Fund group’s ‘clean shares’

It might sound ironic, but a giant mutual fund group hopes to reduce the confusion created by having many versions of the same fund by launching yet another version, called clean shares.

Like most fund managers that sell through brokers and advisers, American Funds has multiple categories of shares for each fund it manages. Each category, called a share class, has the same underlying investments, but different commissions and annual fees depending on how they are sold.

American has 19 — count ’em — different classes. It hopes the newest class will eventually replace the others by making it easier for investors to understand how much they are paying American for investment management and what they are paying the broker or adviser who recommended the fund. It’s much more “simple and transparent,” said Matthew O’Connor, American’s director of North American distribution.

Clean shares, introduced in late January, also could help American compete with lowcost fund groups such as Vanguard, which hauled in more net money last year than all other U.S. fund companies combined, according to Morningstar. Vanguard attracted $277 billion in net inflows. American, the Los Angeles fund group that is the nation’s second largest, had net outflows of almost $5 billion.

“We have gone through share class proliferation. Now we are returning to a single structure, but it is very different from where we started,” O’Connor said.

Unlike Vanguard, American

does not sell directly to investors. Also unlike Vanguard, which manages primarily index funds, American is an active fund manager, which means that it analyzes and picks individual securities, which costs more than running an index fund. For this, it charges an investment management fee averaging 0.25 to 0.3 percent of fund assets per year.

This is on the low side for active managers, but it’s hard to see because American also acts as a “paymaster.” It collects commissions and fees from fund investors and distributes them to the brokerage and advisory firms that sell its funds, the banks that hold the fund’s assets and transfer agents that keep shareholder records.

These fees (but not commissions) are added to American’s investment management fee to come up with an annual expense ratio, which is stated as a percentage of assets.

American has different arrangements with brokers, advisers and service providers. Some brokers want a commission up front, some will forgo the commission for an annual fee. Some large retirement plans can negotiate big fee discounts. To meet these and other demands from its distribution network, American (like its competitors) kept creating new share classes with different fee structures.

So now it has three share classes sold by commissioned brokers to retail investors (labeled A, B and C shares); three sold by fee-based financial advisers (labeled F1 through F3); five sold in 529 college savings plans (labeled 529A through 529F1); and eight sold through retirement plans (labeled R1 through R6).

On American’s flagship fund, Growth Fund of America, the expense ratio ranges from 0.33 on R6 shares to 1.54 percent on 529B shares. Even though they have the same portfolio, if you had invested $10,000 in each of those two share classes 10 years ago, the R6 shares would now be worth $20,997 compared with $18,754 for the 529B shares, according to Morningstar.

With its new clean shares, labeled F3, American will no longer act as paymaster. It will collect only its own fees. On Growth Fund of America, it will charge 0.33 percent annually — 0.27 percent for investment management and 0.06 percent for expenses it pays itself, such as legal and printing costs.

That will make it look more competitive with low-cost leaders such as Vanguard, whose average expense ratio is 0.18 percent.

Brokers and advisers who recommend clean shares can add whatever fees or commissions they want, and they could end up costing much more than 0.33 percent. However, by unbundling investment management and sales-related fees, it should be easier for investors to see how much they are paying American and how much they are paying for advice.

A clean share “has the cost of operating the fund, but it doesn’t include the sales commission paid to the broker,” said Barbara Roper of the Consumer Federation of America. “That is separately negotiated between the customer and broker. It would be the same way when you buy stocks or exchange traded funds.”

The hope is that by separating the two, “market forces” will drive down fund commissions, the same way they drove stock-trading commissions, Roper said.

American’s class A shares charge up to 5.75 percent in up-front commissions, or $575 on a $10,000 investment. By comparison, do-it-yourself investors can go to a discount broker and buy an unlimited amount of exchange-traded funds for less than $7 per online trade and in some cases, zero.

Capital Group, American’s parent, had to get permission from the Securities and Exchange Commission to create clean shares because historically, fund companies — not brokers — set commissions and fees. Janus has also received SEC permission to sell clean shares.

One way fund managers compete with each other is by offering brokers bigger commissions or other incentives, which are not clearly disclosed to investors. This encourages brokers to recommend funds that make them, not their investors, the most money.

People licensed as brokers can do this, as long as the fund is suitable for their client, because they are not held to a fiduciary standard. Fiduciaries must put their client’s interests ahead of their own. People who are registered investment advisers are fiduciaries and are required to act in their client’s best interests.

Clean shares were expected to get a boost from the U.S. Department of Labor’s fiduciary rule, approved last year under the Obama administration. This rule requires brokers, as well as advisers, to act as fiduciaries when they get paid to give advice about retirement (but not other) accounts.

With clean shares, a brokerage firm could pay their salespeople the same fee or commission on all funds. This would eliminate the incentive to favor one fund type or one fund company over another and help firms comply with the fiduciary rule, Roper said.

Companies were supposed to start complying with the rule April 10, but the Trump Administration ordered the department to reconsider the rule. In early March, the department delayed implementation for 60 days. The rule is not likely to survive in its current form, but some version of it could, Roper said.

No matter what happens with the rule, American plans to forge ahead with clean shares and believes the industry will follow suit. The rule, even if it doesn’t pass, has raised awareness about high fees and conflicts of interest.

But investor advocate Mercer Bullard of Fund Democracy wonders why any brokerage firms would sell clean shares if the fiduciary rule is not adopted, because of the price competition clean shares could unleash.

Morningstar’s John Rekenthaler hopes they will. “I like (clean shares) in spirit. We would all be better off if mutual funds, stocks, ETFs, were all owned and purchased the same way. The onus (is) on the broker to have good disclosure.”

I asked O’Connor whether that name implies that its other share classes are “dirty.” He said that possibility was discussed. But “we feel strongly this will be the future of how mutual funds are priced.”

A clean share “has the cost of operating the fund, but it doesn’t include the sales commission paid to the broker.” Barbara Roper, Consumer Federation of America