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Rekenthaler Report

Revenue Share: The Fund Industry's Dinosaur

John Rekenthaler

It’s Not Personal, Just Business
“Ameriprise Limits Sales of American Funds Products,” read Friday’s headline in the trade publication Ignites (the article is not linked because it is paywalled). Strange. I had not realized that American Funds’ performance was poor. Fund distributors, such as Ameriprise, conduct “robust due diligence” to ensure that their customers will be able to assemble a “broad, quality investment portfolio.” (Those quotes come from a 2017 Ameriprise release.) Did American Funds fail that test?

Silly me for thinking such a thing. It turns out that the decision was not about the investments. From the article:

“The impetus for the change is a revised revenue-sharing agreement between Ameriprise and the Capital Group-owned manager, as laid out in a regulatory filing. To be a full partner and play on all platforms at Ameriprise, shops are required to pay up to 20 basis points per year for assets within their funds in 'marketing and sales support payments' and up to 20 basis points per year on sales as of January 2017.

“Ameriprise still offers products from managers that are not full partners, but there is a different agreement. The other managers make ‘distribution support’ payments of up to 10 basis points on the assets in their funds. In the firm’s 2016 revenue-sharing breakdown, the firm claimed to receive $11.4 million in ‘distribution support’ payments, and listed the seven managers that each paid Ameriprise more than $500,000 that year. American Funds was not one of the seven.”

Shell Game
Got that? Neither do I, not fully. What I do understand is that Ameriprise, as with most companies that distribute funds (through online platforms, their staff of financial advisors, or both), expects to be paid by fund companies. Effectively, the fund company overcharges its customers, the distributor undercharges, then the fund company cuts a check to the distributor to settle the difference. Both parties end up roughly where they would have been had they priced their services properly.

The reason for this subterfuge rests with investors. As a general rule, they shun overt charges--brokerage commissions, account fees, and so forth. In contrast, they are relatively insensitive to asset-based arrangements, where their payments are collected quietly, behind the scenes. That preference explains why financial advisors have moved from selling load funds to levying asset-based fees and why fund companies share their revenues with firms that distribute their wares.

Throughout the industry, such deals are negotiated--and sometimes stricken. TD Ameritrade made news late last year by removing several dozen exchange-traded funds from its commission-free platform because Ameritrade and those fund companies could not agree to terms. Similarly, Schwab’s OneSource program has never found room for Vanguard.

Nor are revenue-sharing arrangements restricted to retail brokerage platforms. The 401(k) industry is stuffed with them. Because employees also dislike paying overt fees, 401(k) plan providers frequently do the same revenue-share shuffle. The plan’s funds charge more than they would otherwise need to, then reimburse 401(k) record-keepers with the monies that they have collected in management fees. The same applies to college savings 529 plans.

One can argue that no harm means no foul. A 401(k) investor with a $50,000 account balance who owns funds that have an average expense ratio of 0.70% and who pays no record-keeping fees because the funds reimburse the record-keeper spends $350 per year. So does the $50,000 investor who holds funds that have average expense ratios of 0.50% and who pays a $100 annual record-keeping bill. Since $350 is $350, the investor should be indifferent.

Except ... the artifice is a poison. It abets dishonesty. There isn’t any way that a distributor can tell its customers, “We selected these funds, in part, based on the size of the payment that we receive from their underwriters.” Instead, the distributor must give the impression that its selections are made solely on investment merit. The truths, to the extent that they are revealed, are buried in legal documents. Thus, Ignites got its story not from talking with Ameriprise but instead by combing through a legal filing.

That is no way to inculcate trust.

Consider mutual fund B shares--another form of revenue transfer. The financial advisor sells a fund that assesses no front-end load and, after enough time expires, imposes no exit charge, either. Nor does the financial advisor collect an advisory fee. It’s free! Only it is not. The fund collects a steep annual payment from the shareholder in the form of a 12b-1 fee (typically, 1.25% of assets for a stock fund) and then rebates most of those revenues to its funds’ distributor.

Once highly popular, the B share has become shunned. One reason is that the structure has been replaced by advisory fees. But another is that the shares are, at their essence, unclean. Their existence depends upon a con. It requires that buyers either be unaware of the fund’s high ongoing expenses--the cheapest stock fund B shares have 1.5% expense ratios, and most are well above that--or fail to appreciate the damage that is caused by such costs. The B share is not sold with open hands.

Future Vision
And open hands is where the investment business is heading, albeit slowly. Eventually, funds will be sold as stocks currently are. Distributors will make all funds available to their customers, just as they now make all stocks available. How those distributors will be paid by their clients remains to be determined. But it won’t come from the funds, just as it now doesn’t come from the companies that have issued equity and whose stock shares are traded.

In writing this column, I point no fingers. Ameriprise is but an example; if distributors and fund companies play games with their customers, that is largely because the customers have sought those games. Historically, investors have rewarded firms for engaging in revenue share. But those days are changing. B shares are out, and (relatively) clean ETFs are in. Gradually, slowly, revenue share is on its way to extinction. Its demise will not be mourned.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.