Selling mutual funds is a complicated business. Every day, financial advisers can choose from about 8,000 publicly available mutual funds in a variety of share classes to select ones that best match investors’ needs. To make their selections, advisers can then use up to 22 sources and characteristics, ranging from fund rankings and tax efficiency to fund risk and manager tenure to make their selections.
But what if these objective criteria were compromised by a fund company which made cash payments to advisers who sold their funds? How common is this and how does it change the relationship between an adviser and their client?
These are serious questions which affect thousands of shareholders. But these questions involve a practice called revenue sharing that is largely unknown to investors.
And while it is a common industry practice, revenue sharing and related expenses such as 12b-1 fees are difficult to understand — and commonly not explained by investment advisers. In many cases, these mutual fund fees can compromise fiduciary relationships between advisers and clients and drag down an investor’s net return.
In addition to these fees not being well-understood by the public, they have been controversial in the industry for years and been the subject of numerous lawsuits.
For example, in 2007 the brokerage firm of Edward Jones settled a charge filed against them in 2004 by the SEC. In the 2007 settlement, Jones agreed to pay a $37.5 million fine, and also return $37.5 million in “ill gotten gains and interest” after the SEC said Jones failed to disclose revenue sharing agreements it entered into with seven mutual funds. Instead of disclosing these fee arrangements, Jones told customers that the funds were chosen because of their exceptional performance and investment objectives.
Mutual Fund Revenue Sharing Defined
Revenue sharing, as defined by the SEC, occurs when the investment adviser to a fund makes payments to a broker/dealer. In some cases, the investment adviser may describe those payments as reimbursing the broker/dealer for expenses it incurs in selling the shares. Those payments, regardless of whether they are labeled as reimbursements, give the broker/dealer or adviser a greater incentive to sell the shares of one fund versus another which does not offer to pay revenue sharing.
Revenue sharing can take many forms, including the use of 12b-1 fees. Revenue sharing fees are based as a percentage of the money invested or as a stated dollar amount. These fees can be paid out for as long as an investor owns the fund. As a result, revenue sharing provides an incentive for a financial adviser to promote some funds relative to others, regardless of performance or investor suitability.
Conflicts of Interest from Mutual Fund Revenue Sharing
While revenue sharing and 12b-1 fees have a business role in the sale of mutual funds, many professionals say they teeter on the borderline of ethical disclosure.
In a client-broker relationship, “the act of withholding information from a client even if it is not intentional, still raises the flag of why it is not being disclosed in the first place, “according to Julie Anne Ragatz, a fellow at the American College Center for Ethics in Financial Services in Bryn Mawr, Pennsylvania. When compensation is involved, the burden of proof is on the person (in this case, the adviser) who is not disclosing their relationship with a mutual fund company which is providing monetary compensation, she added.
Ms. Ragatz said the issue of fees is part of the larger issue of conflicts of interest which exist within the financial services industry. Yet while these conflicts are common, Ms. Ragatz said they do not have to be “vicious,” or manifest themselves in ways which are self-serving and ethically wrong.
Compensation arrangements between advisers and their clients raise three key issues:
- The complexity of most forms of compensation between an adviser, their broker/dealer, and a fund distribution company;
- The lack of transparency which exists to discover these compensation arrangements;
- The difficulty of explaining compensation arrangements to clients in an understandable way.
Pending SEC Proposals
Debates about mutual fund fees have being going on for decades, but as part of the recent financial reform legislation, the SEC is finally acting on some key issues.
First, the SEC is slated to announce a new plan which would cap 12b-1 fees at 0.25% of assets. This fee is the amount funds can charge on a continuing basis to cover marketing and administration costs. In 2009, shareholders paid over $9.5 billion in 12(b)-1 fees to financial representatives and fund companies.
Second, SEC Chairwoman Mary Schapiro has stressed that broker-dealers and investment advisers should adhere to the same fiduciary standards which exist in the institutional world, especially with respect to services provided to retail investors. If this standard is enacted, it means advisers would have to fully disclose their revenue sharing and other fee arrangements with their clients.
