With the industry heading toward almost assured legislation relating to fees, the way funds market themselves is sure to morph, and some in the industry are bracing for a "revolution."
Regulators have put the way fund companies conduct business under the microscope since the fund scandal hit the headline news pages in September and, even before Fundgate, legislation proposing increased fee transparency was proposed in the House. Directed-brokerage agreements, soft-dollar arrangements, 12b-1s and other fees are among the practices under scrutiny.
However, the potential elimination, or limitation, of 12b-1 fees - which are one way a fund firm can pass along marketing costs to an investor - would pose significant problems for some fund firms.
The Perfect Storm
Ted Siedle, president of Benchmark Advisory Services in Ocean Ridge, Fla., said the economics of distribution are changing dramatically and the combination of a heightened regulatory environment and rampant abuses in the industry are the makings of the mutual fund industry's version of "The Perfect Storm."
"Most funds don't have spectacular performance, so it's a marketing game. It's always been a marketing game. That's got to change," said Siedle, a former Securities and Exchange Commission attorney and onetime Putnam Investments chief of compliance.
Siedle expects downward pressure on both fees and trading costs. "I think the use of fund brokerage commissions for distribution or marketing will be virtually prohibited," Siedle said. (See the ICI's call for the eventual total abolition of directed-brokerage, page 12.)
"How will funds pay for marketing and research they have been soft-dollaring? The fund companies are going to try and impose fees and loads where possible to make up the difference. If they can impose redemption fees and transfer fees or sales loads to pay for marketing, that will give brokers an incentive to distribute certain funds," Siedle said.
"I think the industry has got the biggest marketing challenge since the mutual fund boom began," he added.
Lou Harvey, president of Dalbar, Boston, is also bracing for a big quake in the industry. Harvey expects a revolution, rather than an evolution, in relation to regulation and marketing.
Harvey said there are two regulatory approaches to correcting the industry's problems in this area. One way is to look at each individual fee, soft dollars, trading costs and front-end loads. "There are a lot of different pockets there," Harvey said.
The other way is to take a macro approach. There is a provision in the 1940 act that prohibits competitive pricing. By eliminating that restriction, a lot of the problems can be resolved, Harvey said. "It will be interesting to see if people think we can just tweak the system," he said.
"It would be my hope that competitive pricing is restored and, therefore, the broker/dealer firms will get compensated directly, rather than from the fund companies," Harvey said. He does not expect fund companies to make investors pay for marketing in the future via some other fee paid to the fund complex. "In the future, the distributor will collect their own fee, similar to the structure in managed accounts. It seems logical," he said, adding it will be up to the investor to shop around for best prices.
Jeff Fishman, founder of JSF Financial, a financial planning firm in Los Angeles, said that he expects investors will end up paying virtually the same cost, whether it is through a 12b-1 fee or a heightened management fee. He doesn't see the dynamics of distribution changing all that much, either. "In the end, regulators can require all the disclosure they want, but the most important thing for investors is the investment adviser they work with. Are they working with good, ethical, people?"
A reduction in fees by fund firms will place pressure on some budgets, said Dan Sondhelm, vice president and partner with SunStar, a strategic communications firm in Alexandria, Va. However, Sondhelm doesn't see doom and gloom. "In the short term, clearly revenues will decrease if everyone lowers their fees by 20%." However, over the long run, Sondhelm thinks companies will be more competitive after regulators are done clarifying what arrangements are acceptable.
Several mutual fund firms, including Fidelity Investments, Dreyfus Corp. and Janus Capital, declined to be interviewed for this article.
Pinching Pennies
Meanwhile, pressures placed on fees that are used to market funds may put a squeeze on sales marketing personnel, including wholesalers, cautioned Charlie O'Neill, principal of MutualFundCareers.com. Firms will be examining every one of their marketing efforts and looking at ways to trim costs. Firms will evaluate the number of necessary field wholesalers and potentially move some of that work to an inside sales team or have it handled electronically.
O'Neill also expects fund firms to scrutinize the way they distribute literature, he said, noting the high cost of shipping. Additionally, there will be more opportunities for outsourcing on the marketing side, O'Neill said (see related article on operations outsourcing, page 6). "Does a mutual fund company need 50 marketing writers on staff, taking a fixed cost, when outsourcing that work would make it a variable cost?"
However, O'Neill warned against regulators getting overzealous and trying to regulate fee amounts or percentages, such as the "inappropriate" settlement Alliance Capital entered into with New York Attorney General Eliot Spitzer. "When regulators tell private companies how much they can charge for their services, that's called communism," he said.
However, some don't expect the giant U.S. mutual fund machine to just let profits walk away. "The mutual fund industry is the most profitable industry I know, and there is a reason for that," said Brent Glading, founder of Montclair, N.J.-based pension consultant Glading Group. "Their profit margins will be aggressively protected. I don't see an industry that has been operating this way for decades changing because Eliot Spitzer scratches the surface."
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