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Rekenthaler Report

How Fund Pricing Has--and Hasn't--Improved

Unbundling fees is a clear improvement, but a couple of problems remain.

Let's Start With "A" (Shares)
Once upon a time, those who invested in U.S. funds through a financial advisor paid entrance fees, in the form of front-end sales charges. There were no-load mutual funds, but advisors wouldn't recommend them, because how would they then be paid? Exchange-traded funds did not exist. The only available funds were those that collected at the door.

This system had its benefits. For one, most such funds had low ongoing expenses. The initial payment could be steep, running up to 8.5% of assets, but long-term buyers-- those who thought in terms of decades rather than years--usually fared well. For another, the sales load declined with the size of the investment. Pony up $1 million, and funds would waive their up-front charges altogether.

It also had a drawback, in that advisors were only compensated for trades. That frequently placed their investment counsel and professional desires at odds. Clients were best served by holding what they had already bought, but advisors required action, to generate new revenue. This conflict of interest created distrust, as prospective fund investors were quite aware of the business' math.

In Transition
Circa 1980, the fund industry responded in two ways.

One was to reduce the sales charge, replacing the lost revenue (from the advisor's perspective) with a 0.25% annual fee, termed "12b-1." The advisor would receive those monies as long as the investor held the fund. With this service fee, the concept went, advisors would not be tempted to churn their customers' accounts. They no longer needed to advocate trades to get paid.

That's partially true: 25 basis points wasn't enough to sustain an advisor's practice, but it did ease the inclination to trade. Also, investors liked the new structure. Most preferred paying less initially, then somewhat more on an ongoing basis. As a result, the new version of the A share quickly supplanted the old.

The other response took the first to its logical limit. Don't just trim the door charge; eliminate it entirely. With the creation of the "B" share class, advisor-sold funds became entirely free--on the first day of purchase. After that, not so much. The typical B share added a percentage point of 12b-1 fees to the expense ratio, so that a fund that previously carried 0.75% in annual expenses became 1.75%. In addition, B shares included an exit charge for shareholders who held the fund for less than five years. One way or another, B shares would get their 5% (or more).

Downgrading
This was the worst solution yet, although it took U.S. investors 25 years to figure that out. Early on, they embraced B shares, such that a certain Internet columnist predicted that A shares might become extinct. That guy should have had more faith in the marketplace. Gradually, as they had previously done with A shares, fund investors began to recognize the new structure's flaw. B shares moved advisors from sitting with their clients to sitting instead with fund companies.

That shift was inevitable. With A shares, advisors had no reason to side with mutual fund expenses. They were compensated by one-time, relatively direct commissions paid by investors, rather than by ongoing, indirect receipts from funds. What's more, those commissions didn't vary according to a fund's costs. Thus, advisors shared the same view on fund expenses as did their customers: All things being equal, the lower the better.

B shares, on the other hand, spurred advisors to downplay the effect of fund expenses, because with B shares, advisors effectively became stakeholders in the funds they sold. Consider the above example, of the B share fund with 1.75% annual expenses (a typical amount). In such a case, the sponsoring fund company would collect 0.75% per year from shareholders, while the financial advisor's firm would receive 1.00%. The advisory firm receives more from the fund than did the fund company itself!

The good news was that B shares removed the incentive for financial advisors to churn portfolios. The bad news was that they forced advisors to defend the undefendable. The research could not be refuted: One dollar taken by a mutual fund is a dollar taken from shareholders. Thus, selling B shares meant denying the truth. That was no prescription for creating customer trust, nor for inculcating professional pride.

The New Model
The marketplace reacted by unbundling. For midsized to larger clients--less so for small investors--the standard became for advisors to charge their customers directly, as a percentage of assets under management. (Generally, something close to the annual 1% that accrued from B shares.) They invested their customers into the cheapest possible funds. Currently, that means mostly institutional share classes and ETFs.

Today's approach is a clear improvement on the era of B shares. Financial advisors have been delinked from expenses. However, a couple of problems remain.

The first is that the temptation to churn continues to exist, but now for different reasons. True, fee-based advisors are not paid to trade. If they instruct their clients to hold indefinitely, without a single portfolio change, they are fully compensated for their counsel. However, advocating nothing is difficult to do in practice, because of the danger that clients will bolt. Why pay fees for nothing?

Thus, fee-based advisors are subtly encouraged to trade more than is necessary. (A few years back, the head of a large brokerage firm informed me that the turnover rate for its fee-based advisors' portfolios was twice that of its traditional advisors'.) The solution is straightforward: Advisors must redefine their businesses to deliver the broad service of wealth creation (and preservation), not the narrower task of portfolio construction. The customer must receive value, regardless of whether trades occur.

The second caveat is that the process of unbundling is incomplete, such that many funds--even institutional shares and ETFs--continue to make payments to brokerage firms for distributing their funds. It is correct to a first level of approximation to state that under the fee-based structure, advisor compensation and fund expenses are separated. But it is not fully correct.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.