Until the 1970s, mutual funds held mostly equity securities and served primar- ily to offer the small investor a way to participate in the stock market. They were sold much the same way stocks were sold—by brokers who received a commission for executing the transaction. Most often, the shareholder paid a front end load—a commission on the purchase transaction—similar to the commission paid on a stock purchase. These commissions amounted to as much as 8.5 percent of the purchase amount on a small transaction, with the commission rate decreasing as the size of the purchase increased. A small percentage of fund families, the no-load funds, sold their shares directly to the investors without any intermediary or sales commission. But in 1970, these funds accounted for less than six percent of the industry’s total assets under management.
The fi rst major change in this pattern occurred in the 1970s, when no-load funds began to grow in popularity. Figure 8.1 shows the portion of total assets under management held by the no-load segment of the industry between 1984 and 2003. As Figure 8.1 shows, much of the growth in popularity of no-load funds closely correlated with the growth of the money market fund segment. In
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Fund Distribution: The Broker Channels 161 the late 1970s and early 1980s, money market funds exploded from nowhere to become almost 80 percent of the industry, driven largely by the artifi cial cap that Regulation Q placed on banks’ ability to pay interest to depositors.
Money market funds are, for all practical purposes, no-load funds. They com- pete against other short-term savings vehicles that carry no commissions, and investors move their money into and out of them quickly. The prospect of paying a substantial commission on a short-term investment would make load money market funds extremely diffi cult to market. They remain rare even to this day—money market funds that impose any type of load hold less than two percent of all money market fund assets.3
As investors moved their money to equity and long-term fi xed income funds in the mid-1980s, the proportion of the industry represented by money market funds declined. In 2000, a shift began to occur. As the popularity of shareholder investments in employer-sponsored pension plans and mutual fund supermar- kets increased, the percentage of assets invested in no-load funds increased as well. Figure 8.1 shows that, for equity funds, no-load funds account for slightly over one-half of total industry assets. Figure 8.2 shows the breakdown for bond funds for the past 20 years. As Figure 8.2 shows, the relative industry share of no-load bond funds now exceeds that of load funds.
0 15 30 45 60 75
Load Funds
No-Load Funds
84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
Percentage of Industry Total Assets at Year End
Year Ending 12/31
Figure 8.1 Load and no-load fund assets as a share of fund assets 1984–2003—
equity funds.
Source: 2004 Mutual Fund Fact Book, Copyright © 2004 by the Investment Company Institute (www.ici.org).
Reprinted with permission.
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During the 1980s, however, the nature of distribution changed dramati- cally. Before 1980, “load” was virtually synonymous with “broker sold,” and
“no-load” meant directly marketed. Shareholders directly shouldered the dis- tribution costs for load funds in the form of commissions; no-load fund spon- sors paid for distribution out of their management and advisory fees. All this began to change with the adoption of Rule 12b-1 in 1980.
Representatives of the mutual fund industry had argued to the SEC during the 1970s that increased size in a fund was a benefi t to existing shareholders because it brought economies of scale to fund operations. This justifi ed using fund assets (i.e., the assets of those existing shareholders) to pay for distribu- tion, since the fund gained from the resulting purchases. In 1980, the SEC responded to this argument, adopting Rule 12b-1, which permitted and set out the rules for an investment company to engage
directly or indirectly in fi nancing any activity which is primarily intended to result in the sale of shares issued by such company, including, but not necessarily limited to, advertising, compensation of underwriters, dealers, and sales personnel, the printing and mailing of prospectuses to other than current shareholders, and the printing and mailing of sales literature.4
0 10 20 30 40 50 60 70 80
Load Funds No-Load Funds
84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
Percentage of Industry Total Assets at Year End
Year Ending 12/31
Figure 8.2 Load and no-load fund assets as a share of fund assets 1984–2003—
bond funds.
Source: 2004 Mutual Fund Fact Book, Copyright © 2004 by the Investment Company Institute (www.ici.org).
Reprinted with permission.
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Fund Distribution: The Broker Channels 163 Rule 12b-1 required that any such plan to use fund assets to fi nance distri- bution be written, that it be approved and renewed annually by the directors or trustees (or, if it is added to an existing fund, by the shareholders), and that it be terminable at any time upon a vote of either the directors or shareholders.
John Bogle had won a specifi c ruling allowing Vanguard to use fund assets to fi nance advertising and other marketing activities shortly before the SEC issued Rule 12b-1 to allow all fund groups to do the same.5 Many observers at the time believed that the SEC’s intent in adopting Rule 12b-1 was to give no- load fund groups like Vanguard more fl exibility in arranging for distribution.6 Instead, the major effects of the rule were to blur the lines between load and no-load funds, and to enable load fund sponsors to devise a variety of com- mission arrangements to fi t both investor preferences and new distribution channel requirements.
During the 1980s, many funds, both load and no-load, added 12b-1 fees amounting to an annual charge of .25 percent of fund assets (25 basis points) to pay for advertising and other marketing expenses. Most load funds also added 12b-1 fees, often as high as 125 basis points annually, to compensate brokers in new ways. By passing on some or all of this fee in the form of a trail commission, paid out periodically to the brokers who controlled a share- holder account, a distributor could encourage the broker to keep the assets in the fund. Management companies also used 12b-1 fees to create contingent deferred sales charge (CDSC) funds, as an alternative to funds with front-end loads. In a CDSC arrangement, the broker earns a commission on the pur- chase transaction, but it is paid by the fund’s distributor, not the shareholder.
The distributor then recovers the money paid out to the broker over some number of years from the 12b-1 fee. If the shareholder redeems the shares before the commission is recovered, a back end commission is deducted from the liquidation proceeds to reimburse the distributor.
By the late 1980s, the SEC had received many angry letters from investors and industry critics who complained that fund companies did not adequately disclose these 12b-1 fees they assessed, making it diffi cult to determine the real expense load the shareholder bore.7 The press refl ected this sentiment in articles claiming that mutual funds “disguise expense burdens”8 and “cheat the investor”9 through their creation of a “fee jungle.”10 Some fund companies labeled their funds “no-load” even though they deducted substantial 12b-1 fees from the shareholders’ accounts to compensate brokers. Some funds fea- tured both front end loads and perpetual, large 12b-1 commissions. Between 1988 and 1993, regulators took several steps to address these issues.
In 1988, the SEC strengthened the disclosure rules, forcing funds to explicitly describe all fees and loads, including 12b-1 charges, in tables at the front of the prospectus. In 1993, the SEC prohibited any fund from terming
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itself “no-load” if it assessed a 12b-1 fee of greater than 25 basis points. (Fund groups that had no 12b-1 fees at all, such as Vanguard and Scudder, took to calling themselves “pure” no-load funds, to distinguish themselves from the 25 basis point 12b-1 no-load funds.) Also in 1993, the NASD adopted rules that placed limits on what funds could charge in commissions.
Another signifi cant regulatory change came in 1995, when the SEC adopted Rule 18f-3, allowing companies to offer multiple classes of shares in the same fund. The industry had found that different load structures in the same fund could be used to accommodate different target markets. For exam- ple, brokers could sell shares with a front-end load, fi nancial planners might be induced to sell the same fund if all it had was an ongoing 12b-1 fee, and institutions such as pension plans might also buy it, but the 12b-1 fee had to be lower. One shareholder might prefer to pay a commission at the time of purchase, while another might prefer an ongoing 12b-1 fee to a front-end load.
Fund companies responded by providing different options within a fund, but to do so they had to get around some regulatory obstacles.
Section 22(d) of the 1940 Act requires an open-end fund to sell its shares at a single, defi ned price—the current offering price described in the prospectus, which is the NAV adjusted for any commission. Rule 22d-1, however, does allow a fund to have multiple commission schemes and therefore multiple offering prices, as long as each applies to a defi ned category of investor. One way to defi ne categories is to divide the fund into multiple classes of shares, each with a different commission scheme. During the 1980s and early 1990s, many funds obtained exemptive orders from the SEC that allowed them to do this. Since 1995, when Rule 18f-3 allowed all funds to establish multiple classes of shares, most load funds and many no-load funds have become mul- ticlass. (This accounts for some of the differences one sees in tallies of the total number of funds available today—if one counted each class as a separate fund, then there were over 19,000 funds in 2004; if one counted all the classes in a fund as a single fund, then the total was approximately 8,100.)11
Some funds use another method—a master/feeder or hub-and-spoke arrangement—to achieve economy of scale in investment management. In this arrangement, the master or hub, which is usually a partnership rather than a registered fund, actually owns a portfolio of securities in accordance with the investment objective. The registered mutual funds sold to investors, the feeders or spokes, all own only an interest in a master fund or in a number of master funds. Each feeder fund can have its own load structure and can be distributed in a different channel from other feeders or spokes. (In fact, the spokes don’t have to be registered mutual funds at all—they could be bank trust funds or offshore funds, for example.) As of November 2004, there were approximately 680 U.S.
registered funds (or fund classes) that were actually feeders or spokes.
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Fund Distribution: The Broker Channels 165 The many different share classes or feeder funds today address the vari- ous channels through which funds are distributed. Figure 8.3 shows the break- down of the industry’s assets by major distribution channel as of late 2004.
The nine channels shown are those defi ned by Strategic Insight, a consulting fi rm that gathers and publishes industry data (the ICI uses a slightly different breakdown of distribution channels). Strategic Insight provides the following brief defi nitions of each channel:
•
Nonproprietary funds are sold primarily or exclusively through brokers not affi liated with the fund’s manager.•
Proprietary funds are sold primarily or exclusively through the captive sales force of the fund’s management company.•
Direct indicates that the fund is directly marketed to the public without an intermediary broker.•
Bank funds are advised and/or sold primarily by a specifi c bank.•
Institutional indicates that the fund is sold primarily or exclusively to institutional investors or high–net worth individuals.•
Insurance funds are sold primarily through the captive sales force of management companies whose primary business is insurance.•
Affi nity indicates that the fund is marketed exclusively to a defi ned group of investors, who often (but not always) have an affi liation with the fund’s management company.•
Exchange-traded funds (include two subcategories, unit investment trusts and open-end index funds) are funds that do not reinvest dividends in the fund but pay them out via a quarterly cash distribution.Direct
30%
Nonproprietary
28%
Institutional
20%
Bank Proprietary
11%
Proprietary
9%
ETF 1%
Insurance .65%
Affinity Group .32%
Exchange Fund .17%
Figure 8.3 Distribution of fund assets by distribution channel.
Source: Strategic Insight Simfund
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Alphabet (and Number and Word) Soup: Fund Share Class Identifi ers Even before Rule 18f-3 was adopted in 1995, fund groups had created many multiclass funds by requesting exemptions, but when the SEC permitted the practice to everyone, classes exploded. Unfortunately, no one was able to establish a standard system of labels for these share classes. Some confusion has inevitably resulted—John Bogle, for example, termed the multiple classes with their varying load schemes “a perplexing miasma.”12
To the extent that any commonality in share class designators exists, it is limited to classes A, B, and C, which most fund groups use in a similar fashion.
• Most funds use class A to designate shares that carry a front-end load. Almost 90 percent of the funds labeled class A at the end of 2004 were front-end load funds, and most of those carried a maximum load above four percent.* But not every fund used A to mean front-end load—approximately 335 no-load funds also designated their shares as class A.
• Class B typically signals a contingent deferred sales charge (CDSC)—95 percent of the time, as of late 2004. Again, the major exceptions were approximately 115 no- load funds that called their shares class B.
• Class C most often indicates a level load fund—97 percent of funds labeled C were also labeled level load, with approximately 65 no-load funds also using this label.
Level load generally means a perpetual 12b-1 fee, with perhaps a small front-end load of one percent.
After that, the patterns break down completely. The Simfund MF database contains over 200 values for share class designators, ranging from letters ( D, E, F, G, H, I, ...Y, Z), to numbers (1, 2, 3) to words (e.g., “Institutional,” “Traditional”). Different funds use these designators to mean completely different things. For example, within the over 200 funds that call themselves class D, one can fi nd the full spectrum of sales commission arrangements. Here are just a few:
• the Gartmore Growth Fund class D features a front-end load that tops out at 4.5 percent;
• the Sentinel Balanced Fund D class carries a CDSC that starts at six percent and an annual 12b-1 fee of 75 basis points to pay off the distributor-fronted commission;
• the Columbia Common Stock Fund class D is a level load fund, with no front-end load or CDSC, but a 100-basis point annual 12b-1 fee;
• the PIMCO Capital Appreciation Fund uses class D for no-load shares that carry a 25 basis point 12b-1 fee; and
• the Morgan Stanley Dean Witter Capital Opportunities Fund class D shares are pure no-load.
The only reliable way to determine exactly what the fund means by its class label is to read the prospectus.
*All fi gures are derived from data in the Strategic Insight Simfund MF database as of the end of 2004.
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Fund Distribution: The Broker Channels 167
•
Exchange funds are funds that were established during the period when IRS tax codes permitted qualifying individuals to diversify their portfo- lios without suffering taxation of capital gains.The fi rst of these channels—proprietary and nonproprietary brokers—are discussed later in this chapter. The next chapter takes up the remaining chan- nels. Finally, Chapter 10 covers two major topics that cross distribution chan- nels—advertising and retirement investing—and steps back to take an overall look at marketing in the fund industry.