Executive Summary
This week is the first that financial advisors must operate under the Department of Labor's fiduciary rule, subject to Impartial Conduct Standards which require that they must give best interests advice, for reasonable compensation, and make no misleading statements. While much has been said about the impact this will have for advisors and their clients, there's also a not-well-discussed secondary shift that will be triggered by the DoL fiduciary rule, which will impact actively managed mutual funds and their performance in the coming years - in a "surprisingly" positive way.
In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we discuss how the DoL fiduciary rule will likely end out causing an improvement in the return performance of actively managed mutual funds, thanks to the rise of clean shares and a shift in how brokers are compensated for recommending such funds!
Most predictions about the likely impact of the Department of Labor’s fiduciary rule is that it will lead to a (continued) decline in the use of actively managed mutual funds, and support the ongoing rise of passive ETFs, thanks to the fiduciary rule’s focus on low cost. But the truth is, that there actually is no requirement in the DoL fiduciary rule that financial advisors eschew actively managed funds and switch to lower cost passive funds. The only real requirement is that if an advisor is going to use an actively managed fund, that there needs to be a clear reason and justification for paying that active manager’s fee. And if you can make the case for the active manager, there’s nothing wrong with using the actively managed fund.
There is, however, a requirement to use the lowest cost share class if multiple share classes of the same fund are available. This is why we've seen the launch of T shares and clean shares – which either pay a uniform 2.5% upfront commission and 0.25% trails, or eliminate commissions entirely with the broker-dealer then wrapping a levelized commission around the whole fund or account. And this matters, because mutual funds currently have to report their performance net of commissions and broker compensation. But as broker-dealers shift to being compensated by levelized commissions outside of the funds (even if the consumer still pays a 1% fee via the broker-dealer equivalent to the 1% trail in a C share), the mutual fund itself will no longer have to count the broker's compensation against their own performance!
And this is important because a lot of mutual fund managers have not been underperforming by the amount of the manager's fee, but instead, they've been underperforming because of the drag of the broker's commission compensation. Which means, "suddenly", we're going to start seeing the average actively managed mutual fund begin to improve on its performance... starting this week, with the rollout of the DoL fiduciary rule (and the rapidly rising adoption of clean shares in particular). Not because mutual fund managers are necessarily managing any differently or better, but simply because they’re no longer paying broker compensation out of their own performance track records! Ironically, this may even handicap RIA performance reporting relative to brokers, given that brokers typically point to mutual fund performance (which will not include the broker-dealer's level commission payout) instead of account performance, whereas advisors in an RIA that want to market GIPS-compliant performance track records will still have to follow specific rules requiring a full accounting for fees.
In the end, this shift may still result in a roughly-similar total cost to consumers - whether it's a 1% AUM fee, a 1% commission, or a 1% broker-dealer payout wrapped around clean shares - but the net result nonetheless is that with a shift to clean shares, reported performance for actively managed mutual funds is going to start looking better. Which means in a few years, we may suddenly be talking about how much better actively managed mutual funds are doing again. But it won't be because "the pendulum swinging from passive to active"... or because that's when the Fed started accelerating their rate increases... or whatever else happens economically from here. It will be because DoL fiduciary reconfigured how brokers get paid, reducing the need for 12b-1 fees, reducing the expense ratio of actively managed mutual funds, and improving the reported performance of the mutual fund itself!
(Michael’s Note: The video below was recorded using Periscope, and announced via Twitter. If you want to participate in the next #OfficeHours live, please download the Periscope app on your mobile device, and follow @MichaelKitces on Twitter, so you get the announcement when the broadcast is starting, at/around 1PM EST every Tuesday! You can also submit your question in advance through our Contact page!)
#OfficeHours with @MichaelKitces Video Transcript
Welcome, everyone! Welcome to Office Hours with Michael Kitces!
As you can see, we're live from the AICPA's Engage Conference. This is the new multigroup conference for personal financial planning, advances in estate planning, and sophisticated tax – all in one giant venue!
But I want to talk this week about frankly something that's kind of coincidental to Engage happening this week which is that this is the first week that the Department of Labor's fiduciary rule for financial advisors is now actually taking effect. June 9th was the applicability date. We had no more delays and, as a result, this week is the first week that we're going to have impartial conduct standards, which are the new requirements that advisors must give best interest advice for reasonable compensation and make no misleading statements.
Today I want to talk about what I think is one of the very important secondary effects of the rule that you'll see begin to emerge slowly over the next couple of years: the improving performance of actively managed mutual funds, starting this week.
DoL Fiduciary Doesn’t Kill Mutual Funds, Just Share Classes [Time - 1:15]
I know most predictions about the impact of the DoL fiduciary rule is that it would lead to a declining use of actively managed mutual funds and support for the ongoing rise of passive ETFs thanks to the fiduciary rule's focus on low cost. But the truth is, there's really no requirement in the DoL fiduciary rule that advisors have to assume actively managed funds and switch to lower cost passive funds. The only real requirement is that if an advisor is going to use an actively managed fund, there needs to be a reason and a justification for paying the active manager's fee. And if you can make the case for the active manager (i.e. they have reasonable performance), there's nothing wrong with using an actively managed fund.
Secondarily, though, there is a requirement under the DoL fiduciary rule that if there are multiple share classes of the exact same fund, you better use the lowest cost version available to you. And to further ensure that advisors aren't even tempted towards a small subset of higher cost funds that might pay them better, financial institutions have a requirement under DoL fiduciary to make compensation uniform across an entire category of investment products. Which means, while there may be cost differences between passive and active funds, the advisor or broker must be getting the same compensation for all of them regardless of which one is used. And this requirement that compensation must be uniform across mutual fund share classes is indirectly why I recently predicted that I think we're going to see a total collapse in the number of mutual fund share classes in the next year or so.
Because, the truth is, the primary reason there are so many mutual fund share classes (e.g., some companies have more than a dozen different share classes) is basically because they have a dozen different arrangements to pay brokers to sell their products. And when compensation has to be uniform, the mutual fund share classes you need become uniform as well, and that's why we're seeing the launch of T shares and clean shares. So T shares, for those of you who aren't familiar, will have a uniform commission paying 2.5% upfront and 25 basis point trails every year thereafter no matter what fund company it is and clean shares are just like what they sound, completely clean. No commissions, no 12B-1 fees at all.
Now, obviously, even with clean shares, the broker still has to get paid, but that'll happen by simply wrapping a levelized commission (such as 1% a year) around the whole brokerage account by the broker-dealer themselves, and the end result is actually that broker-dealers are going to start looking more and more like RIAs that buy institutional class shares and wrap their 1% AUM fee around it to manage it.
In fact, in the DoL guidance, when they confirmed that fiduciary rule was going to go forward on June 9th, even pointed out that they might look at issuing new rules with another streamlined exemption similar to the level fee fiduciary exemptions, specifically for brokerage firms using clean shares and this AUM style of perfectly level commissions. Which means, simply put, there's going to be a lot of dollars flowing into clean shares in the coming years.
How DoL Fiduciary Will Lead To Better Mutual Fund Performance [Time - 4:02]
So here's why this all matters from the perspective of the performance of actively managed mutual funds. As the entire brokerage industry shifts from A shares to lower commission T shares (and particularly from C shares to clean shares), the cost structure of mutual funds themselves begins to change. Now, this isn't necessarily about the difference to the end consumer. You can pay a 1% trail on a C share or you can pay a 1% fee to a broker who uses a clean share. Either way, the consumer pays 1%. But the flow of payments is different. Instead of the consumer as mutual fund shareholder paying 1% out of the fund, the consumer is going to pay 1% directly to the brokerage firm who will remit a portion to the broker because the mutual fund itself is a clean share which means the cost of compensating brokers will no longer be paid from mutual fund assets, which means the mutual fund no longer has to count broker compensation against their own performance.
Just think about that for a moment. What happens when every mutual fund currently paying 1% trail to a broker suddenly no longer has to carry that 1% fee as part of the fund's expense ratio? Think about what that does to performance, when you drop the expense ratio of all of those mutual funds by an entire 100 basis points per year indefinitely. This is a profound shift. We all know that one of the primary blocking points that keeps actively managed mutual funds from outperforming is their cost, right? There are actually a decent number of mutual fund managers who do outperform their benchmarks on a gross basis, just not net of fees. SPIVA actually did a study recently and found that in some of the less efficient international categories, the majority of fund managers actually outperform, at least gross of fees.
Now, obviously, it's kind of a moot point if a mutual fund outperforms gross of fees but not net of fees because the consumer only gets the net return, but the problem is that a lot of mutual funds have not actually been underperforming by the amount of the manager's fee (a gap that may further narrow with the increasing popularity of performance-based and fulcrum fees). They've been underperforming because of the drag of the broker's commission (the original commission plus 12B-1 fees). Those aren't investment management costs. Those are marketing costs borne by shareholders thanks to the 12B-1 rules that allow expenses for marketing to be paid from mutual fund assets, and therefore count against mutual fund performance.
But again, with the shift to both lower commission T shares (and especially the clean shares), the cost will still be paid by the consumer, but not out of mutual fund assets in a manner that gets held against their performance. Which means, suddenly, I think you're going to see actively managed mutual fund performance is going to start improving starting now... starting this week. Not necessarily because they're managing any differently, but simply because they're no longer paying broker compensation out of their performance.
The Beginning Of The End Of The 12b-1 Fee [Time - 6:47]
When I look back over the years, I find it somewhat ironic that asset managers haven't tried to fix this for themselves earlier, given that their performance is often getting buried by the cost of the broker and not their actual management fees. Because, if you go back to the roots of mutual funds, it didn't always work this way. For the first almost 50 years of mutual funds, they only covered management fee costs, not broker costs for commissions. It changed in 1980 when we passed the rule 12B-1 that allowed, for the first time, for expenses to market and distribute mutual funds (including and especially the compensation of brokers) to come directly from the mutual fund assets, and therefore the fund's expense ratio, and therefore the fund's performance.
Arguably, back then, it didn't matter as much. The fund industry was reeling from the bad performance in the 1970s, trying to get growth going, and they found if they paid 12B-1 fees to the rising number of independent broker-dealers, then registered reps would sell their funds and bring in assets to the fund. And, since people just weren't as performance sensitive back then, it wasn't as big of a deal. Remember the time? We launched the 12B-1 fee...in frankly, probably just coincidentally, what was the eve of the great bull market of the 1980s and the 1990s. So most people were pretty happy with their results, and they didn't even have good tools to analyze mutual fund performance to compare to a benchmark anyway. So no one cared about relative performance to benchmarks that much. And even if they did, they didn't know how to measure it.
But now, we have the internet, and both consumers and advisors themselves have a huge number of solutions at their fingertips, including Morningstar itself to show them exactly how their mutual funds are performing net of fees relative to a benchmark and passive alternatives. And, as we know, the results haven't been very good, especially as average investment manager improves, which paradoxically reduces the amount of alpha available on the table – as folks like Larry Swedroe or Andy Berkin have been writing about.
So, now we're in a world where investors are more performance sensitive because they're more easily able to measure investment performance against benchmarks, and their fund managers are still allowing the marketing expenses of the fund company paid to brokers to be applied against their performance records.
At least until this week, when DoL fiduciary takes effect and we see the rise of clean shares. And I suspect that once more mutual fund managers realize this (that if they switch to clean shares, they can get broker compensation out of their performance records) they're going to push for it, because it makes their performance look better. And this may actually be the beginning of the end of the 12B-1 fee altogether.
A Handicap For RIA Performance Against Brokers? [Time - 9:17]
Now, ironically, one final thing that's worth pointing out in this phenomenon where brokers' costs of buying clean shares will no longer be counted against mutual fund performance itself, is that is kind of unique broker-dealers Because, if you're an RIA, your advisory fees absolutely get counted directly against client performance. In particular, if you're an RIA that wants to market a GIPS-compliant performance track record, there are very specific rules about how to construct those performance composites and their associative fees to ensure that net performance is reported properly. And if the RIA has firm reports on performance, it's always reporting net of fees.
So, I suspect that in broker-dealers using clean shares will primarily point to the performance of their mutual funds. Not necessarily performance of the account, because the account is net of the brokers fee, but the mutual funds will not be. Which means, mutual fund will get reported gross of broker compensation but RIA performance will get reported net of AUM fees. Which ironically, means now the fee drag pressure is on RIAs more whereas, in the past, it was on broker-dealers, because that's just the reality of how we've tended to construct the comparisons. We look at RIA firm performance against mutual fund share class performance in broker-dealers.
We'll see how this plays out. Perhaps the industry and consumers themselves will coalesce around some kind of a reporting process that tracks advisor aggregate performance whether at broker-dealer or RIA and it looks like net results, net of all cost and regardless of whether they're applied at the advisor level, the broker-dealer level, or the fund level. Maybe Morningstar itself will get into the fray at some point? I think this is...frankly, how performance should be tracked, right? Net of all fees. But that's not always practical with the available technology and reporting processes today, and DoL fiduciary and the rise of clean shares is certainly rearranging a lot of common industry practices.
But the bottom line is just to recognize that with the rise of clean shares, there is a fundamental shift in how brokers are getting compensated now, even if it doesn't change the total cost to consumers. Because, again, for the consumer, I can pay a 1% commission trail or I can pay 1% AUM fee. It's still the same 1%, though it dramatically changes the expense ratio of the mutual fund, and therefore the performance of mutual funds themselves who will no longer be saddling their performance records with broker compensation.
Which means that in a few years, I think we're going to end up talking about how suddenly actively managed mutual funds started doing better in Q3 of 2017. And it won't be because the pendulum swinging from passive to active... or because that's when the Fed started accelerating their rate increases... or whatever else happens from here. It will be because the DoL fiduciary reconfigured how brokers get paid, reducing the need for 12B-1 fees, and reducing the expense ratio of actively managed mutual funds and improving their reported performance.
And with major broker-dealers and wirehouses now rationalizing which funds to keep on their platforms and eliminating a lot of higher cost and lower performing funds, I think a lot of the weakest funds actually will die from the lack of flows in the coming years. These funds probably should've gone away in the first place, but that means the surviving funds going forward, on average, are going to be even better, right? The higher quality crop with the lower expenses, with the better average performance of actively managed funds in the future.
So watch out for this trend. I think you're going to see a lot coming out about it in the next year or two as we suddenly say, "Wow. Mutual funds suddenly seem to be performing better and this is why."
I hope that helps and provides a little food for thought about what I think is important but not well discussed secondary shift that's underway thanks to the DoL fiduciary rule. This is Office Hours with Michael Kitces. Normally 1:00 PM East Coast times. As you can see, we're here at the AICPA Engage Conference instead. So my timing was off a little this week, but thanks for hanging out and joining us. Have a great day, everyone!
So what do you think? Are actively managed funds going to see a sudden increase in performance due to the changes in broker compensation? Will brokers start pointing to fund performance rather than account performance, since the former won't include their fees? Please share your thoughts in the comments below!
This article would be much more impactful if there were numbers provided to estimate the impact. For example, according to Morningstar Direct, just 2.90% of mutual fund assets are allocated to C shares and 14% to A shares. 33% is allocated to Inst shares, 14% to No Load, 7% to Retirement.
So first off, this ‘wave’ of assets out of C shares is non-existent. Even if all money moved out of C shares today, that’s going to have little effect on the active/passive results. And even if all A shares move to clean shares, we’re only talking 25 basis points of improvement on that 14% of assets. And, the majority of assets today are already in a share class that has no 12b-1s.
More or less, if 2 out of 10 active funds outperform in the current environment net of fees over a 15 year time period, then we’re probably talking about 3 in 10 once we move to clean shares, if that. The conclusion stays the same, passive gives you higher expected long term returns relative to active.
Active will do better someday, but it will be because well over 50% of the current players are driven out of business.