Revenue sharing is one of the mutual fund industry’s most controversial and least talked about practices.
It affects how mutual funds are sold to Registered Investment Advisers (RIAs), how much compensation is paid to mutual fund wholesalers, how conflicts-of-interest are created between RIAs and their clients, how 401(k) plans are structured and what fund they offer plan participants, and indeed how the entire fund industry operates.
If that is not enough, the average mutual fund shareholder has no idea that revenue sharing exists, let alone how it negatively impacts their investment options and fund returns.
Changing the industry’s sales model can also impact other practices, including the need for more transparency, fee reduction, and revenue sharing. Revenue sharing is money paid to financial advisers or broker-dealers in exchange for buying funds from a fund company. These payments are often not disclosed to investors, and they have been cited by mutual fund industry critics as fostering a conflict of interest between fund companies, financial advisers and shareholders.
Selling Funds Without Revenue Sharing
Yet while revenue sharing is traditional in the fund industry, it does not have to be a permanent feature of selling funds. According to Neil Plein, vice president of Invest n’ Retire, a 401(k) advisory firm in Portland, Oregon, the elimination of revenue sharing would have separate effects on shareholders and on plan sponsors whose 401(k) plans offer the funds.
“If revenue sharing were eliminated from mutual funds, those who receive the benefit from revenue sharing would not cease to be compensated, but their compensation level would be more directly controlled by the plan fiduciary,” Plein said.
”This shift opens up a competitive landscape for plans, ensuring that the proper value is being delivered for the amount paid, which will ultimately lower costs for many plans. That is a big win for plan participants,” according to Plein. “However, it is also possible that eliminating revenue sharing could increase expense ratios for mutual funds.”
However, selling funds without revenue sharing would also make fund costs more transparent. This would be welcome by all types of investors. ”Surely if polled, it would be difficult to find a retirement plan participant anywhere that would agree to buy something without knowing the price,” Plein said.
Revenue Sharing: Just Another Form of Compensation?
Another view of revenue sharing comes from an East Coast fund executive who preferred to remain anonymous. Since “mutual fund firms are no different from other businesses, they have to figure out how to get paid for what they do,” this executive said. “The business model has evolved rapidly from a proprietary environment where clients were only offered in-house product, to an open platform where product, not expertise has become the selling point. By this I mean that rather than the broker saying “I’m the smart guy who knows what you need, don’t look under the hood” the pitch now is “I’m the smart guy who’s going to put you in the right vehicle regardless of who the manufacturer is.”
The mutual fund business model has been changed by discounters, who now offer entire fund families from a single platform. As a result, firms that once offered only proprietary funds and wirehouses had to expand their fund offerings. Under this new model, the executive said “mutual funds view themselves as manufacturers, wholesalers are manufacturers’ reps, and advisers are sales people.” He also said that once an adviser offers funds from another firm, the conflict-of-interest issue disappears.
But since advisers need to get paid, their main benefit is to provide investment discipline to clients, rather than being the most informed financial person the client knows. In exchange for providing this discipline, advisers charge a “management fee,” often 1% to 2%, but their firms also have to be paid, which justifies the revenue sharing, according to this executive.
But this answer is not so simple. This fund executive also acknowledged that “there is an inherent conflict of interest between retail investors and mutual fund companies.” That is just a fact of life about how the industry is organized and how funds are sold.