At the beginning of 2017 , in response to the U.S. Department of Labor’s fiduciary rule, mutual funds began to consider offering a new share class that would have commissions that the broker could charge directly to the customer. On Jan. 11, the Securities and Exchange Commission opined that mutual funds can offer “clean shares” under an arcane part of the 1940 Investment Company Act, known as Section 22(d).
This was just the beginning of a discussion that the industry—asset managers, broker/dealers, financial advisors, and others—are now having about how to define clean shares. And regulators are asking themselves what these clean shares supposed to accomplish.
Which fees should be charged on clean shares?
Industry and regulators generally agree that clean shares will not have front-end loads or 12b-1 fees, which are those used to pay for a mutual fund’s distribution costs. So investors will pay an externalized fee for advice—that is, the broker or advisor charges it directly to a client. But there is disagreement about whether clean shares should include sub-transfer agency fees, or sub-TA fees, and other kinds of revenue sharing. A big part of the definition depends on what we expect clean shares to do and how much protection we think they give investors from conflicted advice on their own.
As we’ve told the regulators, there is promise and peril in embracing clean shares.
How clean shares could potentially improve investors’ experiences
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. 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, clean shares could dramatically improve investors' experiences and their outcomes. With clean shares, investors will know exactly what they are getting for the fees to help them evaluate whether 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.
Why it’s crucial to define “clean”
But there is also peril: If regulators assume that clean shares with sub-TA fees and other kinds of revenue sharing are the same as the cleanest shares without them, they will be endorsing products that can have embedded conflicts of interest. These kinds of third-party payments obscure business relationships that can push a firm to sell one mutual fund over another. These back-door payments will elevate the conflicts of interest from the advisor level to the firm level and add opacity to the way mutual funds are bought and sold.
Our advice to regulators: Proceed with caution and scrutiny
There may be good reasons to use arrangements with revenue sharing or sub-TA fees. For instance, some have argued that sub-TA fees can reduce the costs for accounting. We know that someone has to pay for the services the transfer agency provides. However, we believe that a clean-share structure that adds these payments from the mutual fund to a distributor—as opposed to a third party that has no relationship to the sellers of the fund—requires additional scrutiny to ensure investors are getting best-interest advice. Regulators should not assume that such arrangements eliminate conflicts of interest.
We’ve told the Labor Department to proceed cautiously in using clean shares as a new exempted class for the fiduciary rule, and we have told the SEC that the definition in Section 22(d) may not protect investors from other potential conflicts.
Opaque fees and conflicts of interest can hurt investors’ progress toward their goals, which is why Morningstar has created guidelines for the cleanest share classes.