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New Share Classes Pave the Way for Fiduciary Regulation

A new white paper says that fund changes already underway in response to the Labor Department’s fiduciary regulation may well be good for advisors, as well as investors.

According to “Early Evidence on the Department of Labor Conflict of Interest Rule” by Aron Szapiro, Director of Policy Research at Morningstar, and Paul Ellenbogen, Head of Global Regulatory Solutions at the firm, investment management companies are creating two new share classes for their mutual funds in response to the Labor Department’s fiduciary regulation: “T” (or transactional) shares that allow advisors who still sell funds on commission to comply with those new rules, and “clean” shares designed for “level fee” advisors.

Morningstar anticipates that mutual fund companies will create more than 3,500 new T shares in the coming months for advisors to sell to IRA investors, and thinks that this share class could eventually supplant A shares in brokerage accounts as well.

‘T’ Models

The Morningstar analysis notes that quantifying the increased returns investors can expect because of the shift to T shares from A shares is “challenging,” but concludes that it may be around the 44.9-basis-point increase (per 100 basis points of load) the Department of Labor estimated as the benefit from reducing conflicted advice in its regulatory impact analysis. Moreover, at least as a ballpark estimate, the authors say they think that the incentives T shares create to recommend higher-quality funds could add around 50 basis points in returns (30 of which are attributable to manager skill in the form of alpha and 20 of which come from reduced fees).

Further, they opine that a best-interest incentive could save investors about 20 basis points in fees (the typical difference between the median A share fund prospectus net expense ratio and the first quartile breakpoint).

The authors also note that some investors will save money because T shares have lower front-end sales loads than A shares, at least based on early filings that suggest that most T shares will have a 2.5% maximum front-end load, rather than the A shares average of a maximum front-end load of 4.85% among the more than 3,000 A shares with loads tracked by Morningstar database (and that is somewhat “left-skewed” by a few very low load funds).

Pruning ‘Shears’

The paper notes that the so-called conflict of interest rule has also accelerated efforts by advisory and wealth management firms to prune their product shelves, or lineups of funds that their representatives are authorized to sell. Moreover, since the A share loads for fixed income funds are typically lower (Morningstar says about 1.72 percentage points) than for equity funds, the authors suggest that this pruning might serve to better align incentives for advisors that might be at odds with appropriate asset-allocation recommendations.

Additionally, the broadened application of “clean” share classes, which some families have already launched, would strip away indirect payments, not only making it easier for firms that wish to qualify as level fee fiduciaries, but also noting that firms that wish to continue to sell on commission could set these fees themselves and “levelize” their compensation, similar to T shares.

Clean Sheen

While the advent of clean share classes won’t eliminate investor fees for these services, Morningstar says it would allow financial institutions that distribute funds to clearly list how much investors pay for each service, which the paper says could have the effect of producing greater competition: “In other words, clean shares could result in an unbundling in which asset managers manage assets and charge for this service. Instead of passing fees back to intermediaries, these intermediaries would directly charge for the services they offer. In this environment, investors will have much greater insight into what they are paying for and the advice they are getting for their fees.”

The paper concludes that “using a clean share model, advisors can align the level of advice they provide to their fee, and clients can choose how they would prefer to pay for advice: a flat dollar amount, a commission, or a level fee on assets under management.”