Cerulli Questions Clean Shares’ Future With Fiduciary Rule Withdrawal

The firm argues clean share classes can stick to their channels with greater free transparency and lower cost.

Given the revocation of the Department of Labor (DOL) Conflict of Interest Rule issued earlier in June, the latest report from the Cerulli Edge questions the future of clean shares in this economic climate.

 

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Share classes have been outlined as “triple-zero” or “double-zero,” designed exclusively for intermediary channels to tackle conflicts of interest, says Cerulli. However, the semi-recent withdrawal has created doubt on whether the share class type will stay within the intermediary channel. Combating this outlook, Cerulli argues clean share classes can stick to their channels with greater free transparency and lower cost.

 

“From a manufacturer’s perspective, they like the idea of them because they tend to compete a little better with exchange-traded funds (ETFs) on cost,” says Brendan Powers, senior analyst at Cerulli.

 

According to a recent Cerulli survey, clean shares averaged just 1.8% of 2017 gross sales for asset managers, an uptick in comparison to the 1.5% in 2016. Even with a low percentage rate, 80% of managers in the survey believe clean shares will rise in use over 12 months.

 

Cerulli says clean shares may appeal to mutual fund managers and distributors as well, as the shares add edge to the fund due to its resemblance to exchange-traded funds (ETFs) and other accounts. When dismantling distribution and service fees from management fees, Cerulli says the cost structure mirrors ETFs.

 

“Stripping out the asset-based fees, they’re just a bit more competitive,” Powers says. “The competitiveness from the cost structure is something manufacturer’s like, and then distributors are kind of looking to them to use in certain fee-based accounts.”

 

Similar to mutual fund managers, clean shares can serve investors well in the long term as fees hold higher transparency. Yet, Powers says there are hiccups in the shorter stages, as these investors confuse moving service and distribution fees for indirect payment.

 

“Investors would have to buy into the concept that the fees they were once paying indirectly through the cost of the product would likely be charged more transparently somewhere else,” Powers says. “So, I think they have a hard time wrapping their head around the fact, or understanding that, hey, you’ve been paying for this all along, it was just baked into the cost of the product before, now you’re just seeing it as a separate item.”

 

Specifically, the report foresees this as a challenge for distributor adoption, and recommends educational effort from advisers and asset managers. Both will need to work with distribution partners to reorganize payment flows of 12b-1 fees, sub-TA fees and other asset-based fees no longer included in clean shares.

 

“What the asset managers and distributors would have to do to get investor buy-in over the long term is help them understand that [their] all-in cost is likely not changing, if at all it’s going to decrease,” Powers says. It’s not going to go up, but you’ll be charged less for the product, and you may have more in the form of an up-front commission paid directly to your distributor. I think that’s the narrative with investors, it’s less so that they’re avert to them, more so that I think they would have a hard time understanding why they’re all of a sudden paying a fee directly.”

Plan Sponsors Must Remember Fiduciary Duties When Selecting ESG Investments

Although ESG ratings can be useful when used properly, they should not be the sole metric used to make investment decisions. A report gives examples.

The Institute for Pension Fund Integrity (IPFI), which focuses on fighting for fiduciary responsibility in public pension funds, believes it is important to investigate the merits and potential scope of environmental, social and governance (ESG) investments.

“ESG investments should be made when they add value to a fund. When such investments will not improve the financial performance of the fund, or the decision to invest in them is based on political motives, they should be forgone,” it says in a report, “ESG INVESTING FOR PUBLIC PENSIONS: September 2018 Does It Add Financial Value?”

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While the report focuses on issues in consideration of ESG investments for public pension funds, the findings can translate into good practices for selecting ESG investments in private defined benefit (DB) and defined contribution (DC) plans.

Although ESG ratings can be useful when used properly, they should not be the sole metric used to make investment decisions. IPFI considers the Vice Fund (formerly known as the Barrier Fund), which according to Morningstar, has a low sustainability score. The Vice Fund is a mutual fund that invests a significant amount of its funds into firms that profit off human ‘vices’ (i.e. tobacco, alcohol, weapons, and gambling). While such a fund would be politically unappealing to many investors, it consistently yields strong returns. Over the past five years, the fund has had a return of 10.52% and has an alpha and Sharpe Ratio of 2 and 1.008 respectively, making it a relatively high-performing, low-risk investment.

The report says this is a good example showing that while ESG is a useful tool for guiding investments, it is not the only metric that should be considered when designing a portfolio.

IPFI looked at case studies and examples of how problems can be seen in the actions of pension managers in the real world. One example showed that proxy recommendations could guide corporate decisions in less than profitable directions under the guise of ESG proposals. In another, the California Public Employee Retirement System (CalPERS) voted to divest its investments from tobacco companies. This vote resulted in the plan selling off over $670 million in tobacco stocks. CalPERS defended its decision by arguing that tobacco is an unhealthy product that contributes to major health issues and lower life expectancies and that, as a government agency, it could not take part in the funding of such a product.

However, IPFI says politically motivated choices are not the type of decision that a fiduciary should make in regard to its fund. The primary goal of the CalPERS board, and every other fiduciary, is to ensure the strong and stable performance of its fund. Tobacco stocks were, and still are, high-performing investments. According to the report, it is estimated that the annualized return on tobacco-related securities is around 18.6%, compared to a broad market return of 7.4%. Further, a review of the CalPERS divestment concluded the act ended up costing the plan in excess of $3 billion.

“While ESG investing can have benefits when considered as a part of a robust investment strategy, ultimately, if the investment does not add alpha then the fiduciary should opt for something else,” the report concludes.

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