What the U.S. Fund Industry Can Learn From the World

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Overseas as well as in the U.S., investors are benefiting from a trend toward better regulation and lower fees. Joining me to share some research from a recent Morningstar study on this topic is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Happy to be here.

Benz: Russ, let's discuss this Global Mutual Fund Investor Experience study. We've been putting it out since 2009. What's the goal of looking at various countries and taking a look at how they stack up in terms of how fund shareholders are treated?

Kinnel: Well, the experience in different countries really varies tremendously. And so the idea is to highlight those differences, partly for regulators' benefit, fund companies' benefit, individual investors' benefit as well, just to show there are some really big differences and illustrate what are the best practices, what are worst practices. We've seen over the years there have been responses from regulators and fund companies to this study.

Benz: You feel that you are enacting positive change in some cases?

Kinnel: I think so.

Benz: Let's take a look at the metrics that go into determining how each country rates. Let's talk about some of the key things that you and the team focus on.

Kinnel: We look at things like regulation and taxation; fees; sales practices; and disclosure, which really varies tremendously from market to market.

Benz: The U.S. came out on top in the 2017 release of this study. Let's talk about some of the factors that went into influencing the positive score there.

Kinnel: Yeah. So, part of it is simply economies of scale. It's a huge market and so, you get more people together, and naturally, there's some economies of scale.

Benz: The fees come down?

Kinnel: The U.S. has very low fees. The '40 Act, which regulates a lot of the fund industry, has some really strong aspects that have led to some good disclosure rules as well as low fees. So, for instance, the U.S., the average investor in equity fund pays 67 basis points; in Canada, it's 2.23%; in much of Europe, it's in the high 1s. A lot of U.S. investors may not know how good they have it on the fee front. But there's tremendous competition, and part of that is disclosure, part of that is asset size, part of that is that there are ways that fund companies can compete with each other. We have fee wars because there aren't sales channels limiting investors to one or two fund companies. They are out there competing in the marketplace and generally investors win from that.

Benz: Speaking of fees, are the data encompassing mutual fund fees as well as ETF fees?

Kinnel: Yeah, but for sure, the regulations are different, both in terms of how you calculate the fees and also what exactly--the investment vehicles obviously are not exactly mutual funds in every market. It's not a perfect comparison, but you still get the direction right by comparing these fees.

Benz: In terms of best practices, maybe areas where the U.S. could improve, let's talk about that. Are there any things that are going on in other countries' fund markets that the U.S. should consider, that U.S. regulators and U.S. fund companies should consider?

Kinnel: One that's moving across Europe now is called MiFID. Part of that is saying that soft dollars have to be disclosed more clearly, there are more strict limits on what you can pay with soft dollars.

To back up, soft dollars are essentially an added commission that a fund company pays when it wants research back. Maybe they are paying $0.01 a share on execution for a trade they put through a broker. But if they want some research to come back, maybe they pay $0.02 or $0.03 a share and of course, that adds up to hundreds of millions of dollars when you sum that up. It's a cost that essentially means in the U.S. and most places that's hidden from the expense ratio.

If you are paying for research via commissions, you are not going to see that in the expense ratio. So, two funds with similar research costs, one might appear to have lower fees because it's moving those costs into soft dollars. Europe is now saying you have to disclose that. You have to either pay for that explicitly out of the fund company purses or you have to pay for that out of shareholder money, but you have to be explicit about that. There are new rules about how you do that. The U.S., meanwhile, is still pretty murky about both in terms of disclosure of what is being bought with soft dollars, how much is being paid, and it's also not in the expense ratio. So, that's one area where the U.S. really is behind.

Benz: There's kind of a bell curve distribution going on with countries' ratings. Let's discuss the weak end of the scale, where it looks like a lot of the big western European markets don't look so good from the standpoint of the Global Fund Investor Experience. Why is that?

Kinnel: Where they really fall down is fees and sales. The fee part being obviously just have higher expenses, but sales in some European markets, you have very restricted sales channels. For instance, in some markets banks control the sales channels. They may have a limited offering of fund companies. If most clients are going in through that, they really don't have much choice. They kind of have nothing but high-cost funds to choose from and that stifles price competition, that stifles comparisons in general. It's really not a very healthy way to invest. It's very different from the U.S. where whether you invest through a Vanguard or a Schwab or you go to a full-service broker, you have a lot of funds to choose from. That's really another different area.

Benz: Another component of the study is looking at taxation of mutual funds from country to country. Let's talk about this and focus specifically on the U.S. The U.S. doesn't stack up quite as well on this metric as some of the other countries. Let's talk about why that is.

Kinnel: The tax laws in the U.S. are kind of arcane and have not been changed for mutual funds for a very long time. If you look at this bar chart of taxes, what you see is, the U.S. is about in the middle in terms of total tax dollar, but you see that a larger chunk of that is ongoing taxes as opposed to taxes when you actually sell the investment. People who invest in funds for long time know this because you get this annual statement--capital gains distributions and ordinary income, and the capital gains part is what's particularly unusual for the U.S. and that is, the fund as it realizes gains distributes those to the investor regardless of whether or not the fund investor actually made a profit. Whereas if you bought a stock in the U.S., you wouldn't have to pay taxes until you sold that stock. You pay taxes on any dividends, but you wouldn't pay capital gains until you sell the stock.

It would make a lot of sense to me to just do that with mutual funds, too, but instead we have this arcane rule that says, you get this capital gains payout every year and you have to pay taxes along the way that may or may not sync up with the profits you've made. A lot of the rest of the world doesn't do that, and that's a much more sensible approach.

Benz: And I know that Morningstar as a firm has been advocating for some tax reform for mutual funds for many years.

Kinnel: Yeah. It's just something that doesn't seem to resonate with Congress even though there's so many mutual fund investors out there who really hate this, and of course, it's a source of friction for both investors and fund companies to go through all of this. It's a real added cost. It's a real nuisance.

Benz: OK, Russ. Interesting research. Thank you so much for being with us to discuss it.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.