Why Investors Need Regulators to Promote 'Clean' Mutual Funds

This op-ed originally appeared in The Hill.

In 1940, the first modern mutual funds revolutionized investing by making it easy for people without a large fortune to own a diversified portfolio of stocks and bonds. Their importance has only grown over the last 30 years with the rise of 401(k) retirement plans that largely rely on them.

But as the investing and regulatory landscape has evolved, the process of buying and selling mutual funds must be modernized and rationalized. Due to the U.S. Department of Labor's new fiduciary rule, a new way of selling mutual funds using "clean shares" is emerging, which advisors are embracing to demonstrate they're acting in their clients’ best interests, which is now required.

Clean shares have the potential to benefit investors by removing perverse incentives for financial advisors that sell the funds to enrich themselves rather than their clients, but there is an important caveat. Regulators, particularly the Labor Department, must get the details right around promoting clean shares, because defining these share classes too broadly could undermine their effectiveness at helping investors obtain access to unconflicted advice.

To understand the lack of clarity in the mutual fund market right now, imagine walking into a grocery store to buy cereal. The cereal boxes at eye-level are there because companies have paid for "shelf space." Similarly, most mutual fund companies use some of their fees to pay advisory firms to carry their funds on their "shelf," even if they're not necessarily the best option for investors.

Instead, funds with higher fees are more prominent and easier to access. Compounding the problem, advisors collect varying commissions for different products. Unlike with cereal, there are thousands of mutual funds, and the product is very complex and hard for many people to understand. As a result, advisors often sell funds with the highest commissions or the ones that paid the advisor's firm for prominent placement.

Seeking professional advice is not necessarily a bad instinct for ordinary investors. We have found that high-quality advice can make a significant difference in improving investor outcomes, potentially increasing lifetime income by more than 20%.

However, clean shares could dramatically improve investors' experiences and their outcomes by forcing mutual funds to compete on merit as advisors recommend lower-cost, higher-returning funds rather than funds that are most lucrative for the advisor. Investors will finally know exactly what they are getting for the fees to help them evaluate if they are getting a fair value from their financial advisor. Over the last three decades, we have never seen as big a change in industry practice.

So, what makes a share class clean? We believe clean shares must not have any inducements that would make the choice of that investment security more lucrative to the advisor or advisory firm than another investment security. There are three key things that we would look for to certify a share class as clean for the investors that rely on our analysis.

First, clean shares should have no "loads," or one-time payments to fund companies that are largely kicked back to financial advisors as commissions. Second, clean shares should have no distribution fees, commonly called "12b-1" fees for the regulation that permits them. These fees are charged to investors even after they have become fund owners, and they are used to pay financial services companies to sell the mutual fund. Third, we believe that any other payments to firms selling mutual funds cannot be part of a clean share class. This includes "revenue sharing" fees and "sub-transfer agent" fees, "platform" expenses, and any other third-party fees that could incentivize a firm to sell one mutual fund over another.

Right now, many share classes that look clean are only available to institutional investors, or large retirement plans. We believe that making these funds available to masses would greatly improve investors' experiences and enable them to get the best-interest advice they need instead of a sales pitch from their financial advisors.

We hope the shift toward clean share classes continues, and call on our regulators to pay careful attention in how they define them. If the Labor Department makes further changes to the fiduciary rule to rely on clean shares to promote best-interest advice, as they have said they will, they must get the definition right. If clean shares aren't truly clean, the fight to protect investors from unconflicted advice will continue.

Download Morningstar's infographic "How Clean Is Your Fund?" to see our guidelines for the cleanest share classes.