The Securities and Exchange Commission's ban on funds directing trades to brokers in exchange for shelf space, or directed brokerage, has mutual fund companies scurrying for new ways to compensate distributors.

"Every fund family recognizes distribution of its products through the brokerage channel is critical. If they cannot compensate broker/dealers through directed brokerage or find other ways, smaller funds will begin to lose shelf space," said Matt Bienfang, a senior analyst with TowerGroup of Needham, Mass. Bienfang explained that many small firms depend on directed brokerage to supplement distribution and once that is halted, the impact will be significant.

According to TowerGroup, mutual funds pay an estimated $475 million a year in trading commissions through directed-brokerage agreements, and the ban is likely to cut that in half. This is going to have a tremendous impact on fund companies, as brokerage distribution now accounts for more than 60% of fund families' annual sales.

However, Chip Roame, managing principal at Tiburon Strategic Advisors of Tiburon, Calif., still believes there is a chance of survival for smaller funds. The ban will probably drive some consolidation in the industry with smaller funds selling to bigger funds if shelf fees become a fixed amount that could be spread over more funds, Roame said.

Alternatively, "fund adoption," similar to the move made by Schwab acquiring AXA Rosenburg funds and rehiring AXA to manage the fund, is another strategic move that could be anticipated as well, he said.

Other companies may pass the cost along to investors through loads, Bienfang added. "With margins already squeezed and pricing pressure increasing, it is harder for funds to dip into their pockets," he said. "In the end, costs stemming from the [directed-brokerage] ban will likely be borne by the consumer."

But because not all fund companies may turn to these strategies, Bienfang believes there will be a sharp reduction in both trades and revenue at many brokerage firms, particularly the smaller ones.

The ban is likely to have the most explosive impact on the independent broker/dealer community, which at 4% already has the lowest operating margin in the industry, he said. Many independent firms do not share revenue from directed-brokerage agreements with the distribution force, he explained. Therefore, the revenue has dropped right to the bottom line. Large, bulge-bracket brokerage firms, or wirehouses, on the other hand, not only might attract some of these redirected trades but should be able to absorb the loss of revenue from directed brokerage much more readily, he said.

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