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Morningstar Sees Potential, and Peril, in Clean Shares

The mutual fund research shop expects the vast majority of asset managers will offer a so-called "clean" share class of funds in the next five years.

Some asset managers have introduced new "clean" share classes to help advisors comply with the Department of Labor’s fiduciary rule, specifically, the warranty requirements that are part of the best interest contract exemption. Morningstar analysts believe clean shares will play a starring role in the new regulatory environment, but some challenges remain, including their definition and implementation.

“We think there’s a ton of potential in clean shares and perhaps some peril as well, particularly given different ideas about what the definition might be and different use cases from the regulators’ perspective of what they want to see clean shares solve,” said Aron Szapiro, director of policy research at Morningstar.

“From the Morningstar perspective, we think this train has left the station,” said Scott Burns, head of product solutions. “A lot of work to get done to make it happen, but the momentum behind it does seem very real and very good.”

The term “clean shares” is not one that Morningstar came up with, and its provenance is not a moral judgment, but considered more along the lines of having a clean balance sheet. Morningstar uses the strictest definition of clean shares, where payments for advice go direct from the investor to the provider of advice. These may go as a commission, a fee or other ways, but they must be direct to the investor to be constituted as “clean.”

Fees for distribution (broadly defined) and loads and commissions are excluded from the expense ratio, as are transfer agent (TA) and sub-transfer agent (sub-TA) fees, transaction and other operational fees, revenue-sharing, platform or other access fees and fees for advice or planning.

Level share classes, according to Morningstar, include those TA and sub-TA fees in the expense ratio.  

Overall, asset managers are hungry for clean shares, and Morningstar analysts estimate that 90-plus percent of managers will have clean shares in the next five years.

“They’re excited about the prospect of offloading the burden of accounting and all the alphabet soup of share classes and turning that back over to the people who are receiving the compensation for advice,” Burns said.

“Clean shares can also level the playing field between ETFs and no-load funds and traditional active funds,” he added. “Traditional active is carrying the burden for the cost of advice and distribution, whereas ETFs and no-load funds are free of that.”

“‘Clean shares’ exist already in the form of ETFs and some of the no-load shops,” he said. “I think the asset management community sees clean shares as the future of how mutual funds are distributed and evaluated and put out there in the marketplace.”

“Broker/dealers, however, are cautiously wading into the surf to make sure there are no operational issues or unintended consequences,“ said Jeff Schwantz, head of client solutions at Morningstar. The implementation requires a new accounting infrastructure, something many of the clearing firms are helping with.

“There’s so much infrastructure that can be leveraged and deployed by the clearing firms in a very scalable way,” he said.

“If you’re concerned about this and you don’t understand how it’s all going to work in the future, the custodians and clearing platforms have made a lot of advances in this,” Burns said.

As clean shares become more popular, it will likely be at the expense of A Shares, which has seen a decline in the number of assets going into them. Paul Ellenbogen, head of global regulatory solutions, said Morningstar doesn’t see much of a future for the share class.

“The basic problem remains: An A share is a vehicle built for one purpose—a transactional brokerage platform with a kind of expense imbalance,” he said. “About 60 percent of the expenses are not for asset management; 40 percent are. The distinction between those two—management and non-management expenses—is rather blurry.”

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