Mutual funds that levy sales charges and distribution fees are on pace to suffer their fifth and possibly largest-ever year of redemptions, victims of the ongoing battle over the fiduciary standard and the move toward fee-based accounts.
The “A” share-class grouping — the largest among retail mutual funds — is largely made up of funds that assess an upfront sales charge that mostly gets paid back to the broker and their firm, as well as an ongoing fee used in part for the same purpose.
Outflows totaled $122 billion over the first 10 months of the year, Morningstar Inc. estimates. If that figure holds, it could be the worst year ever for that share class, topping the nearly $88 billion in redemptions during 2011. Morningstar started tracking the data in 1993.
Those flows compare with lower-cost institutional-class funds, which increasingly are available to retail advisers and brought in $230 billion in deposits, and no-load funds, which do not assess a sales charge and took in about $12 billion this year.
At the same time, those firms are also selling more products such as exchange-traded funds, in which distribution fees are uncommon and managers don't segment their audience using share classes.
The increasing shift to using cheaper mutual funds offers fresh evidence of the securities industry's response to the threat of extending the so-called “fiduciary” standard governing financial advice to brokers, according to Amy Lynch, president of FrontLine Compliance.
Ms. Lynch said advisory fees are often viewed as more transparent than sales charges and that the standards governing brokers are already beginning to require more disclosure.
“Even if the fiduciary rule never happens — at this point it might never — the threat of it has already been priced into the market and to the firms in terms of how they structure their products,” said Ms. Lynch.
The push toward cheaper share classes took on new momentum this year.
Pershing added 435 new institutional or lower-cost “advisory” class funds to its FundVest platform this year. The Jersey City, N.J.-based firm, a division of the Bank of New York Mellon Corp., provides brokerage services to 811 broker-dealers and 562 mostly high-end registered investment advisory firms.
“The trend toward advisory programs within our broker-dealers has spurred the desire for lower expense ratio share classes to use within their advisory program,” Sandy Bolton, managing director of financial solutions at Pershing, said. “It's because of the increasing demand for transparency of the fees.”
The heavier use of share classes that don't include sales charges can be a boon for broker-dealers, particularly those that do business in the regulated retirement-savings industry.
For instance, the practice of rebating 12b-1 fees to retirement plans clients is a less transparent process than simply using a fund that doesn't charge those fees in the first place, according to Ms. Bolton.
Decades ago, the use of no-load funds and direct sales to retail customers was thought of as a possible threat to the livelihood of financial advisers. But in the intervening years, advisers and brokers have become even more central to the sales strategy of mutual fund companies. Advisory firms and broker-dealers account for about half the $15 trillion in U.S. mutual fund assets, according to Cerulli Associates.
So even though the urgency of the transitions increased this year, broker-dealers have long been moving in the direction of offering more institutional share classes in more fee-based accounts, “converting” assets in funds that assess a load or include annual distribution and marketing fees, which are known by the name of the Securities and Exchange Commission rule that authorized the fees, 12b-1.
Savings on institutional share classes can be substantial. Last year, investors in those share classes paid 50 basis points in fund-management fees. Investors with money in back-end load or level-load like “B” or “C” share classes paid 109 basis points, according to Lipper. (One hundred basis points is equal to 1%.)
“To move to a lower-cost share class for any manager you're already using to the end investor is just intelligent,” said Michael S. Falk, partner at Focus Consulting Group. “The only forward promise of performance anybody can make an investor is that, given the exact same results, one with lower fees is going to put more money in the portfolio.”
The transition is not cost-free, with broker-dealers giving up millions in revenues rebated by fund companies.
UBS AG's U.S. wealth management unit this summer converted clients from class A and C mutual fund shares into institutional and advisory share classes as it competes with its wirehouse rivals and other firms that already widely offered the products. Around the same time, UBS suggested advisers raise annual fees as the firm faced a lost revenue stream that could top $100 million.
Ms. Lynch, the compliance consultant, said she was confident broker-dealers can adapt to the new environment.
“There's always ways to make money in this industry, and they will figure it out,” she said.