Fund industry limits C-share investing, cutting 12b-1 fee income for advisers

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Growing pressure on fees and disclosures drives fund industry limits on C-share investing.

The great share-class migration that has been building this year is starting to unfold, representing a significant pay cut for advisers relying on beefy 12b-1 fees for predictable income streams.

Over the next few months, several fund companies plan to start converting C-class share mutual funds that have been held between seven and 10 years into A-class shares that pay advisers smaller 12b-1 fees.

“I don’t know what the main catalyst is for these conversions, but I think there are multiple reasons,” said Niels Holch, executive director of the Coalition for Mutual Fund Investors. “I’m not surprised that C shares are becoming somewhat antiquated — there has been criticism for a number of years about how C shares work and collect a fee in perpetuity.”

For advisers, the difference between collecting a 1% 12b-1 fee on a C share and a 25 basis point fee on the same fund converted to an A share translates to real money.

For example, an adviser with $5 million in client assets invested in C-share funds would be collecting $50,000 a year in 12b-1 fees, compared to $12,500 from an A-share version.

Most of the fund companies scheduling conversions are mum on the moves beyond regulatory filings and announcements to brokerage firms. But the conversions are scheduled to start happening across the fund industry at such firms as BlackRock, Fidelity Investments, Franklin Templeton, Morgan Stanley and Putnam Investments.

Some industry watchers are tracing the share-class migration to a February Securities and Exchange Commission initiative that announced it would waive fines against advisers who came forward and confessed to having put clients in high-fee mutual fund classes and agreed to reimburse those clients.

“The liability is being exposed and people are starting to realize they were sold the wrong share class,” said James Langston, president of Fiduciary Integrity.

The current share-class migration relates specifically to C shares that have higher 12b-1 fees but not upfront loads, and load-waived A-share versions of the same mutual fund.

In most cases, the break-even point when it makes more sense to pay the upfront load of up to 5.5% on an A share versus paying the higher 12b-1 fee of a C share is about seven years.

At American Funds, for example, most C-share funds convert automatically into A shares after 10 years.

But other fund companies are now moving to introduce conversion policies to both help advisers toe the line with regulators and keep those assets from leaving the fund complex.

A Fidelity spokesperson confirmed that the fund industry is responding to requests from broker-dealers to address the “regulatory environment and reduce operational risk.”

Fidelity’s C-share conversions will take effect March 1, 2019, converting any C shares that have been held for more than 10 years into an A share. The conversions do not require shareholder approval.

“For fund companies, it might be that they see liability coming around the corner, but I’m going to say the broker is ultimately liable,” Mr. Langston said. “You have the obligation to disclose to the investor upfront what the break points would be and when it would make more sense to be in an A-share instead of a C-share fund. And now they are somewhat acknowledging it by converting them.”

Depending on the initial fund investment, Mr. Langston said a 10-year hold period could be almost double the length of time it would take to break even when comparing the C-share fees to A-share fees, which can reduce front-end loads for larger investments.

“If you wait till year 10 to convert, you’re exposing yourself to liability because for a lot of folks it should be year five,” he said.

Tim Holsworth, president of AHP Financial Services, said he is seeing lots of share-class conversions, which he believes could ultimately hurt smaller investors.

“The conversions will impact us, but not yet because we have been aggressively converting accounts to fee-based,” he said. “If you assume investors need no advice or help, then lower fees are good. But that assumption is wrong for the majority of investors. And what adviser wants the liability, hassle and cost of a $10,000 account for $25 in annual revenue, less the broker-dealer’s cut?”

While the current conversions are only designed to limit how long an investor can be parked in a particular C-share class fund, the road ahead could get even rockier.

“There’s a lot of pressure on advisers these days to be upfront about high-fund fees and disclosing compensation arrangements,” said Karen Wallace, senior editor at Morningstar.com. “C shares are going away because they are a bad deal for investors. B shares were a similarly bad deal and they are pretty much, if not completely, extinct.”