Fiduciary Duty and Mutual Funds

Monday, September 18, 2017

Many individuals are of the impression that there is nothing safer than a mutual fund. Additionally, many feel that a mutual fund is the best way for an individual with limited investable assets to develop a diversified portfolio. In many cases this is true, with a few caveats.

Investment advisers have to constantly be cognizant of their fiduciary duty to their clients. Typically, investing in mutual fund shares would not be an issue. But for those advisers who invest in mutual funds and include those assets in the AUM for the purpose of fee calculations, but are not providing any type of ongoing review and reporting and/or regular active management of the funds are in reality not doing any type of work for the fee they are charging. The client is already paying some sort of fee to the mutual fund company for the active management of the fund itself. So, if an adviser is charging a fee on top of the fee being charged by the mutual fund company and the adviser is not really providing an added benefit for the fee they are charging, more than likely the regulators are going to be of the opinion that it would have been in the client’s best interest for the adviser to have just advised the client do a little research and take those assets and invest directly with the mutual fund company.

For those individuals who are registered representatives of a broker dealer, and have their own registered investment adviser, the stakes are even higher. Again, even though the individual is not considered to be a fiduciary in regards to their registration with the broker dealer, they are in regards to acting as a registered investment adviser representative to their registered investment adviser. This scenario becomes an issue is when the dually registered individual has clients of the adviser that are custodied with their broker dealer, they recommend mutual funds to their advisory clients, they receive 12b-1 fees for the transaction and then also include those assets in the AUM for the calculation of fees. The regulators are going to take issue with this and may recommend some type of regulatory action against the individual, and their registered broker dealer for failing to supervise.

Now combine scenario one and two. The individual is dually registered, is recommending mutual funds to advisory clients, is receiving 12b-1 fees from its broker dealer for the transactions and is including the assets in the AUM for the calculation fees. If the individual, as a registered investment adviser representative, cannot provide documentation to show that there is some type of continuous and ongoing management of the mutual funds in which the individual is receiving both 12b-1 and management fees, there is no maybe in regards to regulators taking regulatory action; it’s not if, it’s when.

Finally, the one issue in the forefront of concern for regulators is in regard to mutual fund share class and management fees. This one issue is going to cause anyone working in the industry the biggest problems, because it demonstrates a blatant disregard for the client’s best interest and the individual and firm’s determination to make the most money possible regardless of the cost to the client. And this is not one of those sales practices that is limited to registered investment adviser and investment adviser representatives. When recommending/buying mutual funds shares to clients, registered investment advisers and broker dealer representatives alike are warned to do their research and recommend or buy the mutual fund with the lowest fees; i.e. if posed with the option of purchasing A share class of a fund company’s biopharmaceutical fund or one of the other share classes available (if not able to invest at NAV), the only option should be the cheapest for the client. If not choosing the share class that is cheapest for the client, there better be plenty of due diligence on file showing that the returns of the more expensive share class exceed the cost and justify the purchase of the less expensive share class.

If ever in doubt regarding the expense reward ration of share classes of mutual fund shares, FINRA offers a fund analyzer which provides information and analysis on many different mutual fund companies and the share and their share class offerings. And for additional information on what to expect when choosing income over benefit to client, head over to the SEC’s website and read this article.

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