Whether it's capital surcharges for fund companies designated as "systemically important" or dealing with new fiduciary rules for advisors and brokers or the much-feared reform of money funds, the bill is about to come due-and get paid.
At a time when the overall inflation rate hovers around 2.2% a year, 36% of fund firm executives polled by Money Management Executive expect their organizations' spending on hardware, software, education, training, consulting, staff and other expenses associated with regulatory compliance to increase by more than 10% in 2013. Another 41% expect their firm's spending to increase between 6% and 10% and another 20% expect it to exceed 2%.
But it's not only in regulatory compliance where the impact will be felt. There will be a ripple effect on making sure that portfolio management and other operations follow through on and stick with establishment investment policies.
Thirty-three percent of executives polled expect to see spending on technology, training, staff and other expenses that go toward maintaining compliance with investment policies to increase by more than 10%. Another 36% put the increase at 6% to 10% and another 20% put it at more than 2%.
These are the findings of the 2012 Money Management Executive survey on the fund industry's regulatory outlook. In October and November, 158 chief executives, operating executives, compliance officers and other senior managers of mutual fund, exchange-traded fund and other industry funds responded to questions put to them by Lodestar Research of Princeton, N.J.
The reforms that concern them the most may be surprising.
Topping the ranks?
Money fund reform? Nope.
Cost-basis accounting on fund shares? Not even close.
At the top of the list: the Securities and Exchange Commission's review of the use of derivatives by mutual funds and exchange-traded funds.
The federal regulator has initiated a review of such funds' use of futures, options, swaps and other derivatives, whose use has increased significantly in recent years.
The SEC contends this is beyond the relatively limited use envisioned by the Investment Company Act of 1940, which largely governs fund operations.
The fund industry has contended that the use of derivatives gives its investors broader exposure to different types of investments, such as metals, agricultural products and other commodities, in addition to stocks and bonds. And, in turn, help limit investment risks.
Fully 45% of respondents listed the SEC review of the use of derivatives as one of their five biggest regulatory concerns.
Next up: dealing with efforts to align the fiduciary duties of advisors and brokers to the customers to which they sell shares in funds. That effort, still under way, is of concern to 44% of respondents.
Then comes the provision of the Dodd-Frank Wall Street Reform Act which will place a capital surcharge on mutual funds or other fund companies deemed by regulators to be "systemically important." That was cited by 42% of respondents, not all of whom belong to firms that could be considered, in the lingo of financial stability overseers, "systemically important financial institutions."
Then comes a flood of concern about money market mutual fund reform, which the industry thought the SEC had dropped in August, but has come back onto the front burner, also due to concerns about market stability. The Financial Stability Oversight Council re-introduced a series of proposals for letting the net asset value of such funds float or introducing capital buffers against runs on the fund. They are largely variants of the proposals that the SEC dropped, earlier in the year.
The biggest concern, cited by 37%, is that regulators might allow or require the $1 a share value of the assets in a money fund to float. That would formally "break the buck" promise made to investors, that led to a run in the first place in 2008. The foundation of such funds is the idea that an investor can expect to get $1 back for every dollar put in, like a bank account.
Of the executives polled, 35% feared what systemic regulators might do; and, 27% still worried about the SEC taking action. At this writing, it's not clear exactly which regulatory body will carry the cudgel, but it is the SEC which has rule-making power.
And never going away is the concern that change is coming to marketing and distribution fees that funds can charge. These fees once were considered to help lower costs of funds by helping achieve scale, but have become vehicles for paying commissions. Critics charge the fees do nothing to actually enhance performance of a fund.
Whatever the pros and cons, 37% of respondents say they are concerned about the elimination or restructuring of such 12b-1 fees.
The amount of spending on regulatory compliance and investment compliance, while stepping up significantly, does not constitute staggering amounts, however. Only the very largest firms, those with 5,000 or more employees, expect to spend more than $11 million a year. Fully one-fourth of firms expect to spend under $1 million. The average spend, however: $9.6 million.
The result is similar for investment compliance spending.
Only in this case, fully one-third of firms expect to spend under $1 million a year. The average spend is expected to be $7.5 million and the midpoint, the halfway point among all firms, is $500,000.
The rise of reform and the need to manage it is seen at the highest levels of the executive suites, as well.
Almost two-thirds of respondents, 65%, indicated that their firms now employ a dedicated chief compliance officer. Another 36% have chief risk officers.
This is slightly lower, however, than last year's poll. In the 2011 survey, 67% of respondents indicate their firms had chief compliance officers - and 42% had chief risk officers.
Why does any of this matter?
Forty-five percent of respondents said because the outcomes affect their firms' bottom line performances. Another 38% said it affected their firms' ability to grow. And 36% said it affected their ability to innovate.
Fund Firms Not Getting Social
The returns are in.
Fund firms still do not 'like' social media.
Two-thirds of respondents-actually 68%-said they are either "not" or "not very" active in the biggest social network, Facebook, when it comes to communicating with customers, according to the 2012 Money Management Executive regulatory outlook survey.
And that kind of disengagement is present across the social media spectrum. Seventy-six percent are not very active with YouTube, the video presentation site. Another 64% are not active with Twitter, the 140-character message site. And more than half of respondents, 52%, say their firms are not even involved on LinkedIn, the social network for communication between career professionals.
It gets worse, when it comes to marketing directly at customers. This, of course, can get tricky with regulators. Fund firms don't want to get stuck making promises about their products that they can't keep.
For marketing, 78% avoid YouTube, 77% avoid Facebook and 66% avoid Twitter. But get this: 79% avoid LinkedIn.
LinkedIn does have one practical purpose: 30% of respondents say their firms use it for recruiting talent.
But maybe not for social media communications with and marketing to customers.
Here are some comments from respondents as to why:
Social media is social media. It's just basically getting education out there to our targeted audience. Do we put specifics of our products and strategies? No. Do we think it will make us money? No. It is just a channel you can't ignore.
- FINRA doesn't have a clue what they are getting themselves into.
- We're very cautious about describing portfolio holdings, strategies, and discussions of that nature. Don't want to be on FINRA's "list."
- Concerns over regulatory implications have prevented our firm from entering the social media space. However, we use LinkedIn to search for candidates (not to post).
- We still rely mostly on word of mouth.
The Business of E-Business
The time is fast approaching when advisors and brokers may not even meet their clients when they sell them shares.
Propsecti can be sent electronically. Explanations carried out by Skype or iChat. Signatures sent back online.
What kind of complications might be in store? Or will this be a better way of doing business?
Here are some pros' responses:
- A fully electronic sale would make this process much easier to comply than a paper version where someone could just sign off that they got the disclosure doc without really getting it.
- At first it will be difficult and then easy.
- As long as investors check a box saying that they understand the information, an e-signature should hold as much weight as pen and ink.
- This is a digital world. Set up bulletproof processes and do not deviate from those processes.
- If an investor tries to rescind a transaction, how can you prove that an investor downloaded and accessed (I am deliberately not using the term "read") the prospectus?
- The challenge is creating a trail through the electronic (website) process whereby you can validate the investor actually looked at the prospectus. There is no way to confirm they actually read it.
Finding Fraud, Fighting Fraud
Fraud never goes away.
But how does any firm know that its funds are being used to launder ill-gotten gains or manipulate markets?
Here are approaches that top executives at top firms say they take, according to the 2012 Money Management Executive regulatory outlook survey.
- Account registration review
- Background checks for new accounts; Daily supervisory reviews of all trade activity; Email monitoring; system alerts established for various types of trading activity; Compliance training throughout the year.
- Risk team which electronically watches portfolios for unintended bets
- We require three separate individuals to be involved before a trade can be fully executed and all trades appear on the main blotter, which is viewable by all portfolio managers and traders.
- Employees are prohibited from transacting in securities held in any of our strategies.
- Increased electronic oversight, chief risk officer oversight
- Mulit-layered authentication
- Trader's lines are recorded; tapes are reviewed and kept for one year.
- Segregation of duties, substantial monitoring by management, internal audit, department and fund compliance staff, external auditors, controls on cash handling and transaction approvals
- Electronic processes and oversight committees
- Constant vigilance