Clean shares of mutual funds are expected to revolutionize how brokers and advisors are compensated for investment advice, irrespective of how the Labor Department uses the products to revise the fiduciary rule, according to experts at Morningstar.
The Labor Department has strongly signaled its interest in using clean shares to create a new exemption under the fiduciary rule.
Clean shares strip 12b-1 distribution fees, which are paid to advisors and brokers when recommending investments, from the cost of mutual funds.
Because different funds come with different payment levels, advisors and brokers face a potential conflict of interest by recommending funds with higher distribution payments that might not be in investors’ best interest.
Clean shares neutralize the potential conflict by allowing advisors and brokers to charge their own fees on top of the expense ratio of a clean share mutual fund.
The fiduciary rule, and talk that regulators are looking to leverage clean shares to amend the landmark regulation, has created a tremendous tailwind for the new share class, experts from Morningstar said in a recent client webinar.
But even if Labor doesn’t craft a new clean share exemption, the revolution is here to stay.
“Clean shares will play a staring role in the new environment when we finally get to a compliance and enforcement mechanism,” said Aron Shapiro, director of policy research at Morningstar.
Shapiro says the question is not whether the rule has generated a tailwind for clean shares, but whether a new exemption will generate a “super tailwind.”
Mutual fund companies, led by the Capital Group, are chomping at the bit.
The Capital Group owns American Funds, a prominent provider of actively managed mutual funds. Public attention to fees on investments has driven years of record outflows from actively managed funds into cheaper passively managed mutual funds and exchange-traded funds.
Paul Ellenbogen, head of global regulatory solutions at Morningstar, says that under traditional shares of mutual funds, like A shares, 60 percent of the cost investors pay goes to distribution payments and other fees, and not to the cost of investment management.
With those costs stripped from clean shares, actively managed mutual funds will be able to better compete with passive products, says Ellenbogen.
“Clean shares have created a strong rallying point in the asset management community,” said Ellenbogen. “They see it as the future of how mutual funds are distributed and evaluated.”
As is, actively managed funds and passively managed funds are competing on an un-level playing field, he said.
By not having to focus and building distribution and administration costs into their products, asset managers can focus on their core competency, and do what they do best—manage money. And they’ll be able to put a much more attractive price point in front of investors.
The cleanest shares
Shapiro said career professional staff—those that were behind writing the fiduciary rule—have driven the interest in clean shares within the Labor Department.
But political appointees have started to warm to clean shares as a way to neutralize potential conflicts of interest in the advisory market, and potentially streamline the overall fiduciary rule.
However, considerable work needs to be done on the regulatory front. Specifically, guidance will have be crafted on what exactly defines a clean share. Transfer Agency and Sub Transfer Agency fees, which investors pay to have their assets administered, are the largest sticking point so far.
In an interpretive letter issued by the Securities and Exchange Commission earlier this year, regulators were deafeningly silent on the question of TA fees.
That silence has led some securities lawyers to interpret that clean shares can embed agency fees and still be clean.
But Morningstar has staked out a firm position on the question: In order to be clean, agency fees must not be embedded in clean shares.
“We are not saying that these services are not valuable, or that they don’t have to be paid for,” said Ellenbogen. “We regard them as valuable and necessary services. But when they are included in an expense ratio of a fund and involve indirect payments, that would trip our standard.”
In order to satisfy the strictest definition of clean shares, which Morningstar will ultimately rate, transfer agency fees will have to be unbundled from expense ratios, and either paid by investors directly to service providers, or perhaps absorbed by fund companies.
No smear on commissions
Morningstar’s experts were eager to underscore that their strict application of clean share standards is not to be interpreted as disdain for commission-based compensation.
Under clean shares, brokers can charge a one-time commission on sales of investments, just as affiliated and independent registered advisors will be able to charge an ongoing advisory fee.
In other words, clean shares do not amount to a ban on commission-based business, said Jeff Schwantz, head of client solutions at Morningstar.
While clean shares will represent a historical evolution in the advice market—Ellenbogen expects 100 percent of asset managers to issue clean shares within the next five years, and that they will be used for both qualified and non-qualified investment accounts—industry faces a tremendous infrastructure challenge.
Distribution platforms will have to be reconfigured to accommodate how clearinghouses and custodians receive transfer agency fees from investors.
How long will that take? That’s the big unknown, Morningstar says.
“Unraveling 40 years of infrastructure to handle how money flows isn’t that simple,” said Schwantz.
The good news for clean share advocates is positive actions have already been seen across service providers, from asset managers to custodians to broker dealers, Schwantz noted.