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Morningstar probes ‘modern conflict’ that Reg BI must address

Widespread industry practices with serious potential conflicts of interest remain shrouded in mystery, according to Morningstar.

The independent investment research giant is calling for greater clarity from asset managers and broker-dealers about revenue sharing — which a new study by Morningstar defines as “a variety of opaque arrangements” posing impacts on advisors’ mutual fund recommendations.

Educational conferences, select fund lists and the type of revenue sharing that Morningstar views as most likely to affect fund flows — volume or asset-based incentives — make up some of the most common forms of revenue sharing. But disclosure is often spotty at best, according to the Nov. 18 whitepaper.

Mysteries about the level and nature of kickback payments contrasts with other conflicts of interest. The SEC has leveled some 100 cases in 2019 relating to 12b-1 fee disclosures, and bundled funds with distribution expenses and commission loads have sustained outflows for years.

The now-vacated fiduciary rule accelerated the long-term shift toward cheaper, higher-quality share classes dramatically, according to Aron Szapiro, Morningstar’s director of policy research. The SEC’s Regulation Best Interest could help alter practices around revenue sharing.

Szapiro and fellow authors Lia Mitchell and Jasmin Sethi argue that Reg BI should extend the prohibition on sales contests to any direct targets linked to revenue sharing. Conferences, preferred fund lists and all revenue sharing also need to be disclosed more clearly, they say.

“They're not standardized,” says Sethi, who is Morningstar’s associate director of policy research. “Reading them, you don’t know exactly what's being paid for what.”

While Morningstar can track the vanishing 12b-1 fees and — until a recent technical change to SEC rules — commission loads, the research firm can’t find the amount of revenue sharing between funds, custodians and BDs. The firm is pushing for additional scrutiny, Szapiro says.

“The fact that there's definitely no credible estimate that we could give demonstrates the problem,” he says. “This paper is a really good effort at trying to scope the problem, but until there's enhanced disclosure, it's going to be really difficult to know that dollar figure.”

A spokeswoman for the SEC declined to comment.

The regulator has focused on cases involving funds' direct fees to clients rather than revenue sharing. A pending case filed against Commonwealth Financial Network in August could represent new emphasis on disclosure of revenue sharing arrangements, Morningstar says.

“Fund advisors often distribute revenue-sharing payments in return for brokers distributing funds in particular ways or in certain volumes,” the research paper states. “While revenue sharing is not paid for directly by investors, it may be paid indirectly since a fund could lower its management fee if its advisor did not engage in revenue sharing and accepted a lower fee.”

Dually-registered advisors also consistently place clients in underperforming funds that pay revenue sharing, according to a study conducted earlier this year by Northeastern University professor Nicole Boyson. Morningstar cited Boyson’s research in its study as well.

Such practices appear to be falling out of favor, though. Morningstar defines semi-bundled share classes as those with revenue sharing and sub-accounting fees and unbundled shares as having only management and operating expenses.

Between July 2018 and August 2019, the outflows from bundled share classes nearly matched the combined inflows to unbundled and semi-bundled shares. The inflow to unbundled shares was also five times higher than the amount to semi-bundled funds over that 14-month span.

Morningstar refers to revenue sharing as the “modern conflict” that’s become more relevant as 12b-1 fees and loads decline. The study includes examples displaying the complexity of assessing the conflicts from revenue sharing for researchers and advisors — let alone clients.

One fund’s statement of additional information mentions of revenue sharing with its affiliate but doesn't include any reference to the actual amount or even the rate. Another fund prospectus says the level of payment derives from an unknown formula involving sales, assets, accounts or other factors.

“All of the possible bases of the revenue sharing detailed in this disclosure create a conflict of interest for BDs distributing the fund,” according to Morningstar, “and the relative size of this conflict is impossible to ascertain from this disclosure.”

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Payments for due diligence work and placement on “recommended” or “preferred” fund lists represent the second most likely type to create a conflict, followed by data arrangements, platform fees and conference educational expenses, the study argues.

Although Morningstar calls for Reg BI’s prohibition on sales contests to extend to volume and asset-based incentives, the authors stop short of advocating for a ban on the other revenue sharing. They note the complexity of designing firms' disclosure and mitigation of the conflicts.

SEC examination and enforcement will decide the extent that disclosure of a recommended funds list satisfies the best-interest requirement. Information about educational conferences should also state whether they are independent of sales targets, the whitepaper says.

“If it is a type of perk, then the question arises as to how brokers mitigate this conflict,” the report states. “Ironically, one form of mitigation would be that brokers receive education and training from multiple fund complexes, and fund complexes could end up in a ‘race to the top’ in providing these services as perks to win the favor of brokers.”

Szapiro arguest that Department of Labor rule would have bolstered scrutiny and cut down on revenue sharing, but he says the firm is aiming not to be proscriptive about its recommendations under Reg BI. Morningstar isn’t accusing anyone of “doing anything nefarious,” he says.

“The important thing is that there's comparability across the disclosures,” Szapiro says. “Whatever way the SEC would want to tackle this would be great, but right now there's just no way to assemble that information for anyone.”

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