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SEC Calling Attention to Hidden Costs

It already settled with one firm in a recent sweep examining sub-transfer-agency fees, but there may be others.

Russel Kinnel, 10/13/2015

The SEC has been shining a light on a dark corner of mutual fund expenses--sub-transfer-agency fees. Recently, the SEC sanctioned one firm, First Eagle, for unlawfully accounting for what, in fact, were sales and marketing expenses as sub-transfer-agency fees. If reports are to be believed, the SEC has had other firms in its sights as part of its Distribution-in-Guise Initiative.

While the First Eagle case hasn't garnered a ton of attention, it's important nonetheless. First, this is a case in which a firm was charged with violating regulations meant to ensure that it appropriately pay and account for sales and marketing expenditures, and that violation harmed every shareholder in its funds. (Accordingly, we've lowered our Parent rating of First Eagle funds to Neutral from Positive.) Second, it's symbolic of the lengths to which firms have gone in pushing the limits of rules governing the practice of using fund assets to pay for sales and marketing activities.

Transfer agents handle the fairly mundane work of processing mutual fund transactions, making distributions, calculating cost basis, and more. A fund's transfer agent can be affiliated with the fund company, or it can be a third-party firm. In either case, transfer agents will sometimes elect to outsource at least a portion of the work to a sub-transfer agent. For instance, a fund company that acts as the transfer agent of a fund that it offers might elect to outsource the transfer agency work to a brokerage house if that fund is offered on the brokerage house's platform. In that scenario, the fund pays--from its assets--the brokerage house for its services. This is pretty straightforward and entirely permissible.

Running Afoul
What's piqued the SEC's interest, though, is the nature of the services being rendered under some of the sub-transfer-agency agreements it has examined. To be clear, the issue here isn't necessarily that fund companies overcharged their shareholders. Rather, it's whether they've disguised sales and marketing expenses as sub-transfer-agent fees. Indeed, that's what the SEC found at First Eagle, which had entered into two sub-transfer-agency agreements that included explicit provisions linking sub-transfer-agency fees to sales of First Eagle funds on the brokerage houses' platforms, a no-no.

Punishment and Principles
The SEC imposed a $12.5 million penalty on First Eagle and additionally ordered it to compensate investors for damages amounting to $25 million plus $2 million in interest. Spread out over more than $60 billion in mutual fund assets under management, it's a pretty small amount, but there are some important principles involved:

  • Competition intensifies when it's out in the open. For instance, the incursion of lower-cost vehicles like exchange-traded funds into the U.S. fund industry has exerted downward pressure on prices across the market. But when firms use subterfuges like mislabeling sales and marketing expenses, it short-circuits competition and, ultimately, short-changes investors.
  • While management fees have ticked lower, sales and marketing expenses have been more-or-less impervious to that trend. Why? One could argue that, far from being out in the open, they're largely concealed in fund expense ratios (where they're levied as 12b-1 fees). So is it any wonder they haven't come down? Fund companies often feel they have little choice but to pay to be in key platforms and supermarkets, and those fees have actually risen during the past decade.
  • Even when you set up a system to police the bundling of sales and marketing fees, you have excesses at worst, confusion at a minimum. Indeed, fund accounting is apparently so opaque, or subject to interpretation, that fund firms sometimes have to engage outside consultants and legal counsel to vet their agreements and the way they've classified the associated costs. (First Eagle reportedly did so, to no avail.)
  • The market has voted against the bundling of sales and marketing fees. How? They've moved en masse into products like index funds and ETFs that don't charge these fees. So while the traditional fund industry might have won the battle to avoid having to pay for all of these fees out-of-pocket (as opposed to paying from fund assets, the prevailing method), it looks like it's losing the war.

It's an open secret in the industry that the costs of putting a fund in a retirement plan, brokerage platform, or supermarket are greater than the fees explicitly allotted for distribution. The cost for this distribution is generally covered by 12b-1 fees, which are the only fees that can be used for such purposes from a fund's assets.

Other fees come from a class of fund expenses deemed "administrative" or related to "shareholder service" and may involve transfer agents and sub-transfer agents and other parties unfamiliar to most individual investors.

One suspicion is that, somewhere in the gap between what a shareholder pays a fund company for transfer-agency fees, and what the fund company in turn pays to a sub-transfer agent that provides most, if not all, of the actual service to a shareholder, can be found what the SEC calls "distribution in [dis]guise." While the First Eagle case doesn't resolve that issue, it does point toward what is likely to be greater enforcement by the SEC around such arrangements. 

Russel Kinnel is Morningstar's director of mutual fund research. He is also the editor of Morningstar FundInvestor, a monthly newsletter dedicated to helping investors pick great mutual funds, build winning portfolios, and monitor their funds for greater gains. (Click here for a free issue). Mr. Kinnel would like to hear from readers, but no financial-planning questions, please. Follow Russel on Twitter: @russkinnel.

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