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The Fiduciary Duty to Investigate Conflicts-of-Interests with “Zero” and “Negative” Fee Funds

The Fiduciary Duty to Investigate Conflicts-of-Interests with “Zero” and “Negative” Fee Funds
June 04
00:03 2019

It started as an oddity last year when Fidelity loudly proclaimed they would begin offering “Zero” fee funds. FiduciaryNews.com was quick to warn of the potential fiduciary trap posed by these novelty mutual funds (see “When Must a Fiduciary Say ‘No’ to No-Fee Funds?FiduciaryNews.com, October 2, 2018).

Now the SEC has approved a “Negative” fee fund. The Salt Low truBeta US Market ETF has promised to reimburse 34 basis points on a fund with an expense ratio of only 29 basis points. The net is a “negative” five basis points.

The race to the bottom has just gone through the floor.

In effect, a “Negative” fee fund pays shareholders for their business. In a distant world, the SEC might have questioned this practice. Even though that’s the practical impact, the wording of the Salt Low prospectus makes it clear this isn’t the case.

The Salt Low truBeta US Market ETF prospectus states, “The Fund’s investment adviser has agreed to waive the Fund’s full unitary management fee of 0.29% and to contribute to the Fund’s assets an amount equal to an annual rate of 0.05% of the Fund’s average daily net assets on the first $100 million in net assets (i.e., up to $50,000 per annum)  until at least April 30, 2020.”

In other words, the shareholders aren’t receiving the extra 5 basis points, the fund is. In fact, the shareholders will get only what the fund earns (or loses). That extra 5 basis points merely provides a cushion that can evaporate in a falling market. Imagine a bank giving you a free toaster that vanishes from your kitchen countertop if the bank has a bad year.

While such a blatant conflict-of-interest therefore appears to be mitigated, a diligent fiduciary will nonetheless seek to kick the tires most thoroughly on “Zero” and “Negative” fee funds. It starts by analyzing the very motivation behind these financial product marketing innovations.

“The primary motivation for behemoth fund groups, such as Fidelity and Schwab, to offer ‘Zero’ fee funds is gain market share, primarily at the expense (no pun intended) of the largest and, historically lowest cost fund company, Vanguard,” says J.R. Robinson of Financial Planning Hawaii in Honolulu, Hawaii.

Just like groceries offering popular goods at rock bottom prices to entice you into the store to buy higher priced goods, so, too, may mutual fund companies be viewing “Zero” fee funds for the same purpose. “Mutual funds are offering ‘Zero’ fee funds to attract assets in a price war that has pushed expense ratios to that level,” says Paul Ruedi, CEO of Ruedi Wealth Management in Champaign, Illinois. “In my opinion, they are doing it to get their foot in the door and upsell you into their more expensive funds.”

“Although the zero-fee funds can still generate revenue through lending securities in the portfolios,” says Robinson, “they are essentially intended as loss-leaders to stem inflows to competitors and to allow the ‘Zero’ fee fund companies to market other profitable products and services to the zero-fee shareholders.”

If “Zero” fee funds will cause a rush to the mutual fund store, “Negative” fee funds will create an outright stampede. This can be an attractive option for a firm looking to get its foot in the door. “To encourage innovation and competition, it appears that the SEC has allowed negative fees (i.e., paying shareholders to invest) to help new entrants achieve scale,” says Robinson. “A key difference between the negative fee structure and the zero-fee structure is that the negative fee structure is disclosed as temporary, as it is tied to an operating expense waiver that will go away when the fund/ETF achieves a certain scale, such as $100 million in AUM.”

It may be easier to hide the unsustainability of the “Zero” fee fund business model (q.v., what Robinson said about securities lending above), but it’s virtually impossible to conceal it with “Negative” fee funds. “A mutual fund company might initially offer a negative fee fund in order to attract initial investment and achieve a certain size,” says Ruedi. “The catch seems to be that they will eventually raise fees to a normal level at some point, ending the negative fees that attracted people to initially invest in the fund in the first place.”

Even during the period when the “Zero” or “Negative” fees are in effect, a good fiduciary knows that investment decisions cannot be made by fees alone. “A ‘negative-fee’ fund presents itself as a potential good value for the investor,” says Barry Mione, CEO of SaveDay in Austin, Texas. “A word of caution: see what index fund the mutual fund tracks, if it does at all, and what its performance has been. Newer entrants of funds will sometimes offer negative-fee fund to attract new investors, since they may have little or no historical track.”

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The sense of priority of performance over fees suggests a broader issue because there are other aspects that may be in the best interests of investors. “This could represent a conflict-of-interest,” says Daniel R. Hill, president of Richmond, VA-based investment advisory firm D.R. Hill Wealth Strategies, LLC, “because investors need to select a management company having the savviness and sensibility to select various investments for their client’s financial growth; however, in reality the choices made by mutual fund management companies could be laced with concoctions of kickbacks and commissions if certain funds are selected over others. So, the conflict-of-interest may only dwell within the broker or it might dwell deep within the management company.”

Indeed, if the mutual fund becomes addicted to winning the price war through “Zero” or “Negative” fees, it may be tempted to seek other revenue sources. This can produce conflicts-of-interest far beyond what we have previously witnessed. Companies may discover other reasons to offer “Zero” or “Negative” fees. “They may also do it in order to entice people to invest and provide their data,” says Ruedi. “You have to provide a ton of personal information to open accounts, and that information is worth something. I wouldn’t be surprised if companies try to monetize that data in one way or another.”

Still, despite the ease of which these ploys can slide to the Dark Side, there is precedent for them evolving from the novelty to the norm. “The negative-fee fund, as of now, is being used as a marketing gimmick that could make its way into the mainstay,” says Hill. “For example, today it is commonplace for credit card companies to offer 0% balance transfer from one credit card to a new, specific credit card for a customer. Several decades ago, this was a novelty-based practice or provided only to customers with outstanding credit, but today this marketing gimmick is a marketing truth.”

Whatever the future holds, we live in a present where there is no such thing as a free lunch. “I am not sure that it is a conflict of interest, per se,” says Robinson, “but consumers should be aware that the fund companies issuing zero-fee funds are ultimately motivated by profit and market share potential rather than by any great sense of altruism toward consumers.”

Thus, the basic notion of caveat emptor continues to hold true.

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary Solutions,  Hey! What’s My Number? How to Improve the Odds You Will Retire in ComfortFrom Cradle to Retirement: The Child IRA, and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on TwitterFacebook, and LinkedIn.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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