Rethinking Mutual Fund Pricing, Entirely

The One True Road? The past two columns have delved into the details of mutual fund pricing. Fascinating material, for those who like to view George Seurat paintings from 18 inches away.

This article, mercifully, stands further back. It considers an entirely different approach. Today, mutual funds price their share classes according to the needs of their distributors. If financial advisors want an annual 1% payout, create C shares with a 1.00% 12b-1 fee to meet their wishes. The new Department of Labor guidelines won’t permit the existing A shares? Invent T shares, priced to meet the distributors’ new requirement.

What if that scheme were to change? What if there were but a single share class for mutual funds, around which distributors add their prices? After all, that is what already occurs with stocks, bonds, and exchange-traded funds. Nobody creates one version of those securities to sell on Schwab’s No Transaction Fee platform, a second version to use with midsize 401(k) plans, and a third version for institutional use. The cost to purchase a bond is determined by the company that sells you that bond, not the issuer.

One mutual fund, one price. The fund would carry no upfront or exit fees, nor ongoing sales charges in the form of 12b-1 fees, nor embedded payments to transfer agents or record keepers. Its only costs would be for its ongoing management and operations, as reflected in its ongoing expense ratio. No multiple share classes, no asterisks. And those expense ratios would be at most equal to those of today's institutional share classes and in some cases even less than that.

Then, the entity that sells the fund may charge what it wishes for its service, billed separately. That invoice might come as an annual fee or as a one-time commission. The form matters not. The critical thing is that mutual funds, as with stocks, bonds, and ETFs, would no longer collect revenues on behalf of other parties.

That sounds suspiciously simple. Surely, somebody must have thought of this idea before.

Legal Matters Indeed they did. However, until now those who had such a vision have been blocked by an obscure passage, Section 22(d), in the Investment Company Act of 1940, which governs mutual fund sales. There is some debate about the intent of Section 22(d)'s authors but until now no question about its outcome: Fund pricing is to be established by the funds themselves, not by the firms that distribute them.

That is about to change. On Jan. 6 of this year, American Funds sent a so-called “no-action letter” to the SEC, titled “Request for interpretative guidance regarding Section 22(d) of the Investment Act of 1940.”

American Funds’ argument rests on the distinction between investment brokers and investment dealers. The two functions are often conflated, thus the term “broker/dealer.” However, they are quite different. Investment brokers do not own the securities that they offer to their clients. Brokers are matchmakers; they arrange a meeting between buyers and sellers. Dealers, on the other hand, hold inventory. They are retailers who buy supplies at one price and sell them at another.

American Funds petitioned that the SEC clarify that, with respect to a new, stripped-down share class that the company intends to launch, Section 22(d)'s restrictions apply to dealers but not to brokers. In this motion, American Funds had good reason to expect success. Previous no-action requests from different fund companies had already led the SEC to drive a wedge between broker and dealer activities. It would seem logical to extend those same principles to American Funds' proposed "clean shares." (That name carries the strong whiff of marketing, but it will do for now.)

That the SEC did, in a response dated five days later. (Something tells me that this letter did not catch the commission completely unprepared.) Wrote the SEC--

"You [American Funds] conclude, therefore, that subject to the preceding representations, a broker, acting as agent for its customer, may charge a commission for effecting transactions in Clean Shares without violating section 22(d). You point out that under your proposal, a fund’s shares will be sold at net asset value, a secondary market in fund shares will not develop, and investors will benefit from being able to choose the brokerage compensation model that suits their needs. You also believe that your proposal will provide investors with greater clarity into the services and costs offered by different brokers and will subject fund commissions to the same competitive pressures placed on equity and ETF commissions.

"In our view, under the circumstances described above, the restrictions of section 22(d) of the 1940 Act do not apply to a broker, when the broker acts as agent on behalf of its customers and charges its customers commissions for effecting transactions in Clean Shares. We also believe that section 22(d) does not prohibit a principal underwriter of Clean Shares from entering into a selling agreement with a broker under these circumstances."

In other words, a resounding yes. The commission not only accepted American Funds’ legal request but also agreed with the economics. While some broker/dealer conditions concerned the Investment Company Act’s authors when they crafted their legislation during the Great Depression, they no longer seem to apply. Nobody today acts as a fund dealer. All intermediaries are brokers. As such, they face the same market pressures, in the form of price and service competition, that have driven down stock and ETF commissions. The same will hold true for mutual fund clean shares.

Unbundled

This means that, in addition to serving financial advisors, clean shares will be a viable and attractive option for direct investors. Consider, for example,

Now, whether the brokers will price mutual fund shares as they price ETFs and stocks remains to be seen. But, from the fund companies’ perspective, that is the beauty of this new scheme: Commissions are out of their hands. They can concentrate on what they are paid to do: manage money. And if investors don’t like what they must pay to get into a mutual fund, they can pester the brokerages who control the entry gates.

Investment managers, manage; investment brokers, broker. Imagine that.

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.