Mutual fund conflicts pose issues for brokers under Reg BI

Revenue sharing is an opaque practice that may require additional attention from broker-dealers as the SEC rule takes effect, Morningstar warns

Nov 19, 2019 @ 4:51 pm

By Greg Iacurci

Conflicts of interest in mutual funds have grown more opaque and could trip up brokers and broker-dealers when they try to comply with the Securities and Exchange Commission's new investment-advice regulation that takes effect next year.

Conflicts of interest in mutual funds arise from certain payments that fund companies make to financial advisers and their firms for selling their investments. These fees can influence the investment recommendations brokers make to clients.

While there have always been conflicted fee arrangements in mutual funds, they've historically been fairly transparent — the costs associated with commissions and 12b-1 fees (a specific fee paid for fund distribution) are explicitly labeled as part of the fund's overall cost.

However, mutual-fund share classes that use revenue sharing, which is less transparent, have become more popular, according to a report published Tuesday by Morningstar Inc.

Through revenue sharing, fund companies pay a portion of their profits back to broker-dealers based on certain ill-defined metrics. Though the cost of the revenue sharing is not directly borne by investors, there is an indirect cost since fund managers could likely lower their fund fees absent revenue-sharing payments.

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The practice poses a challenge for brokers recommending such mutual funds because they could accidentally run afoul of Regulation Best Interest, which will take effect June 30. The regulation requires broker-dealers to reduce conflicts and disclose to clients the kinds of conflicts revenue sharing can create when they make investment recommendations.

"[Reg BI] is going to require some examination of these practices," Aron Szapiro, director of policy research at Morningstar, said of mutual fund share classes using revenue sharing.

Funds with 12b-1 fees and sales commissions are less popular, as measured by asset flows and new product launches, he said. "We're sort of left with opaque revenue-sharing arrangements as some of the main conflicts of interest intermediaries need to look at."

One notable challenge for broker-dealers in assessing these conflicts of interest is that the "materiality of the conflict can be difficult to assess," according to the Morningstar report, entitled "Regulation Best Interest Meets Opaque Practices." While fund companies disclose the conflicts, the disclosures are often couched in vague terms without any specific costs attached.

Morningstar laid out a spectrum of conflicted types of revenue-sharing payments, ranging from payments with fewer baked-in conflicts (such as those related to educational support) to those with more conflicts (such as when fund firms pay broker-dealers a fee for placement on "recommended" or "preferred" fund lists, pay B-Ds for access to detailed data on sales of their products, or pay platform setup and maintenance fees.)

"The range of revenue-sharing arrangements is extensive and fills a continuum from those that clearly create conflicts of interest to those that do not," according to the Morningstar report. "The challenge in assessing where in the continuum a given arrangement falls is twofold: Both the structure (the degree to which it is tied to sales) and the magnitude of the payment must be considered."


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