Even though revenue sharing has not been heavily scrutinized by the SEC, Morningstar contends that the Regulation Best Interest rule may force changes as brokers work to mitigate conflicts of interest.
In its “Regulation Best Interest Meets Opaque Practices” report, Morningstar explains that the SEC has generally regulated conflicts in the mutual fund industry in limited ways, focusing primarily on conflicts arising through payments reflected in mutual fund expense ratios.
The paper observes that in recent years, however, investors have increasingly purchased mutual funds through new share classes, which eliminated as potential conflicts explicit fees for distribution and front-end loads that are shared with brokers. The new classes, however, expose investors to a different kind of conflict involving revenue sharing and the practice of a fund sharing money with B/Ds in an “opaque way” and in a variety of arrangements.
And because brokers now have an obligation under the SEC’s Reg BI to mitigate and disclose the kinds of conflicts that revenue sharing can create, Morningstar expects certain kinds of arrangements to get increased scrutiny as the regulation goes into effect.
Limited Disclosures
Authors Lia Mitchell, Jasmin Sethi and Aron Szapiro of Morningstar’s Policy Research team explain that revenue sharing has the potential to create a “variety of distortions” in the advice investors receive from brokers. This is, in part, because disclosures on revenue sharing are limited and are presented in an open-end format that “stifles efforts to summarize and quantify” the wide variety of potential conflicts of interest they create, they note.
“In contrast to payments from the expense ratio for distribution, the SEC has not focused on revenue-sharing payments from the fund sponsor to the broker – perhaps because these do not factor into the fund expense ratio. However, precisely because these payments are not disclosed in the expense ratio, they are more opaque and more likely to create a conflict of interest for broker/dealers and advisors selling mutual funds,” the authors write.
They go on to explain that these revenue-sharing arrangements must come from the “legitimate profits” of the advisor, but in practice, these profits are derived from the management fees in the expense ratio, among other management fees the advisor charges to its clients.
Moreover, they note that fund advisors often distribute revenue-sharing payments in return for brokers distributing funds in particular ways or in certain volumes. “While revenue sharing is not paid for directly by investors, it may be paid indirectly since a fund could lower its management fee if its advisor did not engage in revenue sharing and accepted a lower fee,” the authors state.
Not All Conflicts
Morningstar emphasizes that not all revenue-sharing payments create conflicts, but limited data impedes assessing which payments do and to what degree. The authors note that it generally depends on the magnitude of the payments and the degree to which they are tied to sales. “The range of revenue-sharing arrangements is extensive and fills a continuum from those that clearly create conflicts of interest to those that do not,” the paper states. The challenge is in assessing where in the continuum a given arrangement falls, the authors note.
To that end, Morningstar built a taxonomy of revenue-sharing payments from the least to most likely to create conflicts of interest beginning with educational expenses, platform fees, data fees and select lists, and ending with payments based on sales, assets or accounts. “Revenue-sharing arrangements that create obvious conflicts of interest that can distort a broker’s recommendations include those in which payment is based on sales, assets, accounts or some combination of the three,” the authors underscore.
Recent Crackdown
Morningstar’s paper further notes that although the SEC has not historically regulated revenue sharing, it has recently begun to crack down on failures to disclose it. In February 2018, the Commission launched the Share Class Selection Disclosure (SCSD) Initiative, which found that advisors were placing their clients in higher-cost mutual fund share classes that charged 12b-1 fees without disclosing to their clients that there was a lower-cost option in the same fund.
The SCSD Initiative resulted in settlements in which 79 investment firms agreed to return $125 million to their clients, a substantial majority going to retail investors.
Going Forward
Morningstar suggests that Reg BI will both “challenge and alter” the industry in its fund-distribution practices. While it will provide “tremendous amounts” of data through the client relationship summary and broker disclosures, the authors contend that these disclosures could be more standardized for ease of analysis. Nevertheless, they note that the disclosures serve as a starting point to provide investors with comparisons of conflicts across the industry.
