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But look out: Many 'no loads' are loaded with other fees

By Daisy Maxey 

Mutual-fund investors may soon see changes on the shelves of fund supermarkets: No-load share classes are likely to dominate the offerings because of a new government conflict-of-interest rule aimed at financial advisers.

The rule, which takes effect in April and requires advisers offering retirement-investment advice to put clients' needs ahead of their own, is expected to reshape the distribution of mutual funds and accelerate the demise of loads, or the fees fund firms charge investors to compensate brokers for selling the funds.

On its face, it is a positive development for investors, who likely will be able to buy funds more cheaply and better understand what they are paying for.

Persistence of 12b-1 fees

But there is still reason for investors to be wary. Many no-load funds will continue to carry marketing or distribution charges known as 12b-1 fees, embedded in the fund's expense ratio. A fund can charge investors a 12b-1 fee of 0.25% annually and still call itself a no-load or no-commission fund.

Among the 19,598 noninstitutional mutual-fund share classes tracked by investment researcher Morningstar, 4,218 charge no loads and no 12b-1 fees. (Most are available only in certain 401(k) plans or through financial advisers who charge by assets under management, Morningstar says.) An additional 2,485 share classes have no loads but charge 12b-1 fees of 0.25% a year, or $250 a year for every $100,000 invested.

"It's messy to have these sales charges wrapped up in the fund's expenses," says John Rekenthaler, vice president of research at Morningstar. Investors would have a clearer idea of what they're paying and to whom if distribution costs were separated completely from investment-management costs, he says.

Some experts say that over time, the Labor Department's new fiduciary rule and an era of greater transparency could begin chipping away at 12b-1 distribution fees just as they have with loads.

Loads have been under pressure for years, leading fund companies in many cases to waive them. The new fiduciary rule is adding to the pressure by encouraging distributors -- including fund supermarkets (platforms that permit investors to buy and sell funds from hundreds of companies), major brokerage firms, independent and regional broker-dealers, and bank-and-trust companies -- to add no-load-fund share classes to their offerings.

From 2010 through 2015, investors pulled more than $641 billion from load share classes and invested $1.42 trillion in new money in no-load share classes, according to the Investment Company Institute, a mutual-fund trade group. This year through September, investors have pulled an estimated net $113 billion from mutual fund A shares, or those that charge a sales fee up front, Morningstar says.

Many investment managers, meanwhile, are preparing for the possibility of an even more sweeping rule next year. The Securities and Exchange Commission may require brokerage firms and advisers to apply the fiduciary standard across the board to all investors, says Denise Valentine, a senior analyst on wealth management at Aite Group.

To better position themselves, many mutual-fund companies are filing with regulators to create lower-fee or no-load share classes or discussing with their distributors what type of share class they want to offer clients.

Do it the ETF way?

For now, distributors continue to embrace fund share classes with 12b-1 distribution fees.

Broker Charles Schwab Corp. stopped selling fund share classes with front-end sales loads in May, but continues to offer an array of funds "with and without a 12b-1" fees, it says. The firm declined to reveal how much of its business comes from share classes with 12b-1 fees.

It would be much clearer for investors, says Mr. Rekenthaler, if the brokerage firm itself charged the distribution fee, and fund companies stopped wrapping it in with their expenses. "That's how it works with an ETF."

Capital Group's American Funds appears headed in that direction.

In late October, the firm filed with regulators to create a new fund share class that will be free of commissions, 12b-1 fees and so-called "sub-transfer-agency fees," which are typically paid to a transfer agent for mundane tasks such as calculating cost basis. The firm hopes to offer the new share class early next year.

"This is our first offering to the individual investor that will have a management-fee structure as opposed to any structure that will go back to compensate for any expense or 12b-1, etc.," says Matthew O'Connor, head of distribution at American Funds.

The new environment is demanding fee transparency and simplicity, he says.

Sales of fund shares with 12b-1 fees also are diminishing at Prudential Investments, part of the investment-management business of Prudential Financial Inc. The firm says two share classes that charge no loads or 12b-1 fees now account for 75% of the firm's gross sales.

Legg Mason Global Asset Management declined to break out its sales by load or no-load fund shares classes, but says about three-quarters of new inflows in recent years have gone to two share classes that charge no loads or 12b-1 fees.

At the end of the day, the client will have to pay for distribution, but it's likely to be a clearly disclosed charge, says Ms. Valentine of the Aite Group.

Ms. Maxey is a reporter for The Wall Street Journal in New York. Email her at daisy.maxey@wsj.com.

(END) Dow Jones Newswires

November 07, 2016 02:49 ET (07:49 GMT)

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