Mutual Fund Fees: A Bad Incentive Fades Away

Revenue sharing payments from asset managers to brokerages are likely to become a thing of the past

By Jason Zweig


Photo: Christophe Vorlet
 

One of Wall Street’s most opaque practices may be on the verge of fading away.

In what’s called revenue sharing, asset managers pay brokerages to subsidize the costs of distributing their mutual funds. The industry describes these payments as a potential conflict of interest, since they could create incentives for a brokerage to promote the funds that pay the most instead of those that are best for their clients.

These fees may be, but often aren’t, disclosed in a fund’s disclosure documents. To learn more about them, you will have to look up your broker or adviser’s policy on the practice. It’s usually on the firm’s website, although you might need a magnifying glass to find it and a quart of coffee to read it. No investor should shed a tear if these fees become a thing of the past.

This spring, the Department of Labor is widely expected to issue a rule requiring anyone offering investment advice on retirement accounts to put clients’ interests first and foremost.

Despite heavy lobbying and various bills in Congress seeking to derail it, the rule is likely to go into effect by early 2017. It is also likely to put revenue sharing into retreat.

The fees can pay for data analysis, meetings and conferences, educational and marketing materials, seminars for clients and so on. Similar payments defray the costs of brokers’ and advisers’ hotel bills, meals, entertainment and travel expenses at sales and training events.

The financial industry calls these fees “payment for shelf space,” and they can add up. At Edward Jones, revenue-sharing fees from fund companies topped $153 million in 2014, or just under 20% of the the St. Louis-based brokerage and advisory firm’s total net income that year.

At Merrill Lynch, fund companies pay up to 0.25% of sales and 0.10% of assets annually for “marketing services and support,” according to a 2015 disclosure. Morgan Stanley collects $750,000 per year from each of 28 fund companies it has designated “global partners” and $350,000 annually from each of another 11 “emerging partners,” according to the firm’s latest available disclosure.

The disclosure statements warn that revenue sharing can be an ethical minefield. Edward Jones says the payments create “an additional financial incentive and financial benefit” to the firm and its advisers. Merrill Lynch points out that funds that don’t enter into such arrangements “are generally not offered to clients.” Morgan Stanley says the firm may “promote and recommend” funds that pay higher revenue sharing.

“We strive to always act in our clients’ best interests,” an Edward Jones spokesman says when asked about the practice, adding that the firm supports regulation that doesn’t limit how investors choose to pay for financial advice. Merrill Lynch and Morgan Stanley declined to comment.

Privately, brokers say the influence of such fees is complex — but doesn’t determine which funds investors are offered.

“Revenue sharing helps fund companies cement their relationships with us and be more integrated into the organization,” says a senior executive at a major brokerage and investment-advisory firm. “But I can tell you with absolute certainty that it doesn’t give them an advantage in terms of what gets approved or what people buy or sell within our firm.”

“It just doesn’t,” he adds.

Firms emphasize in their disclosures that while the parent company may benefit from the fees, individual brokers, financial advisers and their managers don’t earn extra money for selling funds that happen to pay revenue-sharing fees. They also tend to exclude retirement assets from having to make these payments.

The debate could soon be moot. The proposed Department of Labor rule would require anyone offering retirement-investing advice to avoid incentives or quotas that could create the potential to act against an investor’s best interest. Under that regime, revenue sharing will be hard to sustain.

The impending rule is “forcing a lot of investment managers and distribution platforms to account for why they might not have offered a cheaper fund to retirement plans,” says Andrew Foster, chief investment officer at Seafarer Capital Partners in Larkspur, Calif. “That pressure is changing the industry at a very rapid pace.”

Brokerage and advisory firms, he says, are suddenly willing to consider forgoing those extra fees.

“It is all going to change,” says the senior executive at a major brokerage and advisory firm.

The restrictions on IRA funds will “affect all revenue sharing,” he says.

Financial advisers, like anyone providing a service, deserve to be paid. But the people buying the service are the ones who should pay for it. Until advisers are paid solely by their clients, no one will be able to tell whether the advice is tainted.

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