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Mutual Fund Share Classes: Don't Forget to Review for Proper Share Classes as an Advisor

Introduction


Mutual fund share classes have distinct characteristics that directly impact investment returns through varying fees and expenses. Investment advisors have a fiduciary duty to act in their clients' best interests, a responsibility that extends to the selection of mutual fund share classes. The SEC has provided a plethora of useful information, providing us with a knowledge base to inform the standards expected of advisors, including those who do not receive 12b-1 fees.

 

Understanding Share Classes


Mutual funds often come in various share classes, which differ mainly in their fee structures. Class A shares typically have a front-end sales load but lower annual expenses, while Class C shares might have higher annual expenses but no front-end load, benefiting investors with a shorter investment horizon. Importantly, the choice of a share class can significantly affect the investor's returns due to the differing costs associated with each class.


The Issue of Higher Fee Share Classes


Advisors might inadvertently place clients in higher-fee share classes, which can erode investment returns. Such actions may be seen as conflicts of interest, especially if a lower-cost share class is available. The SEC has underscored this issue in its enforcement actions, highlighting that failing to disclose such conflicts or to seek the best execution can constitute a breach of fiduciary duty.

Higher fee share classes can occur for several reasons, often rooted in the complex structure of mutual funds and the diverse needs of investors. Here are some of the primary ways in which higher fee share classes might occur:

 

Broker Commissions and 12b-1 Fees: Some share classes include 12b-1 fees that pay for the fund's distribution and marketing costs, which often benefit the broker or advisor selling the fund. These fees can make a share class more expensive for the investor. Advisors might opt for these share classes because they or their affiliates receive commissions from these fees, despite the availability of lower-cost shares that do not include such fees.

 

Different Service Levels: Higher fee share classes can also provide additional services such as enhanced shareholder services or access to a broader range of investments. These services might be valuable to certain investors, justifying the higher fees.

 

Minimum Investment Requirements: Lower-cost share classes often have higher minimum investment requirements that may be out of reach for certain investors. Consequently, investors with smaller amounts to invest may only have access to higher fee share classes.

 

Inertia and Legacy Holdings: In some cases, investors or their advisors may not actively seek to convert existing investments to newer, lower-cost share classes. This inertia can be due to a lack of awareness about the availability of lower-cost options or the perceived hassle of making changes.


Lack of Disclosure or Understanding: Sometimes, higher fee share classes are chosen because the advisor has not fully understood or disclosed all available options. This can stem from a lack of comprehensive training or from misleading or incomplete information about the costs and benefits of different share classes.

 

Situations Where Higher Fee Share Classes May Be Justifiable


In certain scenarios, the higher fee share class might be more beneficial for a client. For example, switching from higher-cost to lower-cost share classes could trigger significant tax consequences in taxable accounts. Therefore, if the tax costs outweigh the savings from lower fees, maintaining the current share class might be more beneficial. Additionally, certain share classes might offer services or benefits that are valuable to the client and are not available in lower-cost share classes.

 

Operational Solutions for Compliance


Investment advisors must establish and maintain robust compliance programs that include regular reviews of share class selections. This can be facilitated through:

Initial and Periodic Review Processes: Regularly, from the initial investment decision and throughout the client relationship, evaluate all available share classes to confirm alignment with the client's best interests. Employ the client's investment objectives to substantiate why the chosen share class serves their best interests, avoiding default selections based on firm familiarity or convenience.


Documenting Rationale for Share Class Selection: Thoroughly document the reasons for each share class selection, explicitly including justifications for selecting higher-cost options when applicable. Ensure that documentation clearly articulates how the chosen share class aligns with the client’s specific investment objectives and circumstances.

Client Disclosures: Clearly disclose all fees and expenses associated with each share class and the impact on investments to the client. Ensure that clients understand how their share class selection aligns with their investment goals and the cost implications of their choices.


Ongoing Training and Education: Ensure that advisors are continually trained on the latest regulatory developments and internal procedures concerning share class selection. Emphasize the importance of understanding and adhering to KYC principles to tailor advice to the specific needs and objectives of each client.


Deficiency


Regulatory oversight has highlighted issues with the selection of mutual fund share classes, where advisors have not adequately justified their selection of higher fee share classes. To address such deficiencies, it is crucial for advisors to rigorously evaluate and document their share class selection process to ensure it aligns with their fiduciary duties. This involves transitioning clients to more suitable share classes and enhancing disclosure practices to communicate the rationale behind specific investment choices clearly. Advisors must also establish a systematic approach for regular portfolio reviews to prevent similar issues in the future, thereby upholding the standards of care required under regulatory guidelines and reaffirming their commitment to serving their clients' best interests.



Compliance Check List


To assist advisors in maintaining compliance and acting in the best interest of clients, the following checklist can be utilized:


Review Available Share Classes: Regularly review all available share classes for each mutual fund offered to clients, not only initially but as part of the ongoing reviews of clients' portfolios. Understand the database of mutual funds the advisor has access to and ensure they can access the lower-fee shares. Implement a periodic review schedule to adapt to any changes in the mutual fund offerings or client needs.


Analyze Cost vs. Benefit: Assess whether the benefits provided by higher-cost share classes justify their expenses and be prepared to defend those decisions several years out. Include a rationale for any decision favoring higher-cost share classes that considers the client’s specific financial goals, risk tolerance, and investment timeline.

Document Decision-Making: Keep detailed records of the decision-making process for share class selection. Document every step, decision, and rationale thoroughly in the client's file to ensure transparency and ease of understanding during audits or reviews.

Enhance Disclosure Practices: Ensure that all potential conflicts of interest are fully disclosed to clients. Develop and maintain clear, comprehensible disclosure statements that are regularly updated and shared with clients.


Stay Informed on Regulatory Changes: Keep abreast of any changes in regulations that could impact share class selection and compliance. Subscribe to industry publications, attend seminars, and participate in workshops to stay current with ongoing regulatory developments.


Engage in Continuous Education: Encourage ongoing education for all advisory staff about the nuances of mutual fund share classes and the importance of alignment with client interests. Consider regular training sessions to discuss new products, share class changes, and case studies that reinforce best practices.

 

Implement Quality Control Measures: Establish quality control mechanisms to regularly audit share class selections. These audits should verify that selections remain aligned with the client's best interests and check for any needed updates or changes based on new available share classes.


Solicit Client Feedback: Regularly solicit feedback from clients regarding their understanding of mutual fund share classes and the costs associated with their investments. Use this feedback to improve educational efforts and client communications.


Conclusion


The responsibility of investment advisors to act in the best interests of their clients is a continuous commitment, underscored by regulatory scrutiny on practices such as placing clients into higher fee share classes. This is a concern that persists even for RIAs who do not receive 12b-1 commissions. Ensuring that mutual fund share class selections align with client interests requires diligent oversight. Advisors must engage in regular reviews, maintain comprehensive documentation, and communicate clearly with clients to uphold trust and adhere to regulatory standards. These practices are essential not only for compliance but also for providing ethical and transparent financial advice.


If you would like specific compliance education, training, and services to help with your compliance program or project, please contact Coulter Strategic Services. 


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All information provided is for educational purposes and shall not be construed as specific advice.  The information does not reflect the view of any regulatory body, State or Federal Agency or Association.  All efforts have been made to report true and accurate information. However, the information could become materially inaccurate without warning. Not all information from third-party sources can be thoroughly vetted.  Coulter Strategic Services and its staff do NOT provide legal opinions or legal recommendations. Nothing in this material shall be considered as legal advice or opinion.  



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