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The Future of Clean Shares

As new share classes evolve, we untangle their meaning

Aron Szapiro and Janet Yang

 

Clean shares.  

The term has a nice ring to it. After all, who wants to invest in dirty shares? Over the past year or so, we at Morningstar have been working to wrap our arms around this new term, identifying emerging share classes and helping investors understand what these new share classes might mean for them.  

Our first observation: We do not love the name. The term implies that anything called “clean” is the best choice for an investor, and that’s not necessarily the case. Given the different flavors of new share classes, we believe more descriptive names and categories would help mutual fund investors understand the answer to a few key questions: Who are they paying directly and who is being paid indirectly for services? What conflicts of interest might any indirect payments create?  

From ‘clean’ to ‘service-fee arrangement’  

There’s still no common definition of “clean.” There is universal agreement that clean shares will not have loads or 12b-1 fees, which are both fees used to pay for a mutual fund’s distribution costs.  

To help investors and the industry untangle what these new share classes mean, Morningstar is labeling emerging share classes a little differently. Although “clean” may stick in the lexicon, the heart of our idea is to describe the service-fee arrangement and shed light on what an investor pays for whether it’s directly (say, by writing a check to an advisor) or indirectly (via a fund’s expense ratio).

We think that most share classes fit into three broad buckets: unbundled, semibundled, and bundled. 

3 ways to categorize share classes 

  1. Unbundled: An investor simply pays for investment management and fund operating expenses, and the fund and its advisor do not pay third parties who sell their funds to the public. Unbundled share classes reduce conflicts, but investors still need to ask if they are paying a reasonable amount for advice and for the services that their intermediary charges them directly.  

  2. Semibundled: No traditional distribution fees (or 12b-1 fees) or load-sharing but can have revenue sharing or sub-TA fees. Semibundled share classes could create some potential conflicts of interests that investors need to ask about.  

  3. Bundled: Traditional share classes, where the investor pays a load and a 12b-1 to the mutual fund, which in turn pays the intermediary. Bundled share classes are purely transactional, which can work well for sophisticated investors who have done their homework and wish to pay up-front commissions. Advice associated with these share classes may ultimately cost less, particularly with rights of accumulation.  

How advisors and asset managers can use these categories of share classes 

One category isn't inherently better than the other; each of these service arrangements can be appropriate for different kinds of investors. Rather, investors and advisors should use them as starting points to have better informed conversations. For investors, the categories can help them understand where potential conflicts lie. Semibundled share classes, for instance, can have potential conflicts of interests if these arrangements are a deciding factor for a fund to be included on an intermediary's platform. 

For advisors, it can be an opportunity to demonstrate how their particular service model benefits their clients. Bundled share classes, for example, may be in industry decline, but advice associated with these share classes may ultimately cost less for long-term investors.  

Meanwhile, the unbundled category may give active asset managers a clearer way to showcase their skill: Because unbundled share classes are stripped of all the servicing and compensation burdens that come with bundled and semibundled share classes, investors and advisors have a clearer view of a portfolio manager’s value-add. 

Promising innovation  

While the momentum toward clean and unbundled share classes slowed a bit this year, we expect it to rebuild—and we welcome that trend. That said, these promising innovations are not standardized, and one version won’t necessarily be best for all investors. Our system of evaluating and classifying each share class according to its service-fee arrangement will help investors and advisors make best-interest assessments. 

Users of Morningstar DirectSM, Morningstar® Advisor WorkstationSM, and Morningstar Cloud editions can see these new labels for all U.S. funds at the share class level under “Clean Share—Service Fee Arrangement.” 

This blog post is adapted from an article that originally appeared in the June/July 2018 issue of Morningstar magazine. Read the full article or subscribe for free.

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