Future Fiduciary: Fee Transparency and Share Class Evolution for RIAs | American Funds

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Future Fiduciary: Fee Transparency and Share Class Evolution for RIAs

Key Takeaways

  • Share classes that externalize distribution and sub-transfer agency fees enable registered investment advisors to compare investment expense ratios across investment vehicles with more precision. 
  • A new breed of share class allows fiduciaries, including RIAs, to present investors with a clear delineation of any expenses they are paying.
  • Research shows low expense ratios have been associated with stronger investment results over time. Our management fees are among the lowest in the industry.1


Idea in brief: New mutual fund pricing structures – and institutional ones made available to investors – clearly itemize all the fund fees clients are charged to be consistent with fiduciary needs and regulatory oversight. American Funds Class F-3 shares externalize distribution and sub-transfer agency fees. This structure gives fiduciaries a way to meet the goal of transparency while allocating client assets.

Low Expenses Can Be Critical for Positive Investment Outcomes

Academic research shows a correlation between investments’ expense ratios and their net returns over time. Fund track records bear this hypothesis out. Funds with lower relative expenses have been associated with higher total-return success ratios, Morningstar found.2 U.S. equity funds with the lowest quintile of expenses between 2010 and 2015 were successful 62% of the time based on the number that survived and outpaced their category group average.2 The success rate drops to 48% for the funds with the next higher expense ratios and funds with the highest expense ratios were successful just 20% of the time. Morningstar defined success as those that delivered category-beating results on a number of measures during the period and excluded those that were merged away or liquidated.

Lower expenses correlated with higher success ratios of funds in the balanced, taxable bond and municipal bond categories as well, Morningstar found. Funds with low expenses were three times more likely to succeed than those with the highest ones, Morningstar found. Capital Group’s own research using rolling returns corroborates Morningstar’s findings. For example, both U.S. and International large-cap equity funds with the lowest expenses outpaced the indexes at least half the time based on monthly five-year rolling periods, which was significantly higher than the success rates of the universe of all screened equity funds (see chart below). Funds whose managers invest more of their own money in their funds, in addition to having low expenses, have tended to outpace the index even more frequently. U.S. and International funds with both low expenses, in the lowest cost quartile, and high manager ownership, in the highest quartile, outpaced indexes 72% and 84% of the time, respectively (see the disclosure in the chart below for the methodology).
 

Lower Expenses Have Translated to Higher Returns Percentage of Monthly 5-Year Rolling Periods in Which the Category of Funds Collectively Outpaced Indexes

Lower Expenses Have Translated to Higher Returns
Sources: Capital Group Analytics, based on Morningstar data. All screened equity includes U.S. and foreign large-cap funds. Based on rolling monthly periods from January 1997 to December 2016. U.S. funds are those in the Morningstar Large Value, Large Blend and Large Growth categories. U.S. index is S&P 500. International funds are those in the Morningstar Foreign Large Value, Foreign Large Blend and Foreign Large Growth categories. International index is MSCI ACWI ex USA. The indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index. Unless otherwise indicated, all distributions were reinvested. Least expensive quartile was calculated using annual report Net Expense Ratio (NER) for all observed Morningstar categories for the period indicated.

Client Assets Moving to Lower Expense Options: The Business Benefit

More than $306 billion in money flows poured into open-end equity and fixed income funds in the lowest Morningstar expense quintile in the 12 months ended February 2017, while more than $40 billion flowed out of the funds in the highest expense quintile, according to a Capital Group analysis of data from Morningstar. Low-expense funds saw inflows across categories ranging from U.S. equity to allocation and fixed income, while money flowed out of all the same categories of high-expense funds. The movement toward lower expense investments is creating new opportunities for fiduciaries to tailor client portfolios to address this and other goals. The corresponding movement by the asset-management industry to separate certain non-management expenses gives fiduciaries greater control and flexibility in assessing which share classes would best benefit different clients based on their investing approach. For instance, fiduciaries could elect the share class that allows them to adjust their “all in” fee to match the cost of services being provided. They might alternatively select the share class that minimizes transaction fees, which might benefit accounts with smaller balances or those that are frequently rebalanced. 
 

Money Is Flowing Into Lower Expense Funds Flows Into Open-End Funds by Morningstar Expense Quintile

Money Is Flowing Into Lower Expense Funds
Sources: Capital Group, Morningstar, based on one-year net flows through February 2017. Allocation funds include target date funds.

Class F-3 Shares May Offer Three Potential Benefits

Advisors looking to find investments that fit clients’ objectives but offer lower expenses and greater transparency have new tools to accomplish these goals. The industry’s introduction of new share classes should externalize distribution and sub-transfer agent fees so fiduciaries can delineate those expenses to clients. In some cases, these are not new share classes but are institutional share classes made available to investors through advisors. “Clean” or “zero” shares, names by which these share classes have become known, separate expenses associated with distribution and marketing from those linked with investment management. These are often the lowest expense share classes available in the marketplace. The benefits, over time, could make these shares another option and narrow the expense differential with passive investment vehicles and, as a consequence, change the results profile relative to those index-based strategies. These share classes can also make it easier for advisors to explain to clients the benefits of the funds they have selected.

The advantages of shares that externalize certain fees not associated with investment management including distribution and operational fees to administer a mutual fund include: 

  1. Increased transparency
  2. Lower embedded expenses
  3. Greater flexibility for fiduciaries

Class F-3 shares may be effective for fiduciaries and their clients because they offer a way to:

1. Increase transparency. Class F-3 shares can be helpful to fiduciaries because they externalize fund expenses not associated with investment management. That includes 12b-1 fees for distribution and sub-transfer agency fees for service. Many advisor share classes might feature a 12b-1 fee, sub-transfer agency fee or both. Having the option of these share classes allows advisors to optimize the fee structure that is best for their client. These share classes also allow advisors to better compare similar strategies inside different investment vehicles, be that mutual funds or exchange-traded funds. The chart below shows how our F-3 shares externalize expenses such as distribution and sub-transfer agency expenses.

 

Advisory Share Class Comparison

Advisory Share Class Comparison
Note: Management fees and other expenses vary by fund.

2. Lower embedded expenses. Separating non-management items from Class F-3 shares highlights our funds’ already low expenses compared with their categories. The expenses of our equity funds are significantly lower than the industry averages and rival some passive investment vehicles in comparable asset classes. All 18 American Funds equity Class F-3 shares are ranked in the lowest quintile of expenses among their Morningstar categories as of April, 19, 2017, based on prospectus net expense ratios relative to the peer group percentile as measured by Morningstar. Ratings are based on Morningstar’s data on 1,349 investments in U.S. open-ended large value category, 811 investments in the U.S. open ended foreign large blend category, 396 investments in the U.S. open-ended 70% to 85% equity category, 516 investments in the U.S. open-ended world allocation category, 853 investments in the U.S. open-ended 50% to 70% equity category, 1,523 investments in the U.S. open-ended large growth category, 963 investments in the U.S. open-ended world large stock category, 1,536 investments in the U.S. open-ended large blend category, 185 investments in the U.S. open-ended world small/mid stock category and 434 investments in the U.S. open-ended foreign large growth category. Past results are no guarantee of results in future periods. Gross and net expenses for funds are available at   https://www.americanfunds.com/ria/investments/allfunds.htm.
 

One example showing how fees for American Funds compare with industry averages is EuroPacific Growth Fund. The fund’s Class F-3 shares have an expense ratio of 0.51. Not only is that below the 0.60 expense ratio of the fund’s F-2 shares, it is 46% lower than the 0.93 average of mutual funds in the relevant Lipper category and compared with similar share classes.


Figures shown are past results for Class F-3 shares and are not predictive of results in future periods. Current and future results may be lower or higher than those shown. Share prices and returns will vary, so investors may lose money. Investing for short periods makes losses more likely. Fund results shown are at net asset value with all distributions reinvested. Class F-3 shares are sold without any initial or contingent deferred sales charge. For current information and month-end results, visit americanfunds.com.

 

How Fees for F-3 Shares Compare Class F-3 expense ratios are typically much lower than those for F-2 and F-1 shares.3

How Fees for F-3 Shares Compare
Sources: Capital Group, Lipper. Expense ratios are as of the most recent prospectus. The expense ratio for the F-3 share class is estimated. Lipper category data, excluding funds of funds, for the most recent periods available as of 9/30/2017.

Optimizing embedded expenses gives advisors a cost-effective way to provide clients investments with historical benchmark-beating track records. American Funds equity funds have delivered superior results compared with their benchmarks over one-, three-, five-, 10-, 20- and 30-year rolling periods (monthly basis) between 1934 and 2016.4 It’s not just a matter of a few strong fund results pulling up the average. Seventeen of the 18 equity funds outpaced their relevant benchmarks, many by a wide margin, over their lifetimes.5 As the chart below shows, all 15 equity funds with at least 10 years of history have delivered returns above their benchmarks since their inception during 10-year rolling periods on a monthly basis.6 For instance, EuroPacific Growth Fund has returned more than 3% above its benchmark, on average, during 10-year rolling periods. Capital World Growth and Income Fund has delivered even better relative results, surpassing its benchmark by 4.8% during the 10-year rolling periods. The New Economy Fund has surpassed its benchmark by 0.70% during the 10-year rolling periods. More recent results also demonstrate the persistence of our funds’ strong results.There may be other periods when funds have lagged their benchmark indexes.
 

Track Record of American Funds Equity Funds Benchmark beating results based on 10-year rolling returns (monthly) including funds with adequate history. Average excess return of the 15 funds below was 2.2% during the time periods studied.

Track Record of American Funds Equity Funds
Source: Capital Group. Based on Class F-3 Shares. Returns are average annual total returns for benchmark indexes and average annual excess total return for funds at net asset value from fund inception through 12/31/16. The American Funds equity focused funds used in our analysis and the relevant index/index blends with which they were compared are as follows: AMCAP, GFA, NEF, AMF, FI, ICA and WMIF (Standard & Poor’s 500 Index); EUPAC (MSCI All Country World ex USA Index. Prior to 4/1/06, the fund was compared to the MSCI EAFE Index); NPF (MSCI All Country World Index. Prior to 10/1/12, the fund was compared to the MSCI World Linked Index); NWF (MSCI All Country World Index); WGI (MSCI All Country World Index. Prior to 12/1/11, the fund was compared to the MSCI World Index); SCWF (MSCI ACWI Small Cap Index. Prior to 9/30/08, the fund was compared to the S&P Developed <$1.2 Bil Index Linked Net Index); CIB (70% MSCI All Country World and 30% Bloomberg Barclays U.S. Aggregate indexes. Prior to 11/1/14, the fund was compared to the S&P 500 Index); and IFA and AMBAL (60% Standard & Poor’s 500 and 40% Bloomberg Barclays U.S. Aggregate indexes). All relevant indexes listed are funds’ primary benchmarks, with the exception of The Income Fund of America (IFA), whose primary benchmark is the S&P 500 index. To provide a more relevant comparison, IFA was compared to a 60% S&P 500 and 40% Bloomberg Barclays U.S. Aggregate blended index, which better reflects its investment universe and is a secondary benchmark. IFA’s lifetime return also exceeds the S&P 500 Index.

3. Increase flexibility for fiduciaries. Additional share class offerings provide advisors with more ways to serve a client’s best interests. Importantly, notwithstanding their advantages, F-3 shares might not be the best choice for all investors. Some clients might be better served with share classes that feature higher internal expenses but are not subject to account or transaction fees assessed by the custodian. For example, some custodians charge transaction fees for trades in F-3 shares, but not in F-1 shares. This could potentially create situations where total expenses over time could be lower for some clients in F-1 as opposed to F-3 shares. For instance, clients with smaller accounts might be more efficiently served paying the slightly higher asset-based internal expenses of F-1 shares than the accumulated transaction fees if their portfolio is regularly rebalanced. But for many larger accounts or those rebalanced on a more infrequent schedule, the lower expenses of F-3 shares versus other share classes should help offset for any transaction fees charged by custodians.

Optimize Your Business With Share Class Choices

Idea in action: Lower embedded expenses, transparency and access to investments that have delivered superior results over time are all advantages of Class F-3 shares.

Fiduciaries evaluating if shares that externalize some fund expenses are appropriate for their clients’ portfolios should consider how this new share class can: 

  • Reduce expenses, an important factor in improving clients’ financial outcomes over time.
  • Provide an economically competitive alternative to index-based investments in some areas of clients’ asset allocations. With the difference in expense potentially narrowed in comparison to some passive investments, fiduciaries have an opportunity to focus on finding investments with the potential for superior returns over time that can more than justify expenses.
  • Allow you to tailor your offering, where appropriate, for certain clients. Judgment and client knowledge allow you to choose the optimal share class depending on a variety of variables. Since some custodians charge transaction fees for F-3 shares, smaller accounts or accounts that are rebalanced frequently might be better served with non-transaction fee share classes, like F-1 shares, despite higher expenses. 
  • Position your business and clients for industry trends. The asset management industry is making new types of share classes that externalize expenses not associated with investment management increasingly available and they could become the eventual standard. As more of the industry shifts to such shares, we believe our F-3 shares will become an ideal choice for many fiduciaries looking to improve value and deliver results.
     

 


 

Class F-3 shares were first offered on January 27, 2017. Class F-3 share results prior to the date of first sale are hypothetical based on Class A share results without a sales charge, adjusted for typical estimated expenses. Please see americanfunds.com for more information on specific expense adjustments and the actual dates of first sale.

When applicable, investment results reflect fee waivers and/or expense reimbursements, without which results would have been lower. Please see americanfunds.com for more information.

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© 2018 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. These numbers were calculated by the Capital Group based on underlying Morningstar data.

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1On average, our management fees were in the lowest quintile 73% of the time, based on the 20-year period ended December 31, 2016, versus comparable Lipper categories, excluding funds of funds.

2Morningstar Fund Spy, ”Fund Fees Predict Future Success or Failure,” May 5, 2016. Morningstar’s total-return success ratio examines the percentage of funds that survived or delivered returns in excess of their category group. The ratio was calculated based on “total return over ensuing period(s), load-adjusted returns, standard deviation, investor returns and subsequent Morningstar ratings.” The success ratio factoring in mutual funds that were merged or liquidated over the time period. The analysis looked at average cumulative results, for instance in the five years ended December 2015, the four years through 2015 and so forth.

3Includes funds with at least 10 years of history from their dates of inception.

4Data from published sources were calculated internally. Numbers of periods are based on rolling monthly data for all funds — reducing entry- and exit-point bias and better reflecting the range of entry points experienced by investors. American Funds represents 18 equity-focused funds, in aggregate: AMCAP Fund, American Balanced Fund, American Funds Global Balanced Fund, American Mutual Fund, Capital Income Builder, Capital World Growth and Income Fund, EuroPacific Growth Fund, Fundamental Investors, The Growth Fund of America, The Income Fund of America, International Growth and Income Fund, The Investment Company of America, The New Economy Fund, New Perspective Fund, New World Fund, SMALLCAP World Fund, American Funds Developing World Growth and Income Fund and Washington Mutual Investors Fund. Past results are not predictive of results in future periods. See footnote 5 for the funds’ benchmarks.

5The 18 American Funds equity-focused funds used in our analysis and the relevant index/index blends with which they were compared are as follows: AMCAP, GFA, NEF, AMF, FI, ICA and WMIF (Standard & Poor’s 500 Index); DWGI (MSCI Emerging Markets Index); EUPAC (MSCI EAFE Index through 3/31/2007 and the MSCI All Country World ex USA Index, the fund’s current primary benchmark, thereafter); IGI (MSCI World ex USA Index through 6/30/2011 and the MSCI All Country World ex USA Index, the fund’s current primary benchmark, thereafter); NPF (MSCI World Index through 9/30/2011 and the MSCI All Country World Index, the fund’s current primary benchmark, thereafter); WGI (MSCI World Index through 11/30/2011 and the MSCI All Country World Index, the fund’s current primary benchmark, thereafter); SCWF (S&P Global <$3 Billion Index through 9/30/2009 and the MSCI All Country World Small Cap Index, the fund’s current primary benchmark, thereafter); CIB (70% MSCI All Country World and 30% Bloomberg Barclays U.S. Aggregate indexes. From 7/30/1987 through 12/31/1987, the MSCI World Index was used); GBAL (60% MSCI All Country World and 40% Bloomberg Barclays Global Aggregate indexes); AMBAL (60% Standard & Poor’s 500 and 40% Bloomberg Barclays U.S. Aggregate indexes); NWF (MSCI All Country World Index); and IFA (65% S&P 500 and 35% Bloomberg Barclays U.S. Aggregate indexes. From 12/1/1973 through 12/31/1975, the Bloomberg Barclays Government/Credit Bond was used).

6Excess returns of the 15 American Funds with at least 10 years of history between 1/1/2002 and 12/31/2016.


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Investment results assume all distributions are reinvested and reflect applicable fees and expenses. 

When applicable, investment results reflect fee waivers and/or expense reimbursements, without which results would have been lower. 

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