August 12, 2010
I have been a financial advisor since 2000. Ive always used C-shares for my practice, and treated the 12b-1 fee as my "advisory fee". In my opinion, by limiting the sales charge on the C-share, you are creating a major "conflict of interest". In my practice now, when a fund starts to underperform, I make recommendations to the client to sell their fund and buy a new C-share to replace it. The client knows that they are paying the 1% regardless if they keep the fund (the fund pays 1% trails), or take my advice and buy the replacement (the fund will pay 1% at the time of purchase, but not pay trails until after the first year). There are no conflicts of interest because our fee stays the same at 1%. By capping the 12b-1 fee on the C-share, my client now has to wonder if my recommendation to replace the fund, lets say after 3 years of ownership, is sincere or is it because my pay will be cut in the next year or two. The solution I've put forward in the following paragraphs simplifies the world of mutual funds and advice, along with adding the transparency for investors that you are currently seeking through your reform.
Currently there are A, B, C, R, Institutional share classes, and a few more that I wont get into. My solution is to have only two classes of shares available. Lets call them "Direct sold" shares (maybe refer to as D shares) and "Advisor sold" shares (maybe refer to as A shares). Next, completely eliminate the 12b-1 from both. I think we can all agree on the fact that 12b-1 fees are no longer used for what they were initially meant for. For the "Direct sold" shares, these would be funds offered by fund families that are appealing to the do-it-yourselfer's, similar to the current "no-load" platform. They would be offered through the fund companies directly, or in wrap accounts at brokerages. They (the fund family) can charge whatever they want (because in the end, isn't it all about net performance anyways?), but their expense ratio would solely be comprised of "fund mgmt" fees and maybe a small "distribution" fee in order for it to be sold at the Fidelity or Ameritrade's of the world.
The "Advisor sold" shares would have the "fund mgmt" fee component along with the "advisory" fee component. These shares would be more for the people that would like to get expert advice and assistance in managing their investments. These funds would not cost anything for the client to purchase, and there would be no fee to sell these shares (unlike the current C share that has a 1% penalty if sold within the first 12 months). The "advisory" fee component would be a flat 1%. By making it a flat 1% (rather than allowing the fund companies to set it), you are eliminating conflicts of interest. All funds would pay us the same, and there would be no incentive to use one fund over the other. These share classes would pay nothing to the advisor when the shares are purchased. The "advisory" fee would get paid to the advisor in the form of trails quarterly, based on how long the client owned these shares during the previous quarter.
As far as the transparency issue, the names of these types of funds alone ("advisor sold" and "direct sold") would clear up confusion quite a bit (compared to the current system i.e. no-load, A, B, C, R etc.). But to take it a step further, require all brokerage forms to disclose, on either the monthly or quarterly statements, how much was paid to the brokerage in the form of "advisory" fees. This way the client can see for themselves how much they are paying for the advice and whether they are getting enough value for the advice they receive. If not, they have the option of going to the fund company directly and buying the "direct sold" shares.
I truly believe this solution is a better alternative than what you've laid out. If you approve the changes that you are currently putting forth, I believe you will be opening the investment community up to future litigation that will arise because of the "conflicts of interest" I referred to earlier. If your goal is to move people to the "wrap" or "advisory" platform, just do away with 12b-1 fees completely rather than limping them along in the form of capped sales charges.