More Managers Introduce ‘Clean’ and ‘Transactional’ Shares

According to a new Morningstar report, the Obama-era Department of Labor (DOL) conflict of interest reforms, while facing an uncertain future, have already promoted real change among advice and investment product providers working under the Employee Retirement Income Security Act (ERISA).

In particular, Morningstar has measured a strong increase in the offering of two relatively new mutual fund share classes, known as “transactional” shares and “clean” shares. As the firm explains, the first share class, commonly referred to as “T shares,” aims to help financial advisers maintain their traditional business model—selling mutual funds on commission—while complying with the letter and spirit of the new conflict of interest rules.

They key development around T shares is that they feature uniform commissions, Morningstar explains, “thereby reducing or eliminating financial advisers’ conflicts of interest in making recommendations to clients.”

As Morningstar explains, the second share class, “clean” shares, “help financial services companies that wish to shift to a ‘level fee’ model in which advisers’ compensation only comes from a level charge on a clients’ assets and not from any varying third-party payments.”

Clearly the developing use of these two share classes will be influenced by the future of the fiduciary/conflict of interest rules, yet client demand for fairness and transparency is also driving the trend. Morningstar observes the rulemaking was originally scheduled to be applicable on April 10, 2017, but the DOL has taken steps to delay it until June 9, 2017. For now the rule is otherwise intact.

Already Morningstar has measured a real reduction in promotion of “A shares,” which have been a traditional and widely used package for adviser-mediated access to mutual funds in retirement plans. Such shares generally “front a sales load that investors pay directly to the financial institution selling the mutual funds, some of which the advisers keep as commission, and these loads vary.” Morningstar warns this variation can create, at the very least, the appearance of an incentive for advisers to recommend a fund with a higher load, “as the adviser stands to make more money from such a recommendation.”

NEXT: Envisioning the impact for flat-fee RIAs 

Morningstar goes on to predict directly that mutual fund companies will create more than 3,500 new T share-based products in the coming months, many tailored specifically for advisers to sell to individual retirement account (IRA) and defined contribution (DC) plan investors, “and ultimately this share class may supplant A shares in brokerage accounts as well.”

The research acknowledges that many financial services companies do not sell mutual funds on commission: “Rather, they charge a fee for advice as a percentage of assets under management and generally act as fiduciaries.”

The firm anticipates more advisories to move in this direction: “They can choose to comply with the rule by acting as level fee fiduciaries, which in turn has spurred the development of clean shares. Qualifying as a level fee fiduciary could reduce financial institutions’ legal risks but means that fees and compensation may not vary based on the investments advisers recommend. As many mutual funds pay a variety of fees to the financial institutions that sell their funds—and as these fees vary—the conflict of Interest rule makes them difficult for financial advisers to offer while qualifying as level fee fiduciaries.”

Morningstar concludes that, conceptually, “clean share classes would simply charge clients for managing their money (and other associated expenses) without indirect payments—fees charged to investors by the fund company that they in turn send to an affiliate or third party for services other than managing a portfolio of stocks or bonds.”

This would in effect “strip all these indirect payments away, leaving it to distributors to charge investors directly for any services rendered, such as holding their shares, paying out dividends, operating a web site and call center, and so forth.”

The full analysis can be downloaded here.