Regulators and the industry may finally have come around to recognize the difference between fees that matter and fees that shouldn’t matter. The word de jour is “clean,” as in “clean shares.” You’ve probably read one too many articles.
It looks like regulators and the industry may finally have come around to recognize the difference between fees that matter and fees that shouldn’t matter (see, respectively: “401k Fees That Matter,” FiduciaryNews.com, April 27, 2010; and, “401k Fees That Should Matter,” FiduciaryNews.com, May 3, 2010). The word de jour is “clean,” as in “clean shares.” By now you’ve probably read one too many articles on the subject of this blossoming concept speculating on the future of retirement plan mutual fund investments. This article reveals the one thing those other articles have left out.
“Clean” shares refer to mutual funds with all the sales-related fees stripped out of them. “Unlike other share classes sold through broker/dealers, clean shares are shares that don’t have conflicts-of-interests such as charge sales loads, 12b-1 fees, transfer agency fees, or other investor expenses that generate commissions for brokers and other intermediaries,” says Dan Sondhelm, CEO of Sondhelm Partners in Alexandria, Virginia. “Brokers instead can charge commissions or service fees for buying and selling shares. Since these costs are clearly stated on investors’ account statements, clean shares will give investors a far more transparent view of their actual investment expenses.”
The SEC currently requires some of these conflict-of-interest fees be disclosed on page two or the mutual fund prospectus as either wholly separate fees (i.e., front and back-end loads) or as a separate line item on the expense ratio (i.e., 12b-1 fees). The SEC does not currently require disclosure on other conflict-of-interest fees (i.e., revenue-sharing) and these fees are hidden within the fund’s expense ratio.
All fees removed to make funds eligible to be called “clean” shares deal with marketing and distribution payouts, not with normal operating expenses (which are reflected by the fund’s expense ratio). Andrew Van Fossen of Allevid Advising in Summerfield, North Carolina, says, “Clean shares are mutual funds that don’t have loads or other major fees in buying or selling. The only fee is the typical ‘management fee’ (a small percentage of the mutual funds total assets under management) that all funds use to keep the lights on.”
Studies have shown that embedded conflict-of-interest fees can have a detrimental impact on mutual fund performance (see “Yet Another Independent Study Highlights High Conflict-of-Interest Cost to Retirement Investors,” FiduciaryNews.com, February 26, 2017). Researchers have tried to explain this divergence in return data. They believe funds that payout conflict-of-interest fees have built business models based on success through selling, while those fund that do not rely on conflict-of-interest fees have built business models based on success through superior investment performance.
That most funds contain one sort of conflict-of-interest fee or another suggests the success through selling business model has been widely adopted by the mutual fund industry. “Most mutual funds were built to pay the brokers to send their clients to them,” says Van Fossen. “As such, they had those loads which primarily went to paying broker’s commissions.”
This long-term trend among mutual funds to incorporate conflict-of-interest fees into their business models may have finally hit a brick wall with the DOL’s Conflict-of-Interest (a.k.a. “Fiduciary”) Rule. “Mutual funds have been available for many decades,” says Sondhelm. “The industry was built on compensating financial advisors for advice. These fees were built in to mutual funds. Some firms have become more shareholder friendly over the years. Now, the DOL laws are the catalyst for more firms to participate. Of course, this process will take time. Developing share classes and/or changes to existing share classes, strategic thinking for boutique firms to determine if they want to remain in the fund industry, among other considerations, will take time.”
Indeed, some feel it is the very existence of the DOL’s Fiduciary Rule that has given rise to the push towards “clean” shares. “The concept of ‘clean’ shares came about so that brokers can comply with the new upcoming DOL Fiduciary Rule,” says Scott Salaske, CEO of Firstmetric in Troy, Michigan. “Many mutual funds are likely in no hurry to add the ‘clean’ share class unless their funds are heavily used in 401k products.”
By removing conflict-of-interest fees, fund investors receive an immediate benefit from “clean” shares. “Clean shares will give investors a far more transparent view of their actual investment expenses,” says Sondhelm.
In shifting away from broker-oriented transaction fees, the industry itself may shift towards new business models. “Clean funds are going to push brokers to become advisers,” says Van Fossen. “Instead of being paid on transactions, they will be paid either hourly (less likely) or on a percentage of their client’s assets (more likely).”
With fees no longer hidden, it will be easier to monitor fees and competitive pressure will likely eliminate excessive fees. “The biggest advantages of ‘clean’ shares are simplicity and lower costs for investors/retirement plan participants and transparency for retirement plan sponsors,” says Vitaly Novokreshchinov, Owner of Lestna Capital Group LLC in Chicago, Illinois. “Lower costs intensify the effect of compounding and have direct correlation with better investment outcomes for investors and plan participants. For plan sponsors, it improves transparency by enabling clearer disclosure, being aware of who pays what, and makes it easier to prove prudence of including such funds in the investment menu for plan participants.”
Still, there is no guarantee “clean” shares will result in lower net fees. Salaske says, “Many journalists have written about new ‘T’ shares and ‘clean’ shares over the course of 2017 with varying descriptions that all come back to the concept that clean shares are supposed to eliminate conflicts of interest, offer the lowest cost share class and be more transparent. All investors want 100% transparency when it comes to investing, but with a name like ‘clean’ shares they will likely think what the name implies, everything is clean, but not so fast. Just because something has a new label does not mean that it’s any better for investors. In the end, investors will likely pay the same amount in total investment costs when purchasing ‘clean’ shares, with the only difference being that now the fees are all split out from the fees charged by the mutual fund for investment management and distribution. This will likely help actively managed mutual funds with improved performance because the investment management fee will be lower because it will not include broker distribution fees, but don’t be fooled, those other fees that have been separated out of the total expense ratio of the mutual fund will still be charged, but just presented as new line items by the broker-dealer. It’s just reshuffling the fees and calling them by other names. I’m not sure why the industry is trying to fix something that does not need to be fixed. After all, there are already Class I (institutional) shares, that have low fees, no sales loads and no 12b-1 fees. What exactly is the industry trying to comply with when they already have a solution? Maybe they like the name ‘clean’ because it implies something that it’s not.”
Salaske has a point. For all the talk about “clean” shares and for all the articles written recently on the subject, very little attention has been paid to the fact we already have “clean” share funds available and we have had them available for a long time. It’s not just institutional class shares (which may still have revenue sharing fees). Quite a few funds have no 12b-1 fees, no commission loads, and no revenue sharing. You probably haven’t heard about them because, in rejecting the “success through selling” business model, it turns out they aren’t aggressive when it comes to marketing as their conflict-of-interest competitors.
The challenge is identifying a system for finding these funds. Sondhelm says, “Ask the fund firm specific questions about being ‘clean’ and read the prospectus although current versions may not have all the needed information. Prospectuses will probably have a clean section at some point.”
Because mutual funds are currently not required to disclosure revenue sharing, identifying current funds that qualify as “clean” share funds might prove difficult for the average person. “In order to identify funds that offer ‘clean’ shares, plan sponsors/participants can either do their own research or hire someone to do it for them,” says Novokreshchinov. Doing research on its own could be very time-consuming and requires investment knowledge and expertise. For plan sponsors, a much better way would to be delegate this responsibility. Hiring either a 3(21) Fiduciary Adviser or 3(38) Investment Manager is definitely a preferred for plan sponsors. When it’s plan participants, they can rely on other employees and plan guidance. However, working with a financial adviser is a best way to go.”
The bottom-line, according to Salaske, is that “there is no easy way to tell today that a mutual fund has a ‘clean’ share class. The industry and regulators are still trying to figure it all out.”
It has been this very hurdle that may have enabled the explosion of conflict-of-interest funds in the first place.“Lack of fiduciary and investment knowledge, no time, and even passivity among retirement plan sponsors and investors makes them rarely aware of better and cheaper investment alternatives available,” says Novokreshchinov. “As a result, mutual funds take advantage of this situation and are reluctant to promote ‘clean’ shares and give up more revenue they receive from other types of shares.”
Since we already have funds that can be classified as “clean” shares, why has there been this push of late to get regulators involved? “It helps to have the guidelines of regulators,” says Sondhelm. “Without them, funds will become 60% clean or 80% clean. While that is a step in the right direction, that doesn’t bring the industry far enough towards the goal.”
In addition, recent regulatory actions appear to have been the impetus of the growing interest in “clean” shares. “Since ‘clean’ shares came about for brokers to try and comply with the new upcoming DOL Fiduciary Rule,” says Salaske, “then regulators should step in and help the industry define this concept so at least investors have a fighting chance to be able to compare apples-to-apples and know what they are paying in total investment costs, not just the amount in mutual fund investment management fees.”
We have yet to reach an agreement on the exact definition of “clean” shares. Regulators may be in a better position to help do this. “‘Clean’ shares are in relatively early stage of its development and there is no consensus in the investment community on which other fees, such as sub-TA, they should include,” says Novokreshchinov. “This is where regulators could step in and provide its guidance. Specifically, regulators need to decide whether sub-TA and other revenue sharing fees should be included in ‘clean’ shares or not. Without regulators the industry may end up with another share class which is fair without and foul within.”
In the end, categorizing the cleanliness of funds may represent a business opportunity for someone. Sondhelm believes “research firms like Morningstar will start to cover how ‘clean’ a fund really is. This section will be added to their Morningstar.com or principia pages. Institutional consultants or outsourced CIO’s will be building databases of who qualifies as clean. Firms that put 401k plans together will likely add cleanliness to their criteria for fund selection. Government who is developing the rules may be supervising this over time. Maybe they can keep track to in a user-friendly database. Investment platforms, such as Schwab or UBS, may also be differentiating funds by clean vs not as clean. Financial advisors may be carving out a niche for themselves to promote their additional layer to avoid conflicts of interest. Clean fund firms will be touting their cleanliness in multiple ways, from brochures to videos for their financial advisors. Certainly, the financial news media will be writing about it and keeping track. Finally – select entrepreneurial companies may use this as a catalyst to develop a product focusing on clean mutual funds. As a result, peer pressure – and the publicity around it – will cause even more challenges in attracting investors for those firms who don’t follow along. Some will determine the expense is too much for them to bear and will decide to have their funds adopted or acquired. This will also be a buying opportunity for firms willing to be on the forefront of clean shares.”
Sooner or later, it will be important for 401k plan sponsors to get down and dirty when it comes to understanding the fiduciary liability implications of “clean” shares and their equivalent. Furthermore, since the most successful class action suits have involved different share classes of the same fund, you can be sure the introduction of “clean” shares will catch the eyes of your not-so-friendly neighborhood class action attorney.
Christopher Carosa is a keynote speaker, journalist, and the author of 401(k) Fiduciary Solutions, Hey! What’s My Number? How to Improve the Odds You Will Retire in Comfort and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on Twitter, Facebook, and LinkedIn.
Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.