Morningstar - Summer 2019 - 43

EXHIBIT 1

Culling the Clutter In anticipation of the fiduciary rule, intermediaries moved clients out of mediocre and underperforming funds.
Annual Fund Flows by Morningstar Rating 1998-2018

QQQQQ

QQQQ

QQQ

Estimated Net Flows
$1,000B

500

-500
-1,000
1998

2001

2004

2007

2010

2013

2016

Source: Morningstar Direct-U.S. Open-End Fund (excluding Money Market and Fund of Funds), ETF, Separate Account, and CIT Historical Data.

Asset-Weighted Average Fees by Category for
Actively Managed Funds, 2002-18E

Basis Points

clients into fee-based accounts (as opposed
to commission-based structures). Gatekeepers of
these platforms increased their focus on
fees and performance-leading to a fairly large
pruning of funds from these platforms. For
example, Merrill Lynch (a subsidiary of narrowmoat Bank of America BAC) reduced its
mutual fund offerings to 2,200 from 3,500 in 2016
as the firm culled "underused or otherwise
unwanted clutter" from its shelves. In 2017, the
broker initiated a second round of cuts,
reducing the total number of funds to about 1,800.
Moves like that led to flows out of funds
with lower Morningstar Ratings ( E X H I BI T 1 ).
Although the fiduciary rule might be shelved,
the SEC introduced in May 2018 proposals
for a "best-interest standard of care" rule for
advisors-regardless of whether they work
for broker/dealers or advisory networks.
While the SEC's proposed best-interest framework
(known as Regulation Best Interest) overlaps
a lot of the fiduciary rule, there are two
major areas of difference. The first is that the
SEC's rule would cover
advisors providing2010
2002
2006
recommendations to either taxable or retirement
accounts; the fiduciary rule only covered
Total Contributions

Net Contributions

120
Equity: Global/Intl
retirement accounts. The second
difference is
84
the SEC would be the enforcer of any
regulation, contrary to the Equity:
fiduciary
rule, which
Sector
83
would have relied on class-action
litigation
100
to address violations. The SEC
's ability to
Active Funds
enforce its own regulation 69
will be a key factor
in whether its best-interest framework will
Allocation
be more or less transformative
for the asset and
69
80
wealth management industries than
the fiduciary rule was afterEquity:
it wasU.S.proposed.

banks to charge fund managers separately for
research and brokerage services to avoid
conflicts of interest-as opposed to using "soft
dollars" to pay brokerage firms for their
services through trading commissions. As a result,
fund managers operating in MiFID II compliant
zones now have to pay directly for the
research they use, effectively bringing a cost that
had previously been borne by investors onto
their own income statements.

Meanwhile, in Europe, the Bond:
markets
in financial
Tax-Free
iFID, has been in force60
instruments directive, or M54
since November 2007. It increased transparency
Bond: Taxable U.S.
across the European Union's financial markets
47
and standardized regulatory disclosures
for particular markets. AfterMoney
yearsMarkets
of extensive 40
discussion and debate, the16EU approved
MiFID II, an updated version
of the
original MiFID
Passive
Funds
law, in April 2014, with implementation
14
20
starting in January 2018. The new regulation
included fewer exemptions and expanded
the scope of the original MiFID to cover a larger
group of companies and financial products.
0
For asset
in particular, one of
2014 managers 2018E
the biggest changes brought about by MiFID II was
that the regulation has forced investment

Retail Distribution Disruption
For asset managers, the balance of power in the
retail channel has been shifting to the broker/
dealers and advisors for many years but hasn't had
as negative of an impact on management
fees as one would have expected. While the
financial crisis sparked consolidation among many
of the broker/dealer and advisory networks
selling funds to retail investors, the broader effect
was a limitation of the amount of leverage
asset managers had when negotiating payments
for shelf space as opposed to an overarching
pressure on management fees.
As for the industry itself, the participants have
tended to act as though it is an oligopoly,

Assets
$400B

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Morningstar - Summer 2019

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