Brokers-dealers move to trim fund offerings as they adjust to DOL rule

The Department of Labor’s fiduciary rule has led broker-dealers to take stock of the mutual funds they distribute, and the outlook isn’t rosy for small investment providers.

Many broker-dealers have decided to — or are at least considering — trimming the number of fund families available to advisers on their investment platforms as a way to comply with the regulation, which raises investment-advice standards in retirement accounts.

The fund providers on the chopping block will overwhelmingly be the small shops driving the fewest asset flows, in a play to reduce risk and administrative hassle while minimizing the effect on advisers and clients, brokerage executives and industry analysts say.

“I do think the smaller boutique fund families are going to suffer in the independent brokerage and wirehouse channels,” said Chris Finefrock, vice president of investments at ValMark Securities Inc., an independent broker-dealer. “I think you’re going to have to limit choice. You have to.”

ValMark is an example of one firm that has begun the process of paring down the number of funds it offers.

Prior to the fiduciary rule, the brokerage offered about 100 fund families, but is planning to trim that to around 20 by the time the rule’s implementation period begins April 10. (The Trump administration is currently trying to delay that date by 60 days.)

The providers that will remain are some of the more “mainstream” ones, such as American Funds, Putnam Investments and OppenheimerFunds, Mr. Finefrock said, while many of the funds not making the cut are the lesser-known shops capturing less client dollars.

The 20 families remaining currently represent the vast majority — 90% — of ValMark’s mutual fund business. The firm is still evaluating whether to trim funds across both retirement and non-retirement accounts, Mr. Finefrock said.

“I think we’re definitely seeing more broker-dealers trying to rationalize their fund lineups, close products that aren’t doing well,” said Roger Stamper, associate director of research at FUSE Research Network.

‘MUCH BIGGER REQUIREMENT’

Denise Valentine, a senior wealth management analyst at Aite Group, said most institutions are reducing the number of product options for retirement accounts to streamline their research, due diligence, pricing requirements, disclosures and complicated client discussions.

“The fewer products you have on the platform, the easier that [due diligence] becomes,” said one executive at a large brokerage firm with several thousand advisers, who requested anonymity due to his firm’s policy around speaking to the press. “Let’s just say I would not want to be mutual fund company Number 298 [out of 300] in sales these days.”

While brokerage firms have to go through similar due diligence exercises for all their investment products, it has a larger effect on the mutual fund industry, because “the mutual fund space is where there are by far the most players,” the executive said.

According to Morningstar, there are 750 fund families in the US, with a total $12.8 trillion in assets. The top 20, however, hold 70% of the assets.

Because of a grandfathering provision in the DOL rule, clients would be able to hold or sell positions in funds ultimately cut from an approved list of investments. However, they wouldn’t be able to buy additional shares without incurring more risk.

Firms selling funds on commission in retirement accounts under the DOL fiduciary rule will need to abide by the best-interest contract exemption, which allows receipt of variable forms of compensation such as commissions and 12b-1 fees as long as certain conditions are met.

The provision widely viewed as most onerous is a contract between the brokerage and investor that exposes the firm to potential class-action litigation down the road.

Another requires certain website disclosures of any “material conflicts” between the brokerage and investment providers, Mr. Finefrock said. Those conflicts, not explicitly defined by the rule, could be anything a fund provider pays for in order to educate advisers or the brokerage firm. That includes software to analyze funds, marketing seminars and educational events, he said.

Doing these disclosures for 100 fund families would add a lot of administrative work and, consequently, fixed costs to the point that if brokerage firms kept the same number of funds on their platforms, they’d likely have to reduce advisers’ compensation to make the economics work, Mr. Finefrock said.

The BICE also requires level compensation paid to advisers, one of the most difficult compliance components of the fiduciary rule.

Basically, commissions paid at the adviser level for sale of an investment product must be both “reasonable” and “level,” meaning that an adviser’s commission among similar product types must be the same regardless of which one is selected.

The problem, from an operational standpoint, is that the commissions built into mutual funds can differ among investment providers. So, if a certain fund company doesn’t offer the cost structure a brokerage firm needs, it’s likely to get a kick out the door, executives said.

One way asset managers have tried countering this particular wrinkle is through “DOL-friendly” fund share classes like T shares and clean shares.

T shares are low-load funds, typically 2.5% with a trailing 0.25% 12b-1 fee. They carry the same sales charge across all types of funds, whether stock or bond funds. Clean shares strip out distribution fees and charge only for asset management; advisory firms can charge their own fees on top.

More than 30 fund companies offer T shares, and roughly 20 more have filed for them. A few, including American Funds, Janus and MFS, have said they’re going to offer clean shares.

Small asset managers will have to pivot their sales strategies, perhaps by honing their “niche specialization,” such as smart-beta or ESG, said Mr. Stamper of FUSE.

“Funds with clear and differentiated value propositions, supported by excellent client service, should do well in all environments including one reflecting the DOL fiduciary rule,” a spokeswoman for First Eagle Investment Management said.

First Eagle manages $75 billion in US mutual fund assets, putting it at No. 31 among peers, according to Morningstar.

Further, many shops are restructuring their sales teams, some more toward the registered investment adviser rather than brokerage channel, Mr. Stamper said.

Of course, broker-dealers’ plans to follow through with fund trimming may be delayed or reversed altogether depending on what happens with the fiduciary rule, which the Trump administration has directed the DOL to review, and potentially amend or replace.

“We’d very much like to keep more choice if we were able to,” said Mr. Finefrock of ValMark.

Related Topics: Broker-Dealers, DOL fiduciary rule