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Rekenthaler Report

Brave New World

Mutual funds shed their commissions.

What's to Come
Saturday's The Wall Street Journal carried an article by Jason Zweig that wondered if mutual fund "fee hurdles could come down everywhere?" Zweig noted the United Kingdom has already banned sales charges from being attached to the price of a mutual fund, Australia is in the midst of implementing such a regulation, and the Netherlands will do so on the New Year. Effectively, those countries only permit pure no-load funds--that is, funds that lack both a front-end charge and an ongoing trail fee. (Those are called 12b-1 fees in the United States, although they are not called that elsewhere.) Zweig believes this could be "one possible future" for the U.S.

I would reword to probable. In addition to the three countries that Zweig mentioned, India has also banned front-end commissions (but not yet trail fees), and Germany and Sweden have the issue up for review. And the big dog is walking. The U.S. owns half of global mutual fund assets, and although American regulators have not touched the subject (the SEC briefly put 12b-1 fees up for review but backed down under fierce pressure), the marketplace has. As I reported in late May, today's net cash inflows into U.S. mutual funds are almost entirely into no-commission share classes, namely institutional funds, exchange-traded funds, and load-waived A shares. Commission funds are starving on the vine.

Zweig views the extinction of commission funds as an unambiguously good thing, as does almost every other financial journalist and consumer advocate. I do not. Disappearing commissions do not mean disappearing investor costs. Instead, they represent a change in the payment model. Funds sold through commission make a transfer payment to financial advisors. (You may use the term kickback if you prefer.) In the new, no-commission world, a financial advisor collects directly from investors, typically in the form of an annual asset-management fee. (This fee has many names; in this article, we'll call it an advisory fee.) In either case, investors who use financial advisors pay for services rendered. So, investors are only better off if the new system beats the old.

Right now for the long-term fund investor, it does not. The big problem is that advisory fees generally don't step down over time. With commission-based funds, A shares levy a large upfront sales charge, but after the time of sale they have a small ongoing trail of 0.25% per year. B shares functionally similarly, collecting a large amount the first few years, then converting to A shares and also subsiding to 0.25% annually. However, the new advisory fees typically remain constant, year after year.

That has a big cost for the long-term investor. Under the traditional approach, putting $20,000 into load-fund  American Funds Investment Company of America (AIVSX) costs a 5.75% upfront sales charge and an additional 0.25% per year in 12b-1 fees.* Over 20 years, that makes for 5.75% + (20 years * 0.25%) = 10.75% in total commissions. In contrast, an advisor under the new model who charges a 1% annual advisor fee** would collect almost double that amount, at 20 years * 1% = 20%.

The math doesn't improve for the large investor, as the upfront sales load for A shares on investments of $1 million or more disappears entirely. Thus, that investor's total sales commissions consist solely of its 0.25% annual 12b-1 fee. (There's no cost break for volume with B shares, though, which is why larger investors should never and presumably do never buy B shares.) That same large investor will likely be offered a volume discount for advisory fees, but the ongoing annual cost will surely be above 0.25%. 

It's understandable why advisory fees are flat over time. Investors tend to balk at writing checks for financial services, and they also don't like being charged per activity. So, the natural pricing scheme for financial advisors in setting advisory fees, as for mutual fund companies in pricing funds, is to have a steady, ongoing asset-based charge that varies neither with activity nor with time. Effectively, the long-term, low-trading, low-demand investor subsidizes the short-term, high-trading, and/or high-demand investor. Certainly, financial advisors deserve payment for their services--but the new advisory-fee model does not suit the long-term fund investor. The A share approach was clearly better.

Also, tethering sales commissions to mutual funds makes for better disclosure, better price comparisons, and a more consistent investor experience. Costs are in the open, in a fund's registered prospectus. It is easy to compare one fund's charges versus another's. In addition, except for the breakpoints associated with a higher initial investment, every buyer pays the same. Shopping for advisory fees, on the other hand, is nigh on impossible. There's no database of advisory fees, the services delivered can vary widely, and (unlike with funds) list prices can be negotiated. Advisory fees are an unknown.

These items can be addressed. Presumably, the current scheme of flat, ongoing advisory fees will morph to a structure that more closely matches the advisor's costs; that is, fees will be higher initially, to reflect the upfront work that must be done for each new client. Also, they will fluctuate with activity. One would also think that asset-management services, pricing, and disclosure will standardize as the new model becomes the norm.

Certainly, there are clear benefits that come from removing commissions from mutual funds. The most obvious is eliminating the conflict of interest that occurs when investments pay different commissions. As with any business, financial advisory firms seek the twin goals of customer satisfaction and company profitability. Choosing between high- and low-commission funds can place the firm in the uncomfortable position of choosing one goal over the other. Advisors, naturally, do not enjoy being placed in such a position and are grateful for the escape that the fee-based system brings. Investors should also appreciate that gain.

The new trend simplifies fund shopping, too. Financial advisors, direct investors, and institutions will all be able to own the industry's entire range of funds, without being restricted to those funds that are built with the appropriate commission structures. This process is already under way with the expansion of fund share classes and the practice of waiving front-end loads for certain buyers, but it would be greatly enhanced by the removal of 12b-1 fees. 

Thus, I do not decry the removal of commissions from mutual funds. The benefits are apparent. But changes need to occur to the advisory-fee system before long-term fund investors will be better served than they are now. 

* The actual figures will vary depending upon the behavior of the market, but they won't change the basic relationship.
** As mentioned in an early June column, advisory fees vary, but 1% is a fair median estimate. 

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.

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