Chapter 10. Conflicts of Interest
| People in the industry have financial incentives to sell investors mutual fund shares, even when such shares are not the best alternative for particular investors. This is compounded by the fact that the industry has devised various classes of mutual fund shares to try to entice more investors, but the result is confusion on the part of many investors who end up paying more than they might otherwise because they chose the wrong class of shares. A rule adopted by the SEC in 1995 makes it possible for mutual funds to offer multiple share classes representing a claim on the same underlying portfolio of securities. For reasons covered next , since that time most fund complexes that sell load funds now offer multiple share classes to investors. As an example of what we are talking about, consider the Hartford Capital Appreciation Fund, a fund concentrating on midcap stocks (the market value of the companies in the portfolio is neither small nor large, but in between) using the growth approach.
We consider three classes of Hartford shares, as shown in Table 10-1. [1]
Table 10-1. Three Classes of Hartford Shares
As you can see, an investor could buy any of the three classes of shares and own the same claim on the underlying portfolio of securities. The difference comes in how the investor pays costs and fees to the fund. With A there is an up-front cost, but no redemption cost. The annual distribution fee (i.e., the 12b-1 fee) is much higher with the B shares. With the C shares the upfront fee is low, there is a low redemption fee, and there is a steady annual distribution fee. Class A shares are, in effect, the traditional type of load-fund shares because this class (typically) charges a front-end sales charge. Class A shares are what most investors traditionally thought of when they purchased mutual funds with a load fee ”they knew they were going to pay a fee up front. Therefore, as noted previously, the load (sales) fee goes to compensate the sales agent and represents a direct deduction of the amount of money the investor puts to work in the fund. Class A shares might also impose an asset-based sales charge, which includes, but is not limited to, the well-known 12b-1 distribution fee. We call this the annual distribution fee, as shown in the preceding Hartford example. Consider a typical load fund with a 5.75 percent load fee and a 0.25 percent 12b-1 fee. An investor who invests $10,000 in this fund pays 5.75 percent or $575, in sales charges, leaving a net investment of $9,475. A broker who sells the investor this position receives $500 of the $575, and the distributor receives $75. Each year thereafter, the 12b-1 fee, or distribution fee, of 0.25 percent of the average daily value of the assets in the fund would be assessed, and would be paid to the broker for each year that the investor owns the shares. Note that a 12b-1 fee is not always charged. Class B shares typically do not charge a front-end sales charge. Instead, Class B shares impose a deferred sales charge in the form of a contingent deferred sales charge (CDSC) payable when the shares are sold. This is the redemption fee in the Hartford example, and we refer to it that way. This latter fee declines over time and disappears if the shares are held long enough. On elimination , Class B shares are often converted into Class A shares. This is typically an advantage to the investor because the annual distribution fee is lower for the A shares than for the B shares, as shown in the Hartford example. The redemption fee is generally five to six percent of the amount received from the sale. It declines one percentage point a year until it is eliminated. Therefore, the investor would have to remain in the fund for five or six years to avoid this deferred sales charge. It is important to note here that although an investor pays no up-front sales charge, as in the case of the A shares, the distributor is still paying a broker a sales commission. This commission is comparable to that received when Class A shares are sold. Although 100 percent of an investor's funds go to work for him or her when Class B shares are purchased, these shares are not no-load shares. The sales charge is simply being deferred against the possibility of early redemption. The distribution fee is higher in the case of Class B shares ”typically one percent of assets. Note that this is exactly the case for our Hartford Capital example. The distributor keeps a larger share of the fee this time, and pays the broker an amount comparable to what would have been earned with the Class A shares (0.25 percent). It is also important to note that the expense ratio charged to investors for operating the fund might be larger under this alternative relative to the Class A shares. Annual operating expenses are an important cost to investors, and investors pay less with the Class A shares. In fact, that is exactly the case for Hartford Capital (see Table 10-2). Class C shares, like Class B shares, do not impose a front-end sales charge at the time of purchase. A small charge may be imposed if the shares are sold within a short period, typically a year. The difference is that these shares charge the same higher distribution fee (one percent of assets) as do Class B shares, and these shares do not eventually convert to Class A shares. Therefore, the distribution fee is not subsequently reduced as it is with Class B shares but continues on and on. The broker receives a larger part of the annual distribution fee than is the case with the Class B shares. The annual expense ratio is typically higher for Class C shares than for Class A shares, matching that of the Class B shares, or even exceeding it. According to Morningstar data, the average annual operating expense ratio for Class A shares is 1.24 percent, compared to 1.94 percent for Class B shares and about the same for Class C shares. We can see in our Hartford example that the annual operating expense ratio is slightly higher for the C shares than for the B shares, and considerably higher than for the A shares. Some brokerage firms attempt to steer their customers into Class A shares for most purchases because they feel these shares are the most straightforward in terms of understanding the true costs involved. At A. G. Edwards, for example, 85 percent of mutual fund shares sold are Class shares. Prudential has now instructed its brokers to limit Class B shares to investors placing $100,000 or less in a single fund. [2]
Table 10-2. Hartford Capital Annual Expense Ratios
O'Neal studied these three classes of fund shares to determine what conflicts of interest arise between brokers and investors given this share structure. [3] For investors, the decision of which asset class to buy is dependent in large part on their expected holding period. For example, for a one-year holding period, Class C shares would be the better choice because they would avoid the initial sales charges of Class A shares and high deferred one-year-later redemption fees of the Class B shares.
The compensation systems for brokers, based on the fees involved in the distribution of mutual funds, generate conflicts of interest between brokers and clients . Relative to buying a fund based on expected holding period, the broker typically benefits more if the investor purchases a share class that is different from this choice. In particular, O'Neal found the following based on a careful analysis of the 20 largest equity funds:
O'Neal concluded that: "The existence of such blatant adverse incentives in the mutual fund industry can only undermine the confidence that investors have had in it" (p. 83). Once again, the issue here concerns the problems created for mutual fund investors, directly or indirectly, that make it more difficult for them to accomplish their objectives. Investors must sort out a variety of issues when buying a mutual fund, and this is simply one more. It occurs up front as well ”investors must decide on their objectives, find the right fund from among a variety of names , and choose the correct share class. In a perfect world, each investor would know which class of shares would likely be in his or her best interests, depending on personal goals and his or her situation. In a perfect world, if the investor did not know which class of shares to own, his or her broker or financial advisor would provide the correct information after analyzing the investor's situation.
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