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By Russel Kinnel | 01-19-2017 10:00 AM

How Mutual Funds Are Cleaning Up Their Pricing Act

With 'clean shares,' mutual funds are removing some distribution fees. But is it too little, too late?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. So-called clean shares attempt to put mutual funds on an equal footing with exchange-traded funds from the standpoint of pricing. Joining me to discuss this topic is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Happy to be here.

Benz: Let's talk about these clean shares. They've been a hot topic in our little corner of the world. But let's start by talking about how mutual funds have historically been distributed and some of the fees that have been attached to them in the interest of distribution.

Kinnel: Yeah, you really have standardized pricing so that an investor pretty much pays the same amount no matter where they are going for. If you think about a load fund starts with a front load, and there is a set scale for different levels of investment where the load will come down. But it's the same no matter where you go. And then the underlying expense ratio in an A share, it's the same for everyone. But now, potentially, that could be changing.

Benz: OK. So, funds have 12b-1 fees attached to them. Some of the time investors may pay these commissions that you just talked about. These clean shares attempt to strip out some of those costs. Let's talk about that. Why would that be desirable? Why are firms, why are fund firms, deciding that, oh, we need to reduce or eliminate some of these costs for investors?

Kinnel: Well, if you think about, in some ways, it's kind of archaic to have the fund company responsible for collecting commissions and servicing costs, because if you buy a stock or an ETF from a broker, the ETF or the stock is not paying the broker. Apple isn't paying Merrill Lynch or whoever you are buying your shares through. But funds have done that. So, this is much--a way of opening things up where you're essentially just paying the management fee to the fund company and then the broker is putting whatever additional fees, commissions, or servicing fees on top of that. So, you, kind of, have greater transparency and you are kind of getting the fund company out of the business of collecting money for the broker.

Benz: So, is the fiduciary rule in the mix at all? Is that part of the impetus for these clean shares?

Kinnel: Very much. The fiduciary rule says you've got to act in the investor's best interests. This is a way of saying that--completely separating it so that the advisor is picking whichever fund or investment in general is best for the investor and there's zero incentive to pick from this stock, this ETF, that fund over another, whereas today there are different incentives that may lead a broker to favor one fund over another.

Benz: OK. American Funds has been one of the first movers in this area of clean shares. I'm surprised they have so many share classes already attached to all of their funds. But they didn't have anything like this before. So, let's talk about how the clean shares will work and look for American Funds.

Kinnel: That's right. So, just about every other American Fund share class sold has some kind of 12b-1 to compensate the broker for some of that servicing. This does not--it looks pretty similarly priced to their R6 shares, which are kind of big institutional retirement accounts where maybe those fees are outside of the individual fund. So, now, with these clean shares you're really just getting the management fees and any other related fees from the fund company and then the broker, it would be up to them to decide what additional fees they are going to charge.

Benz: One question I'd like you to cover is, if someone owns no-load mutual funds, have they been getting clean shares all along? Can we talk about that issue?

Kinnel: Yeah. So, the answer is, yes, if that no-load is named Vanguard, because Vanguard is providing those fees at cost. But if it's someone else, if it's a fund through a no transaction fee network, then the answer is no, because the NTF programs charge typically 30, 35 basis points to funds that want to go through them and they don't allow those firms to sell those funds for anything less. So, just as you have to set loads kind of putting a limit on how low fees can get, in the no-load world it's those NTF programs setting limits. So, if a firm is selling through those NTFs, they will either have a 12b-1 or they will just have it embedded in the fees because they've got to pay 30 basis points or whatever to the Schwab, or Fidelity, whoever you're buying through. So, those are not really clean shares because you have some significant servicing costs baked into those fees.

Benz: We've seen traditional mutual fund firms lose significant market share to ETF providers, in part, I think, because of some of this complexity of the pricing of mutual fund shares. I guess the question is, with these clean shares and their introduction, is it too little, too late for some of these fund shops? Did they already get too complicated with their pricing, and investors and advisors are simply opting for products that they feel have more transparency?

Kinnel: Well, yeah, I think, to a degree this probably will, may slow the move out of open-end active funds to ETFs. But I don't know it necessarily stops that, because as you say, a lot of advisors have transformed to models emphasizing ETFs, and I don't see them changing back. But it certainly ups the game of the active industry to say, here are much more comparably priced funds with lower fees, so it's a really good competitive response. It's really early to say how well it will work, but I do think it puts them on a much closer footing, especially because a lot of ETFs that are not from Vanguard, they have their own profit margins built in.

So, if you look at some of these, what American charges for R6 and these clean shares, they are not too far off from some of the ETFs out there. And their performance is quite strong too. So, really, it's a much closer game now. If you have, say, an active fund that's not performing well, they are still behind the eight ball, and I don't think this is going to bail out the poor-performing active funds. So, there are still some challenges out there, but I think it's definitely a win for investors and probably a win for active management as well because you're really separating out the two things and enabling greater competition on price.

Benz: OK. Russ, rapidly evolving area. Thank you so much for being here to discuss your thoughts.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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