cause. Many don’t know they exist despite the many articles that have been written on the topic. Now that you know they exist, ask your adviser to disclose them and make sure you get your money’s worth. Informed investors who do not need or want continuous service can choose mutual funds from firms that do not pay trailer fees. You can also consider low-cost, tax-efficient index ETFs. Low-cost F Class funds which have the commissions stripped out are unfortunately not available to investors without going through an adviser (an attempt by E*Trade Canada to make them available was quickly crushed by industry participants). If you do need financial advice, consider a fee-only account with a trusted, professionally qualified adviser. You’ll get personalized client statements that show personalized returns and an enumeration of fees so you can determine whether or not you are getting value for the fees. In most cases, you should be able to deduct the fees for income tax purposes

Ken Kivenko P.Eng., August 2005

[admin]

the alleged practice of switching third party mutual funds into in house (proprietary) investment products of a similar nature is also suspect as self serving to the firms that allow or promote it.

According to the OSC Fair Dealing Model (appendix F, page 11 or 12) this practice has the effect of tripling or quadrupling the amount of compensation shared by the firm and the salesperson.

Is this the kind of reputation our investment industry is wanting?

[Guest]

39. My financial planner was charging a yearly fee, plus must have been receiving commissions from the mutual funds, which he never disclosed. Is the securities commission scrutinizing this practice?

If your financial planner is a representative of a dealer, then there are rules that require that information about commissions paid for trades be disclosed to you. For mutual fund dealers, commissions charged for a trade as well as amounts deducted as sales, service or other charges are required to be disclosed in trade confirmations.

this question and answer from OSC town hall shows an inability by the OSC to grasp the issue of double dipping, and secondly to fail to grasp their responsibility in the area of investor protection.

http://www.osc.gov.on.ca/Investor/TownH ... -and-a.jsp

[Guest]

I agree that it is a failure of an advisors fiduciary duty as a professional when a client is put into the highest compensating mutual fund class, and insult is added to injury when changes are then made to further increase dollars to the advisor...........it is one money grab piled on top of another

see NASD web site http://www.nasd.com/web/idcplg?IdcServi ... odeId=1246

titled Class B mutual funds, do they make the grade for warning of mutual fund scams, and discussion of investor compensation in the US for this type of "unsuitable" advice.

Reason #1 why it (DSC choice and then switch to non DSC) is unsuitable and not in the client best interest is that a professional advisor (not someone representing him or herself as merely a salesperson) is ethically bound to put the interest of the client first, and the interests of the client is not to choose the mutual fund class that most generously rewards the advisor..........

Reason #2 is when the advisor then puts his or her best interests first when given a chance to double the trailing commission

Reason #3 is that in my experience within the industry for twenty years that the client is not usually informed of the underlying reasons for these choices and these changes. They are the sales reasons, and usually clients are given "other" reasons to buy this version, or make this change, while the underlying motives are hidden from the client, rather than disclosed.

There are a number of good advisors out there who understand this and about 20% of mutual funds are sold with a zero percent front end load because of this. However the other 80% are simply guilty (in my opinion) of the practices the NASD web site warns about, and investors should be angrily demanding refunds.

THE ADVOCATE
(with the understanding that I could be, usually am, and probably will be wrong on much of my thinking)

[Guest]

Yes, the advisor has effectively doubled his/her trailer.

But it could be (and is) worse.

Some advisors, noting the expired schedule, will advise their client to exit the fund entirely and buy something else better (or so they say...). The new purchase nets the advisor a 5% up front commission which (bird in hand) far exceeds the 50 bp trailer bump appeal.

Look no farther than AGF, AIC and Fidelity to see this handy work in action.

Which were the hottest selling families 6 years ago ? Which are in the highest net redemptions today? The answers are the same and this is not by coincidence.

An advisor who sells funds DSC is motivated to churn the portfolio every 6 years or so. There has long been this conflict of interest with mutual fund sales and fiduciary responsibility. The client does not experience any appearant "commissions" so doesn't mind the change. Couple the end of the DSC schedule with some lackluster performance and this makes the case all the more credible for the advisor to sell the client.

Now I believe that advisors are handling the end of a DSC schedule in 2 ways: 1/ If the fund is a strong performer, switch to a front end version and hence double their trailer, 2/ If the fund is a weak performer, sell out completely and buy something else netting a tidy 5% up front commission (easy to do when the fund is underperforming). Clearly the second strategy yields the advisor a more lucrative return, but then both increase an advisors pay for no additional service provided.

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The trailer fee is likely being doubled from 0.5% to 1.0% per year.

That's it exactly. Brandes does that conversion automatically. A couple of other companies have followed their lead, but I don't remember which ones.

The switch makes a difference to the advisor, but not the client. The MER stays the same. The 50 basis point difference between the DSC trailer and the front-end one reimburses the fundco for the upfront commission it paid on the DSC purchase. That cost is covered (more or less) by the time the redemption fee schedule runs out, so fundcos have no problem with upping the trailer to 1%. Of course, if they didn't many advisors would have the client dump that fund and buy a new one.

[Guest]

I would like to know what the motivation, logic or whatever that a mutual fund salesperson has or is using in the following situation.

The client has purchased funds on a DSC basis and they are coming off the holding period. He is recommending that the client transfer the units out of the DSC version of fund into the SC version. The salesperson is not charging them a switch fee (that I can tell) nor is there a load fee being applied to the units being acquired.

What am I missing here? Does it have to do with trailer fees? All comments are appreciated.

[admin]

United States illegalities, sadly accepted in Canada
This article could apply to mutual fund and proprietary fund practices in Canada, also double dipping. Regulators still failing to enforce the simplest rules of fiduciary behavior in Canada. Class action lawyers might have to make it right.
New York Times


April 30, 2005
Mutual Fund Firm Is Fined; Will Repay $11 Million to InvestorsBy JENNY ANDERSON
addell & Reed, one of the country's oldest mutual fund companies, paid $16 million to settle charges brought by regulators saying that it fleeced investors by switching them into financial products that benefited the brokers and the company at the expense of investors.
NASD, the investment industry's regulatory organization, said Waddell & Reed, which settled the case less than a week before it was scheduled to go to trial, would pay a $5 million fine and provide up to $11 million in restitution to clients who responded to a company campaign to move their investments from one variable annuity to another.
The switch earned the brokers more fees and commissions but cost customers more, NASD said. The company, which is based in Overland Park, Kan., and has $38.2 billion in assets under management, will also pay a $2 million fine to state regulators. The company did not admit any wrongdoing.
"What was most troubling about the case is what a concerted and aggressive campaign it was on the part of the company," said Mary L. Schapiro, vice chairman of NASD. "There was little regard given to whether this was good for investors."
In a complaint filed in January 2004, NASD charged Waddell & Reed with violating rules that dictate the steps brokers must take to ensure that investments are suitable for clients. From January 2001 to August 2002, the firm tried to switch customers from variable annuities issued by the United Investors Life Insurance Company to similar annuities from the Nationwide Insurance Company, after Nationwide agreed to a fee-sharing agreement that would benefit the company's brokers and bottom line.
The switches cost investors almost $10 million in surrender charges - fees paid for exiting a variable annuity contract early.
The settlement imposes six-month suspensions and $150,000 fines on Robert Hechler, Waddell's former president, and Robert Williams, the former national sales manager who is now senior vice president for public affairs. Neither man admitted guilt.
"This is a positive step for Waddell & Reed, our financial advisers, our employees and our clients," said Keith A. Tucker, the firm's chief executive. "These matters date back several years and their removal as an issue is an important action."

[Guest]

from my position inside the industry I can back about everything the Jonathon writes here. It was, and is a disgusting way to take advantage of clients and I personally cannot wait for the day when class actoin lawyers get this concept and collect compensation in the billions for Canadian investors. I will be the first in line to testify, and bring documents to prove double dipping. Just find me the lawyer now please.

[Guest]

Thursday » June 23 » 2005

Managing away your money
Shift to annual fees no improvement over old commission model

Jonathan Chevreau
Financial Post


June 23, 2005

Like many things in life, the fee-based investment account is a good idea that is rapidly becoming a bad one.

Some weeks back, this column featured the testimony of a white-hatted financial advisor we called Francis. This source provided an inside account of how black-hatted colleagues were double- or triple-dipping by collecting commissions from new issues on top of the flat annual fee applied to client accounts.

We'll hear more from Francis in an upcoming column, but the original one inspired other white hats to contact me and let me know Francis was "right on."

One was another bank-owned brokerage advisor we'll call Robin, based in a large Ontario city. He says the double-dipping reported by Francis is only one aspect of a culture of "unbelievable greed" that makes him "nauseous."

That culture is one that "creates a horse race out of who can make the most out of ma and pa's assets." He believes a similar environment exists at most rival firms.

After almost two decades in the business, Robin is convinced the best deal for clients is an honestly run traditional brokerage account. "The dirty little secret is that a ma and pa commission-based account is the lowest-cost option if run properly."

I agree, since that's the way I choose to run my own investments.

Anyone who does the math can soon figure this out. I know of a case where an elderly widow was talked into moving her portfolio of GICs and bank stocks to a "managed account" charging 2.75% a year on the value of the account (just shy of half a million dollars). This happened not at a big bank brokerage, but at one of the country's few remaining independents.

Let's say the bank stocks (how ironic!) paid an average dividend of 3% and the GICs paid 4%. For a balanced portfolio, that amounts to a 3.5% annual flow of investment income.

Therefore, this managed account diverts the lion's share (79% by my reckoning) of the GIC and dividend income that once flowed to the widow to the brokerage firm's pockets.

Oh sure, the firm will claim these calculations don't factor in capital gains from the brilliant stock-picking their fee supposedly buys you. But there's no guarantee they can even beat a low-cost portfolio of index funds. Odds are they'll do worse by the amount of their fees.

As with mutual fund management expense ratios (MERs), it's easy to dismiss 2.75% as a small number. After all, we pay $2.75 for a large Starbucks coffee these days so how bad can 2.75% be? On $500,000, 2.75% is $13,750. That's each and every year from your pocket to theirs, or more than what many try to save each year in their RRSPs.

Don't get me wrong. I can see how a more reasonable fee of 1%, layered on top of an honestly run portfolio of quality stocks or exchange-traded funds, might be a decent deal for those who'd rather delegate the process to others. Just be aware of how much that decision can cost you.

Robin's client recommendations tend to be more like the widow's portfolio before the fee-based crowd got to her. They also include insurance and utility stocks and ladders of Canadian government bonds with maturities staggered over 10 years.

The sales pitch for managed accounts is that they provide more reward for less risk. But that's horsefeathers, according to Robin. "It's not diversification. It's diworseification."

His annual portfolio turnover is a low 0.3%, which keeps both commissions and taxes low for clients. But that didn't satisfy his branch manager. He accused Robin of "underutilizing" client assets and demanded he quadruple his turnover rate to 1.25%.

But even as they demanded higher turnover rates, they imposed a double standard. To qualify for top sales awards, advisors could only go so far in "utilizing" client assets. They drew the line at 2%, beyond which advisors could not be admitted to the inner sanctum of top producers.

So while it chastised underutilizers like Robin, it was able to maintain a "holier than thou" stance that it discouraged excessive churning.

One top asset gatherer referred to his clients as "cattle to be herded." Over a quarter century, this person inflicted "unbelievable harm to people and the quality of their retirement," Robin says.

The acid test is to ask such advisors if they put their own money into fee-based accounts. Most don't, he says, but the worst ones are so unscrupulous they may claim they do.

© National Post 2005

[admin]

the post has had recent articles on this topic. I have complained of it for years. Industry speaks against it but secretly finds the increased commissions addicting if they can do it in secret.

Glad to see it coming out into the open.

It involves any of the myriad of ways to add fee upon fee, or fee upon commission, and vice versa. It happens every day and earns the coveted "vice president" title to many sales types I have seen.

Advisor fees added to commissions already paid. Commissions paid by clients to move to firms proprietary products. New issue commissions paid into account where the client is already paying an annual advisor fee.

Anything that adds an additional fee to the client, without a corresponding advantage, is likely a form of double dipping to benefit the advisor. Unfortunately, it is still hidden enough to allow it to go on.