Morningstar Magazine - June/July 2018 - 19

Dispatches

The Future of Clean
Shares As new share
classes evolve, we
untangle their meaning.

POLICY

Aron Szapiro

Clean shares.
The term has a nice ring to it. After all, who
wants to invest in dirty shares? Over the past year
or so, we at Morningstar have been working
to wrap our arms around this new term, identifying
emerging share classes and helping investors
understand what these new share classes might
mean for them.
Our first observation: We do not love the
name. "Clean shares" jumped the pond from the
United Kingdom after new rules called the
Retail Distribution Review went live in 2013. The
term implies that anything called "clean"
is the best choice for an investor, and that is not
necessarily the case. Given the different
flavors of new share classes, we believe more
descriptive names and categories would
help mutual fund investors understand the answer
to a few key questions: Who are they paying
directly and who is being paid indirectly for
services? What conflicts of interest might any
indirect payments create?
The Dash to Offer New Share Classes
At the beginning of 2017, in response to the
U.S. Department of Labor's fiduciary rule, mutual

funds began to consider offering a new share
class. The idea was a direct response to key
details in the best-interest contract exemption
part of the fiduciary rule. The rule's warranty
section required firms to eliminate incentives for
advisors to recommend one similar product
over another based on compensation the product
pays the firm.

Mutual funds created "clean" shares to reduce
these conflicts of interest by eliminating,
or at least leveling, payments from asset managers
to the intermediaries that sell mutual funds.
Intermediaries would then ensure their advisors'
compensations did not depend on the fund
they recommended, reducing conflicts of interest.

without a clear definition, and at some firms,
clean shares could still have elements that might
lead to conflicted advice. Even though
some asset managers have already created
new, innovative share classes that meet principles
of the rule, endorsing a particular version
of clean shares could stifle innovation.

On Jan. 11, 2017, the SEC cleared the
way for these new share classes but left some
key questions unanswered. In a no-action
letter to a fund complex, the SEC clarified that
mutual funds can offer clean shares under
an arcane part of the 1940 Investment Company
Act, known as Section 22(d). These new
share classes would be different from traditional
share classes because they would change
the way intermediaries collect commissions and
other fees for selling funds. Instead of
investors paying fees to a mutual fund, which
in turn paid them back to intermediaries
and ultimately financial advisors, the clean share
would allow intermediaries to charge a fee
to sell a fund.

In November, the Department of Labor
delayed the fiduciary rule's implementation,
causing the industry to press the pause
button on clean shares. However, there continues
to be interest in improving fund distribution,
and new versions of clean shares will be a big part
of how the industry does so. In addition,
the hugely important defined-contribution
retirement plan market is increasingly using types
of clean shares.

However, the SEC did not provide much
information beyond writing that clean shares could
not include distribution fees (also known
as 12b-1 fees) and load-sharing (when a fund
collects a load, usually up front, and shares
it as a commission with the broker/dealer
who sells the fund). Under the no-action letter,
funds were free to include other kinds
of payments to intermediaries that would sell
their clean shares.
This was just the beginning of a discussion that
asset managers, broker/dealers, financial advisors,
and others in the industry are still having
about how to define clean shares. In the summer
of 2017, the Department of Labor issued
two requests for information asking whether
endorsing clean shares, and writing regulation
to encourage them, would be helpful.
We-and many others-told the government
that clean shares represented a promising
innovation, but we noted that writing regulations
to promote the nascent idea would be
challenging. The government would be trying
to build regulations around a product

From 'Clean' to 'Service-Fee Arrangement'

There still is no common definition of "clean."
There is universal agreement that clean
shares will not have loads or 12b-1 fees, which
are both fees used to pay for a mutual
fund's distribution costs. But there continues
to be disagreement about whether clean shares
should include subtransfer agency fees for
recordkeeping (often called sub-TA fees) and other
kinds of revenue sharing where a mutual
fund's advisor pays an intermediary. A big part
of the definition depends on what we expect clean
shares to do and what kinds of conflicts they
are designed to mitigate.
To help investors and the industry untangle what
these new share classes mean, we plan to
label emerging share classes a little differently.
Although "clean" may stick in the lexicon
(particularly given that the SEC used the term
in its no-action letter), the heart of our idea
is to describe the service-fee arrangement and
shed light on what an investor pays for,
whether it's directly (say, by writing a check to
an advisor) or indirectly (via a fund's expense ratio).
We think that most share classes fit into
three broad buckets: unbundled, semibundled,
and bundled ( E XHI B I T 1 ):
Unbundled
Investor simply pays for investment management
and fund operating expenses, and the fund

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Table of Contents for the Digital Edition of Morningstar Magazine - June/July 2018
