Lower-Cost T Shares Coming to a Fund Near You

Baby Boom Another 3,800 mutual fund share classes are about to be born.

Morningstar expects that each mutual fund that now has an A share will soon have a companion T share. Dozens of fund companies have already applied to launch the new share class, and those companies that offer A shares but have not yet done so, surely will. (Fidelity and Janus currently offer funds that are labeled as T shares. They are different than the new breed, and will be renamed.)

The innovation owes to the Department of Labor's April 2016 Conflict of Interest Rule, which extended the fiduciary standard for company-sponsored investment plans to other forms of retirement advice, for example IRA rollovers. Although no court of law has officially ruled on the matter, those who operate and sell mutual funds believe that the existing breed of A shares fails the new standard. Thus, T shares step into the breach.

Level Playing Field T shares differ in structure from A shares in two ways.

One, T shares have the same sales charges across all fund categories, while A shares do not. For example, stock-fund A shares usually carry higher loads than do short-term bond funds. That makes sense; it’s logical to shave the entry fee for lower-risk, lower-return investments. After all, there are no front-end loads on money market funds. Nonetheless, that approach leads to temptation: Sell the fund that pays the higher commission. With T shares, that enticement is eliminated.

The costs for A shares also vary by fund company. Within categories, some funds charge more than others. What’s more--a detail that’s invisible to fund shareholders--the amount that fund companies pay to distributors varies. Two fund companies might each levy 4.5% front-end load charges on their stock funds, but send different amounts to advisory firms. One fund company might give just what it collects from the loads, while the other supplements with payments called “dealer reallowances,” or “rebates,” or “underwriting fees.” Less-generous terms would be “bribes” or “kickbacks.”

Those discrepancies will be eliminated with T shares. All T shares will be priced identically: 2.5% upfront (declining for larger purchases) and an ongoing 0.25% 12b-1 fee. Dealer reallowances will be banned.

Upwards and Onwards The creation of T shares represents continued progress for mutual fund sales practices. The industry has already come a long way. Historically, most fund sales came through full-service Wall Street brokerage firms that steered their advisors toward in-house products, demanded payments from fund companies for their services, and conducted sales contests that rewarded brokers who moved the most merchandise with family trips to the tropics. Over time, much of that behavior has been curtailed. Using T shares will restrict it even further.

Of course, besides structure, T shares also differ from A shares in that most important element: price. For most funds, the initial sales charge will be halved. That dramatically changes the advisory math. Roughly speaking (the exact amount depends on the fund’s performance, but the approximation suffices), T shares that are held for four years will cost the investor 3.5 percentage points of sales charges: the upfront 2.5 points, plus another point for the four years’ worth of 12b-1 expenses. The same fund held for the same time period in an institutional share class, through a financial advisor levying a 1% asset-based charge, would generate 4 percentage points in advisory fees.

The calculation becomes more favorable yet as the time horizon grows. Over a decade, the T shares would cost about 5 percentage points, while the asset-based fee would be double that. Or, to put the matter another way, for investors with a 10-year horizon, the customary advisory fee of 1% per year would need to be halved, to 0.50%, for the asset-based advice to match the price of transaction advice.

Caveats There is a catch. The mutual fund industry has settled on 2.50%/0.25% as its suggested price for transaction purchases. However, not all brokerage firms that distribute mutual funds are fully on board with that price. Some of them would prefer a higher amount. There is nothing to prevent them from doing that--as long as every fund in their platform has the same fee structure, so as to avoid the possible conflict. Thus, it's possible that prices might vary from distributor to distributor. However, at least some firms will offer the T shares--which, presumably, will pressure other firms into following suit.

T shares will not immediately revolutionize the financial-advisory industry. Cost and fiduciary duties are not the only differences between transaction-based and asset-based advice. Also, old habits die hard. That transaction-sold funds are becoming more competitively priced won’t change the views of most financial advisors who have adopted the asset-based model, convinced that it’s better for their clients. Nor, I suspect, will it sway those do-it-yourselfers who email me about the evils of load funds.

Eventually, however, T shares will squeeze the cost of financial advice. Fund investors have already become parsimonious. Funds that are purchased today are far cheaper than those that were bought as recently as a decade ago. The same mindset does not yet apply to the cost of financial advice. It will. Consider the launch of T shares as a warning shot across the advisory industry’s bow.

The Dustbin of History? As for A shares, it seems they must die. A shares may continue to be used for situations that fall outside the Department of Labor's jurisdiction, for example taxable accounts or tax-sheltered college savings plans. However, it's hard to imagine how they can survive the competition of T shares, which will be available to all retail accounts. Which investors will pay 4.75% when the identical fund is available for 2.5%? Cro-Magnon Man, your time appears to be just about up.

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.

Click here for more from Morningstar on the Department of Labor fiduciary standard.