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Rekenthaler Report

Why Mutual Fund Regulations Matter

A look at Morningstar’s white paper on conflicts of interest.

Temptations Abound
Yesterday, Morningstar's Policy Research Team published one of this company's knottiest papers. (There is no naughtiest paper.) By necessity, the three authors--Jasmin Sethi, Jake Spiegel, and Aron Szapiro--conducted some fancy econometrics. "Conflicts of Interest in Mutual Fund Sales" therefore is not an easy read. It does, however, tell an important lesson.

When an investor buys a fund from a broker, the sponsoring fund company reimburses that broker's employer. (Typically, the home office receives some of the proceeds, with the rest going to the broker.) These reimbursements are invisible to mutual fund investors, who see only a fund's unofficial sales charges, not its underlying business arrangements. As it turns out, those vary. Different funds have different payout amounts.

Therein lies the "Conflicts of Interest" in the title. If two mutual funds carry the same load charge and pursue similar investment objectives, but one reimburses brokerage firms more than the does the other, might brokers be tempted to sell the fund that pays them the most? And might that fund not be the best choice for the investor?

The Initial Analysis
These questions were asked in a 2013 article, "What Do Consumers' Fund Flows Maximize? Evidence from Their Brokers' Incentives," by three professors (Susan Christoffersen, Richard Evans, and David Musto). They were answered in the affirmative. Yes, funds that made higher payments to distributors had higher sales than one would have expected, all things being equal. And yes, their performance was subpar. The authors found that for each extra 1% of sales charges paid to brokerage firms--that is, the amount of reimbursement that was above the industry norm--a fund's future returns declined by an annual 0.34%.   

For me, the sales boost is more of a problem than the subsequent underperformance. Study another time period, and that return gap may disappear. Just as it is difficult to select funds that will outgain the averages, so too are there no guarantees that a group of funds will trail the norm. What is uncontestable, though, is that brokers preferred the funds that paid them more cash. 

That can't be justified. It is acceptable for brokers to be paid indirectly through sales charges collected by funds rather than directly by billing their clients. Such arrangements limit the investment universe to load funds, but within that very large pool of funds, the broker can be impartial. The broker's decision can be made solely in a customer's best interest. It is quite another thing for load funds to bid against each other, with more business coming to funds that have the largest payouts. That smacks of bribery.

The Current View
Such is the backdrop for Morningstar's paper, which updates the professors' article. The professors stopped at 2009. (That the article wasn't published until 2013 illustrates the editorial hurdles that face academics.) Morningstar reviewed that same time period, using different but related measurement techniques, then extended the research to 2017. The results are instructive.  

To start, Morningstar's authors confirmed the professors' conclusions. Through 2009, higher payouts to brokerage firms led to stronger fund sales, and then those funds had somewhat worse performance. That Morningstar's observations matched those of the professors was not surprising, considering the initial article's rigor (it was published by the top finance periodical, Journal of Finance), but is nonetheless reassuring.

The pattern did not hold fully in 2010-17, though. Sales for the higher-compensating funds continued to exceed expectations. However, the total returns on those funds no longer trailed the industry averages. Admittedly, the data set was small. But the results that could be tested showed no performance shortfall.   

That outcome could be interpreted as indicating that brokers upped their game by recommending funds that enriched them (not every advisor, of course, or even most-- but enough to make the effect statistically significant) while not harming investors. That assertion is possible, or at least it cannot be disproved. More likely, though, is my earlier explanation: Relative performance is unstable. Even if broker behavior remains constant, the numbers will fluctuate.

What remained intact was the incentives' influence on sales--until 2015, that is. Through 2014, funds that paid greater incentives continued to enjoy greater-than-expected sales. From 2015 onward, however, that relationship ceased. Higher reimbursement rates no longer abetted fund sales.

To be sure, this evidence is preliminary. For the extended time period of 2010 through 2017, there are only five years in the "before" era (2010-14) and three years in the "after" era (2015-17). These results do not reflect the experiences of several decades. Nevertheless, those findings are statistically significant at the 5% level. It appears that, as of 2015, something changed.

The Law's Effect
Something did change. In 2015, the Department of Labor released its suggestion for a new fiduciary rule, which, for the retirement-related transactions covered by the DOL, required that all funds offer identical incentives. The proposal mandated that brokers operate solely in the best interest of their clients, meaning that by law, they could not be affected by differing incentives. The payout game was about to end.

Famously, the DOL's proposal was enacted and then not: The Trump administration delayed the rule and then declined to appeal a decision from the 5th Circuit Court of Appeals that vacated the rule. The reversal had little influence on industry trends, however. From 2015 until late 2016, the fiduciary rule looked to be a sure thing, and even for a while after that, it was unclear whether it would be repealed. Thus, brokerage firms and their employees had to act as if governed by the fiduciary rule.

And so they did. They changed their ways. The upcoming (so it seemed at the time) regulation prodded brokerage firms to adopt new habits, which improved their customers' experiences. No longer might investors seeking advice from brokers be placed into a fund, in part, because of its hidden payment schedule. The trade might not end up being successful, there being no guarantees in the marketplace, but at least its intentions would be pure.

The upshot, as demonstrated by the Policy Research Team's paper: Fund regulations do affect behavior. Ideally, the marketplace will devise its own solution, thereby making those regulations unnecessary. A thinner playbook is preferable. In the case of unequal mutual fund sales incentives, though, the industry shirked its duties, thereby leaving the issue to be resolved by the regulators. The regulators appear to have accomplished it, despite the regulation's repeal. It remains to be seen whether the industry will backslide or whether the SEC will finalize a rule strong enough to maintain this momentum, something it proposed in the spring.


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for 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.