Investment fees can be a tricky factor for investors to consider when choosing among mutual funds that, on the surface, appear much the same.
The costs for financial advisor transactions can vary depending on the advisor, the fund or the fee structure that the advisor charges. Some funds also come in various classes, each with a fee structure designed for a different purpose — to compensate the advisor, to impose charges upfront or to spread them over the years.
While many financial advisors are honest, there are some bad actors who will try to push funds that are more profitable for the advisor, but not the best option for an investor.
“I can tell you that there are literally advisors who allocate clients’ capital — the client’s life’s (savings) — based upon who bought them their most recent meal or offered the best sleeve of golf ball,” says David Karp, a partner at PagnatoKarp, a wealth advisor in Reston, Virginia. “Sad.”
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The Department of Labor’s new conflict-of-interest rule, or fiduciary rule, taking effect in June, is the latest attempt to address the problem. Many funds have responded by adding new share classes called “clean” and “T” shares, Morningstar says in a recent report. Reducing conflict of interest in fund recommendations could improve the average investor’s returns by half a percentage point a year, Morningstar says.
“Most mutual funds offer several share classes designed to appeal to different kinds of investors and for different kinds of sales approaches,” the report says. “These share classes charge different fees in different ways.”
The new rule helped trigger the new share classes because financial services companies are required to structure financial advisors’ compensation so that they do not benefit from recommending one fund over another for their clients’ IRAs, the report says.
The trend will not eliminate all problems but should help, says Kathryn Farrell, associate director of research at Portfolio Evaluations, an investment consulting firm in Warren, New Jersey.
“Since these new clean shares have the same commission for every single fund, they are removing the incentive to select higher-fee share classes, thereby eliminating the conflict of interest associated with that particular investment,” she says. “However, this does not alleviate the concern that a commission-based advisor may exclude certain funds that do not offer these clean share classes when selecting investments for a client, potentially leaving out what might really be their best option.”
Investors should make sure they are getting the class that best suits their needs, since the fund holdings and performance are the same for each class of a given fund. Different fund providers use different terminology, so read the prospectus before investing.
“There are nearly 20 different types of share classes — each provider comes up with their own names,” says Richard L. Stone, a retirement-plan advisor and owner of the Lifetime Companies of Gaithersburg, Maryland.
Here is a rundown on the common classes:
A shares. The class commonly sold by advisors, A shares carry a front-end “load” or sales commission that compensates the advisor or broker for making the sale — typically 5 percent or more, Morningstar says. A shares also carry an annual “asset-based” fee, usually between 0.25 percent and 1 percent. Ideally, the load is payment for advice, and it makes no sense to pay it if there is no new advice involved — if the choice is the investor’s or it’s a monthly or quarterly purchase according to a plan that was paid for earlier, for example.
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B shares. These don’t have the upfront load but may charge a larger asset-based fee than A shares, plus a charge if the shares are sold within a certain number of years.
C shares. While there is no up-front load, and a smaller charge for selling, the asset-based fee may be larger for C shares than with A and B shares. Before investing, try to figure which class would have the lowest drain to fees over the period you’re likely to keep the shares. Also, look for breakpoint discounts, which are fee reductions if you make a large purchase, have other holdings with the same fund family or commit to purchases at regular intervals.
T shares. Morningstar expects most advisors to replace A shares with these transactional shares, which will establish uniform charges to eliminate the incentive to recommend high-fee funds. With A, B and C shares, fees can vary widely between asset classes and between fund firms. The T class front-end load is likely to be about 2.5 percent.
Clean shares. Also spurred by the conflict-of-interest rule, these eliminate other payments commonly made by the fund company to others involved in fund management, marketing and sales — charges often wrapped into the 12b-1 fee paid by investors. With clean shares, commission-based advisors will have to separately charge for such services and report the billings to investors, making the process more transparent.
While these new share classes could be an improvement for investors, the Morningstar report notes they will not eliminate the incentive for an advisor collect a fee by convincing a customer to move from one fund to another. The firm views T shares as a step in the right direction, and says an industry that relies primarily on clean shares, a model common in the United Kingdom and Australia, would best serve investors.
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“Will a new share class solve the problem? No,” Karp says. “But it will definitely help and is a place to start — better than nothing. The devil is in the details.”
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Clean and T Shares May Make Investing Easier originally appeared on usnews.com
