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Rekenthaler Report

Enough With Revenue Sharing!

Ban it. Ban it all.

Back-Door Payments
This is not the first column I have written about this topic, nor will it be the last. But the argument bears repeating. Across the mutual fund industry (and sometimes with exchange-traded funds as well), revenue sharing is a problem. Quietly, mutual fund companies pay outside parties that help them grow their businesses with shareholder assets. Our money, their benefit. And that needs to stop, entirely.

Revenue sharing occurs within 401(k)s, when fund companies cover a plan’s administration costs. It occurs at full-service brokerages and financial-advisory firms, when funds indirectly buy their way onto recommended lists by spending monies on those companies' advisors. It occurs at discount brokers, when funds underwrite the payments received by no-transaction-fee, or NTF, programs. Whether investing in employee-sponsored plans or IRAs, through financial intermediaries or directly, investors are likely to encounter revenue sharing.

These arrangements inevitably create conflicts of interest. Paying plan administrators, financial-advisory firms, and brokerages increases a fund’s expenses, thereby making that fund less attractive to shareholders. (The fund industry likes to argue that those extra costs are offset by economies of scale, but that claim rarely proves true.) At the same time, the fund’s policy of sharing revenue makes it more appealing to its business partners. Worse for one party, better for the other ... the incentives are misaligned.

Sometimes, the policy of revenue sharing eliminates funds entirely from consideration. An NTF program that charges funds an annual 40 basis points (0.40%) for access won’t feature funds that have expense ratios below that amount, because that the fund company would lose money with each new sale. (When margins are negative, adding volume is not a solution.) Similarly, an administrator that sells "free" 401(k) plans that have no explicit participant fees must select at least some funds that share their revenues. Otherwise, that administrator won’t get paid.

Failed Excuses
The defense for such agreements is that they are openly discussed. Revenue-sharing arrangements are not clandestine kickbacks; they are discussed in public filings. Investors can't complain they didn't know what they were getting.

To start, that is not strictly true. Over the years, the regulatory agencies have frequently modified their statutes, to account for revenue-sharing deals that landed outside their rules. Thus, investors who arrived before those legal changes were indeed unaware of the revenue sharing. More recently, according to the trade publication Ignites, the SEC filed suit against an advisory firm, Commonwealth Financial Network, for failing to inform its clients of a revenue-sharing arrangement. Commonwealth disputes this allegation, but the action suggests that gaps remain.

At any rate, even when the legal requirement is satisfied, the practical effect is negligible. Very few investors--this author included--read every filing from every fund company, brokerage platform, advisory firm, and 401(k) plan that they frequent. Even if they did, they would struggle to decipher the relevant sections. Disclosure language about revenue-sharing arrangements is often so vague that even Morningstar’s researchers, who are paid to understand such material, concede failure.

In short, revenue sharing is an ongoing mess. The organizations that engage in such agreements aren’t keen on providing the details; their compliance departments struggle to keep up with the business units; and the regulatory agencies play Whack-a-Mole, pursuing those unfortunate companies whose practices come to their attention while missing the ones that have their heads safely buried.

The process is not only petty, but anticonsumer. Imagine entering a sporting goods store, asking about tennis rackets, and being sold a brand that rebates some of its proceeds to the retailer. Or being prescribed a drug that is manufactured by a company that recently paid for your doctor to attend a medical conference--in Bermuda. Or visiting a dentist who receives a $200 commission for each patient whom he convinces to undergo gum scaling.

Such practices, self-evidently, are unappealing. Of course, they are not unknown within U.S. consumer industries. Yesterday, Expedia (EXPE) notified me that hotels that placed at the top of my search might be there, in part, because they paid for the privilege. That did not endear me to Expedia's services, but I was not shocked. These things happen. However, I would hope and expect for better from the fund industry, particularly as its payments come directly out of shareholder assets. 

Brand Management
I will not overstate the case. The investment damage caused by revenue-sharing agreements is only moderate. For one, relentless pressure on fund fees has reduced the amount of revenues that funds can share. To cite one example, two decades ago, Kaufmann Fund--now known as Federated Kaufmann --attracted several billion dollars of inflows, despite an annual expense ratio that approached 2%. Such a feat could not occur today. The priciest of the best-selling funds have expense ratios that are only one fourth of that level, and most are lower yet. 

For another, as discussed in this column last month, most mistakes made by financial advisors appear to be accidental, not intentional. If U.S. experience mirrors that of Canada--and in this case, I think it does--advisors invest their clients’ assets in much the same fashion that they invest their own. As the saying goes, they eat their own cooking. 

That doesn't make revenue sharing beneficial, though. Whatever the magnitude of the effect, the direction is clearly negative, as are the side effects. What social gain occurs from plan sponsors and the consultants who serve them scouring documents, to ensure that they understand the underlying financial arrangements, should they later be faced with a lawsuit? What good comes from the SEC investigating tips about improper disclosure? How are investors better served because a fund company paid a platform fee?

None, none, and none. It's time to rewrite the rules, to eliminate revenue sharing between fund companies and their business partners. One short legislative effort today, one ongoing benefit tomorrow. 


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for 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.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.