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Fund Spy

SEC Calling Attention to Hidden Costs

It already settled with one firm in a recent sweep examining sub-transfer-agency fees, but there may be others.

The SEC has been shining a light on a dark corner of mutual fund expenses--sub-transfer-agency fees. Recently, the SEC sanctioned one firm, First Eagle, for unlawfully accounting for what, in fact, were sales and marketing expenses as sub-transfer-agency fees. If reports are to be believed, the SEC has had other firms in its sights as part of its Distribution-in-Guise Initiative.

While the First Eagle case hasn't garnered a ton of attention, it's important nonetheless. First, this is a case in which a firm was charged with violating regulations meant to ensure that it appropriately pay and account for sales and marketing expenditures, and that violation harmed every shareholder in its funds. (Accordingly, we've lowered our Parent rating of First Eagle funds to Neutral from Positive.) Second, it's symbolic of the lengths to which firms have gone in pushing the limits of rules governing the practice of using fund assets to pay for sales and marketing activities.

Transfer agents handle the fairly mundane work of processing mutual fund transactions, making distributions, calculating cost basis, and more. A fund's transfer agent can be affiliated with the fund company, or it can be a third-party firm. In either case, transfer agents will sometimes elect to outsource at least a portion of the work to a sub-transfer agent. For instance, a fund company that acts as the transfer agent of a fund that it offers might elect to outsource the transfer agency work to a brokerage house if that fund is offered on the brokerage house's platform. In that scenario, the fund pays--from its assets--the brokerage house for its services. This is pretty straightforward and entirely permissible.

Running Afoul
What's piqued the SEC's interest, though, is the nature of the services being rendered under some of the sub-transfer-agency agreements it has examined. To be clear, the issue here isn't necessarily that fund companies overcharged their shareholders. Rather, it's whether they've disguised sales and marketing expenses as sub-transfer-agent fees. Indeed, that's what the SEC found at First Eagle, which had entered into two sub-transfer-agency agreements that included explicit provisions linking sub-transfer-agency fees to sales of First Eagle funds on the brokerage houses' platforms, a no-no.

Punishment and Principles
The SEC imposed a $12.5 million penalty on First Eagle and additionally ordered it to compensate investors for damages amounting to $25 million plus $2 million in interest. Spread out over more than $60 billion in mutual fund assets under management, it's a pretty small amount, but there are some important principles involved:

  • Competition intensifies when it's out in the open. For instance, the incursion of lower-cost vehicles like exchange-traded funds into the U.S. fund industry has exerted downward pressure on prices across the market. But when firms use subterfuges like mislabeling sales and marketing expenses, it short-circuits competition and, ultimately, short-changes investors.
  • While management fees have ticked lower, sales and marketing expenses have been more-or-less impervious to that trend. Why? One could argue that, far from being out in the open, they're largely concealed in fund expense ratios (where they're levied as 12b-1 fees). So is it any wonder they haven't come down? Fund companies often feel they have little choice but to pay to be in key platforms and supermarkets, and those fees have actually risen during the past decade.
  • Even when you set up a system to police the bundling of sales and marketing fees, you have excesses at worst, confusion at a minimum. Indeed, fund accounting is apparently so opaque, or subject to interpretation, that fund firms sometimes have to engage outside consultants and legal counsel to vet their agreements and the way they've classified the associated costs. (First Eagle reportedly did so, to no avail.)
  • The market has voted against the bundling of sales and marketing fees. How? They've moved en masse into products like index funds and ETFs that don't charge these fees. So while the traditional fund industry might have won the battle to avoid having to pay for all of these fees out-of-pocket (as opposed to paying from fund assets, the prevailing method), it looks like it's losing the war.

It's an open secret in the industry that the costs of putting a fund in a retirement plan, brokerage platform, or supermarket are greater than the fees explicitly allotted for distribution. The cost for this distribution is generally covered by 12b-1 fees, which are the only fees that can be used for such purposes from a fund's assets.

Other fees come from a class of fund expenses deemed "administrative" or related to "shareholder service" and may involve transfer agents and sub-transfer agents and other parties unfamiliar to most individual investors.

One suspicion is that, somewhere in the gap between what a shareholder pays a fund company for transfer-agency fees, and what the fund company in turn pays to a sub-transfer agent that provides most, if not all, of the actual service to a shareholder, can be found what the SEC calls "distribution in [dis]guise." While the First Eagle case doesn't resolve that issue, it does point toward what is likely to be greater enforcement by the SEC around such arrangements. 

First Eagle the Steward
First Eagle has a history of good stewardship, but that has eroded a bit in recent years. The firm acquired Jean-Marie Eveillard's operation from Societe Generale in the late 1990s. Eveillard had a remarkable record of serving shareholders well even when others were cranking up risk levels to win customers in the dot-com bubble era. Eveillard held fast, and clients were rewarded when the bubble burst.

However, more recently the funds were allowed to become huge as  First Eagle Global (SGENX) was kept open even as assets grew to $50 billion. ( First Eagle Overseas (SGOVX) was closed in 2014 at $14 billion, but its holdings significantly overlap with First Eagle Global's.) When two former First Eagle managers launched IVA funds in 2008, they later made a point of closing at $15 billion in total firm assets under management. Even as assets at First Eagle have ballooned, expenses are only 9 basis points cheaper than when the fund was much smaller a decade ago. Fees aren't bad, but they certainly could have come down more. There are no breakpoints in the funds' management fees.

That gets back to our earlier point that First Eagle, like many in the fund industry, could deliver greater value for fundholders by pushing harder on fees. Fees and closing funds are two spots where fund company interests and fundholder interests can diverge.

We've lowered our Parent rating to Neutral from Positive, though there are still positives as well. This is how Morningstar senior analyst Greg Carlson described our view:

We have downgraded First Eagle's Parent rating to Neutral. On Sept. 21, 2015, the SEC said the firm would pay nearly $40 million to settle charges that First Eagle improperly used fund assets to pay for distribution and marketing. A secondary consideration: The majority of the firm is set to be acquired by two private equity firms, which means the family that founded First Eagle will be a minority shareholder for the first time. This could put the firm's corporate culture at risk.

The firm has its merits. It offers a limited number of mutual funds, all of which share a distinctive value orientation. Four of the funds--Global, Overseas, U.S. Value (FEVAX), and Gold (SGGDX)--are run by its global-value team. First Eagle High Yield (FEHAX) is run by a fixed-income group that First Eagle absorbed in 2011, and the family's newest offering, First Eagle Global Income Builder (FEBAX), is run by both the global-value team and the fixed-income team.  First Eagle Fund of America (FEFAX) is run by a subadvisor.

The firm has moved past upheaval before, especially after a 2007 change on the global-value team. The team has been relatively stable since then, though veteran manager Abhay Deshpande departed in 2014 and there has been some analyst turnover. One other negative: First Eagle Global has been allowed to grow to more than $45 billion, impeding its ability to take sizable stakes in smaller-cap stocks (typical here under former longtime skipper Jean-Marie Eveillard).

Looking Forward
We'll be following closely to see if the SEC finds other problems in its sweep. We'll be interested in whether shareholders or boards were deceived in the process. About 10 years ago, it emerged that Smith Barney was offered a big discount on transfer-agent costs but decided to keep the savings for themselves: They created their own transfer agent that then contracted out all the work and marked up the fee in order to make millions more for Smith Barney. In that case, directors and shareholders were clearly deceived, and the ensuing fines, totaling more than $200 million, were large enough to worry the industry for more than a decade. 

The SEC doesn't show anything like that in the First Eagle case, and that's encouraging. But there's no telling what the SEC will reveal in any subsequent enforcement actions. And as that list of offending firms grows longer, the drumbeat for breaking with the status quo will get louder still.  

Russel Kinnel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.