(PUB) Investing 2015

15

November 2015

Morningstar FundInvestor

case in which a firm was charged with violating regu- lations meant to ensure that it appropriately pay and account for sales and marketing expenditures, and that violation harmed every shareholder in its funds. (Accordingly, we’ve lowered our Parent Pillar rating of First Eagle funds to Neutral from Positive.) Second, it’s symbolic of the lengths to which firms have gone in pushing the limits of rules governing the practice of using fund assets to pay for sales and marketing activities. Transfer agents handle the fairly mundane work of proc- essing mutual fund transactions, making distributions, calculating cost basis, and more. A fund’s transfer agent can be affiliated with the fund company, or it can be a third-party firm. In either case, transfer agents will sometimes elect to outsource at least a portion of the work to a sub-transfer agent. For instance, a fund company that acts as the transfer agent of a fund that it offers might elect to outsource the transfer agency work to a brokerage house if that fund is offered on the brokerage house’s platform. In that scenario, the fund pays—from its assets—the brokerage house for its services. This is pretty straightforward and entirely permissible. What has piqued the SEC ’s interest, though, is the nature of the services being rendered under some of the sub-transfer-agency agreements it has examined. To be clear, the issue here isn’t necessarily that fund companies overcharged their shareholders. Rather, it’s whether they’ve disguised sales and marketing expenses as sub-transfer-agent fees. Indeed, that’s what the SEC found at First Eagle, which had entered into two sub-transfer-agency agreements that included explicit provisions linking sub-transfer-agency fees to sales of First Eagle funds on the brokerage houses’ platforms, a no-no. The SEC imposed a $12 . 5 million penalty on First Eagle and additionally ordered it to compensate investors for damages amounting to $25 million plus $2 million in interest. Spread out over more than $60 billion in mutual fund assets under management, it’s a pretty small amount, but there are some important principles involved:

p Competition intensifies when it’s out in the open. For instance, the incursion of lower-cost vehicles like exchange-traded funds into the U.S. fund industry has exerted downward pressure on prices across the market. But when firms use subterfuge like mislabeling sales and marketing expenses, it short-circuits competition and, ultimately, short-changes investors. to that trend. Why? One could argue that, far from being out in the open, they’re largely concealed in fund expense ratios (where they’re levied as 12 b- 1 fees). So is it any wonder they haven’t come down? Fund com- panies often feel they have little choice but to pay to be in key platforms and supermarkets, and those fees have actually risen during the past decade. p Even when you set up a system to police the bundling of sales and marketing fees, you have excesses at worst, confusion at a minimum. Indeed, fund account- ing is apparently so opaque, or subject to interpre- tation, that fund firms sometimes have to engage outside consultants and legal counsel to vet their agreements and the way they’ve classified the associ- ated costs. (First Eagle reportedly did so, to no avail.) p The market has voted against the bundling of sales and marketing fees. How? They’ve moved en masse into products like index funds and ETF s that don’t charge these fees. So while the traditional fund industry might have won the battle to avoid having to pay for all of these fees out-of-pocket (as opposed to paying from fund assets, the prevailing method), it looks like it’s losing the war. It’s an open secret in the industry that the costs of putting a fund in a retirement plan, brokerage platform, or supermarket are greater than the fees explicitly allotted for distribution. The cost for this distribution is gen- erally covered by 12 b- 1 fees, which are the only fees that can be used for such purposes from a fund’s assets. Other fees come from a class of fund expenses deemed “administrative” or related to “shareholder service” and may involve transfer agents, sub-transfer agents, and other parties unfamiliar to most individual investors. K p While management fees have ticked lower, sales and marketing expenses have been more-or-less impervious