In the midst of the largest scandal in its 80-year history, and as a spate of new regulatory requirements gets underway, the mutual fund industry faces a major overhaul in the way it distributes funds.
Disclosure to investors will likely represent the most dramatic change, according to a recent study published by Financial Research Corp. of Boston. "When the smoke clears and most fines and settlements have been paid, one of the most likely changes to the mutual fund industry will be a significant increase in disclosure requirements," the report said.
Enhanced disclosure rules will fatten already jumbo-size mutual fund prospectuses, which could have negative consequences for investors, giving them yet more information they don't understand to digest. However, there is a feeling among many fund professionals that the SEC's point-of-sale disclosure rule will have the most broad-based impact because it will affect all members of the distribution food chain.
Any way you slice it, complying with these new rules will cost money. The question is, who will pay for it? FRC suggests that when all the new rules are put in play, the brokerage industry is going to look for fund companies and investors to help finance the cost of disclosure. The Securities and Exchange Commission estimates that fund shareholders will each pay $55 per year to help subsidize the costs associated with new disclosures, FRC said in the study. The Securities Industry Association, on the other hand, is gaming the cost at a much higher $125 a year.
FRC believes that the proposed compliance changes could have an adverse effect on the broker/customer relationship. For starters, the new rules will be expensive to implement and monitor, costs FRC says will trickle down to the end client. On top of that, point-of-sale disclosure forces the investor to dwell on the information contained in the disclosure in two separate instances without an understanding of other aspects of a particular product. This could lead, FRC speculates, to investors wondering why they are paying a broker if they have to make all kinds of important decisions.
Another area that mutual funds will have to contend with is the fate of revenue-sharing arrangements. Directed brokerage has already been abolished, so no longer will fund companies be able to steer transactions toward brokers as a reward for pitching their funds. However, other forms of revenue sharing have had a positive impact on fund shareholders, particularly in the defined contribution plan marketplace, FRC said. In that space, revenue sharing has enabled proprietary platform providers to offer access to external managers. This type of open architecture increases the number of investment options available to plan participants significantly.
A potential pitfall of disclosing revenue-sharing arrangements is that fund companies could gain access to the details of their competitors' deals and engage in fierce bidding wars to gain great access to distributors, the survey noted. One good thing that would come from more disclosure is that the crux of investment selection would revert back to performance. Not only does that benefit individual investors, but it also levels the playing field for smaller firms, which in the past could not compete with the major fund houses with respect to revenue sharing.
Further Margin Pressures
As for soft dollars being used to pay for research, they are likely here to stay, FRC said, but in a "significantly more transparent form." The elimination of directed brokerage and potentially 12b-1 fees would "reduce margins even more by creating additional hard-dollar costs for fund companies." If 12b-1 were to be completely retooled or abolished, FRC predicts that a new economic model would develop, as fund companies would be hard-pressed to fill the revenue void for themselves and their distributors through some other form of service fee.
In the new distribution landscape, FRC contends that firms will begin taking a fine-tooth comb to all of their business lines, distribution relationships and individual products, with many rooting out areas that don't reflect their core competencies. The merger and acquisition market will "heat up" but will remain more strategic in nature.
After coping with several years of dwindling sales forces, a number of securities firms have begun adding staff, albeit with a much more stringent interviewing process. Based on an FRC historical perspective, increased hiring could result in broker/dealers needing help from product manufacturers in training new advisers and building their books.
Another growing concern outlined in the study is that some broker/dealers may change the way they run their business, separating management and distribution for example, while others may decide to get out of the management business entirely. In either case, sweeping changes in regulation will probably result in proprietary products "losing their ability to gain share through compensation and having to compete with third-party products on a more even footing."
Ultimately, the market's recent resurgence and a recovery in fund sales in 2004 will not be enough to stave off increasing pressure on profit margins at many fund firms. This is not to say that distributors and other players won't view asset management as a highly profitable business, but it will not be as lucrative as it was prior to the trading scandal. With regulators pushing for lower management fees and more stringent compliance, the industry will certainly feel the pain.