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DOL Fiduciary Rule
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DOL Rule Doesn’t Necessarily Make Traditional Share Classes Obsolete

The introduction of T shares and clean shares is well intentioned, but in many cases, older share classes already offered by fund managers can save investors more money, and mitigate conflicts of interest.

By Alma Piscitello

To help financial advisors and brokers comply with the Department of Labor’s fiduciary rule, some investment managers are offering two new share classes for their mutual funds. However, while the new T shares and “clean shares” are designed to lower fees for investors and eliminate the incentive for advisors to recommend one fund over another, the alphabet soup of share classes in today’s market isn’t likely to lose many of its existing letters, as some have predicted.  

In general, one of the more expensive share classes is A. When investors purchase A shares through a broker or advisor, they usually have to pay an up-front fee (known as a “front-end load”) to the financial institution selling the fund, as a percentage of the purchase price. Advisors can keep a portion of the front-end load as their commission, which creates a potential conflict of interest that the fiduciary rule is, commendably, attempting to eliminate. A shares also saddle investors with 12b-1 fees, which cover management, distribution and marketing expenses.

To enable advisors and brokers to continue to sell their funds without changing their commission-based business model, some investment managers are filing and/or offering T (transactional) shares, which charge a universal commission for all funds and also come with lower front-end loads and 12b-1 fees. Morningstar expects more than 3,500 T shares to be created in the coming months, and believes that this share class will eventually overtake A shares to dominate the assets in brokerage accounts.

The goal behind creating T shares is a good one, but A shares won’t go away. Filings for new share classes are expensive, especially for smaller investment managers. Broker/dealers, custodians and other intermediaries that provide access to funds on their platforms and play a significant role in fulfilling those funds’ distribution strategies, understand the expense and disruption, and they often refuse entry to funds that have higher fees, and equal or lower performance, compared with other funds in their categories. Intermediaries aren’t likely to recommend that the thousands of fund managers on their platforms offer T shares if they already offer A shares or other existing share classes that are reasonably priced.

Acceptable front-end loads and 12b-1 fees for T shares have not yet been finalized by the industry, but press reports have speculated that most T shares will have front-end loads near 2.5 percent, and 12b-1 fees of around 0.25 percent. Among the more than 3,000 A shares with loads that are tracked by Morningstar, the average maximum front-end load is 4.85 percent, and the most common maximum front-end load is 5.75 percent. While these fees are higher than the loads that T shares will likely offer, A share expenses can vary. If a fund already offers A shares with a front-end load of 3 percent (or a little higher or lower), and 12b-1 fees around 0.25 percent, and its expenses and performance are in line with its peers, would it really be worth the expense for the manager to file and offer T shares?

Furthermore, no intermediary would recommend that a manager whose fund already offers the least expensive share class, I (institutional), file to offer T shares in order to obtain or maintain a presence on its platform. Since institutional shares don’t charge 12b-1 fees, and offer front-end loads that are either very low or waived altogether, they are less expensive than T shares, and already mitigate the conflicts of interest that T shares were designed to eliminate.

Clean Shares Are No Match for Institutional Shares, but Can Help Put C Shares Out to Pasture.

In order to accommodate advisors who charge an AUM-based fee for advice and don’t receive sales commissions, some fund managers are launching clean shares. Advisors that sell this share class can only charge fees to investors for investment management, not for distribution. Fund managers have historically paid much of the 12b-1 fees they charge investors, which cover distribution, to the financial institutions that sell their funds, so clean shares are designed to eliminate these conflicts of interest by requiring fund distributors to directly charge investors for any expenses.

Here again, if funds already offer institutional shares, which are the least expensive share class in part because they have no 12b-1 fees, and an intermediary offers access to those institutional shares for fee-based accounts through its platform, why would the fund’s manager need to issue clean shares?

T shares and clean shares aren’t likely to shrink the alphabet soup of share classes, but by helping to lower fees for investors across the board, they may replace the most expensive share class, C. Although C shares have no front-end load, their 12b-1 fees are often close to the 1 percent maximum, which makes their overall expense ratio the highest among all share classes. T shares, by universally lowering front-end loads and 12b-1 fees, and clean shares, by only charging a fee for investment management, may lead fund managers to retire the C share class.

The introduction of T shares and clean shares is well intentioned, much like the fiduciary rule that spurred their creation. But in many cases, older share classes already offered by fund managers can save investors more money, and mitigate conflicts of interest.  

Alma Piscitello is executive vice president of The Gemini Companies and Northern Lights Distributors.

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