Morningstar - Fall 2019 - 15

MiFID II's Long Reach
European regulations
might enhance
transparency for U.S.
investors, too.
POLICY

Aron Szapiro

Investors have intently focused on expense ratios
over the past decade, overwhelmingly choosing
to invest in mutual funds with the leanest costs.
(See "Investors Pay Less for Funds Than Ever
Before" on Page 49.) But there are still opaque
ways funds can spend money for research and
other services without it showing up on
an expense ratio or anywhere else. The costs to
investors may not be obvious but are still very real.
In fact, since at least 2003, Morningstar
researchers have been calling for funds to disclose
what they spend in these so-called "soft
dollar" arrangements. (To give credit where it is
due, the SEC has cracked down on some more
egregious practices in the intervening years.) Now,
a new European regulation may have the
salubrious side effect of shedding some sunlight
on these practices in the United States.
Soft-dollar arrangements involve funds overpaying
for trade execution, in exchange for which
a broker provides research and other benefits. The
cost of trade executions reduces a fund's
returns, but it's not accounted for in the fund's
expense ratio, because the SEC regards trading
commissions as an investment cost, not a
cost incurred by management. As we recently told
the SEC, given a new mismatch between U.S.
and EU regulations, now is a great time to reform
the soft-dollar system with new disclosures.
Soft-Dollar Costs
Soft-dollar disclosures in the U.S. are opaque, and
the magnitude of any harms to investors from

these arrangements can be difficult to discern.
The only disclosures on commissions that mutual
funds pay to execute trades are in absolute
dollars on the statement of additional information,
and these disclosures do not disaggregate
between the cost of execution and the cost of
research that broker/dealers may provide to funds
as part of their fees for executing trades.
An ordinary investor cannot glean much
information on a fund's brokerage costs relying on
disclosures of commissions in absolute dollar
terms. Such arcane disclosures tell investors
next to nothing about the extent to which trading
costs reduce their returns. At best, one could
calculate a fund's brokerage costs using the
dollar value of commissions divided by the average
assets under management for the period, the
method Morningstar uses. However, this
calculation would not accurately reflect the actual
reduction in returns due to commissions
because the timing of the commissions throughout
the year is unknown. Moreover, without going
through the whole exercise for comparable
funds, there is no way to understand if the trading
costs for a fund in question are unusually high.
The upshot is that we do not really know the
extent to which soft dollars reduce returns for
investors because these costs are not
disaggregated from the costs of commissions.
However, given the high degree to which
investors respond to management fees, which
are clearly disclosed, we can assume that
this is information investors would like to have.
Further, undisclosed soft-dollar payments present
a conflict of interest. For example, firms have
an incentive to engage in more trading than they
otherwise would, as they attempt to hit specific
trade-volume targets to receive research services.
Europeans Could Spur the SEC
This brings us to the Markets in Financial
Instruments Directive, also known as MiFID II,
which European regulators finalized last year. The
regulation requires mutual funds to either pay
directly for the research they receive from
soft-dollar arrangements or pass the costs on to
their customers explicitly through a very
complicated mechanism. (So far, most funds are

just eating the costs.) The flip side of this is
that brokers must now separate out the costs for
research from the costs for trade execution.
But in the U.S., brokers are not supposed to
provide advice unless it is incidental to their
business, and they are prohibited from breaking
out these costs. European funds executing trades
with U.S. broker/dealers and U.S. funds with
European clients are thus caught between two
conflicting regulatory schemes.
In the short term, the SEC threw up its hands.
It took a temporary step with "no-action" letters
that helped ensure broker/dealers and asset
managers could comply with MiFID II for 30
months. This approach is fine for now, but it could
lead to some unintended outcomes in the
long term. For example, the no-action letters may
encourage asset managers to use commissions
from non-EU clients to pay for research,
perhaps worsening any existing conflicts that
soft-dollar commissions create.
The good news is that MiFID II presents an opportunity for the SEC to revisit and clarify soft-dollar
regulations in the context of modern arrangements.
To both address the differences between
regulations and improve the situation for U.S.
investors, we recommended that the SEC:
1 Create a "safe harbor" to allow U.S. brokers to

disaggregate research costs from execution costs.
2 Require U.S.-based mutual funds to disclose

soft-dollar payments for research in the Statement
of Additional Information as a percentage cost.
These two steps would harmonize the U.S. system
with MiFID II's and allow asset managers
with clients in the EU to more easily comply with
the European directive when they must.
(We don't think the SEC should adopt some of
the more controversial and complicated parts
of MiFID II, such as the mechanism for passing on
costs of soft-dollar research.)
Furthermore, the SEC should support a longoverdue increase in transparency in the U.S. fund
market. We would expect such disclosures to
help advisors, ordinary mutual fund investors, and
asset managers better assess the value of this

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Morningstar - Fall 2019

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