Get ready, brokers
All of the hand wringing during the last two years over faulty research and enhanced disclosure will seem like grade school compared with the newest cannons trained on mutual funds. New SEC proposals could drastically change both the way mutual funds are distributed to brokerage firms and how they are sold by brokers — and that could mean big changes to the way reps are paid.
The SEC proposed to ban directed brokerage, the practice of directing trades to broker/dealers' trading desks to reward them for selling an asset manager's mutual funds. The SEC may also recommend that 12b-1 fees be eliminated, arguing the rule helps funds hide distribution costs from retail investors. In a bluntly worded statement, SEC Chairman Bill Donaldson wrote, “Rule 12b-1 fees and directed brokerage quietly generate a lot of money for people in the fund and broker-dealer industries, and unlike some of our other proposals, this one is going to hit them where it hurts.” Interestingly, when he read the statement at the SEC's Feb. 11 meeting, Donaldson softened his language to say the proposals “will have a major financial impact on people in these industries.”
Either way, the statements are true. According to a January Lipper Analytics report, 12b-1 fees account for nearly $10 billion in annual expenditures out of fund assets to broker/dealers, and “thoroughly dismantling or modifying the rule would wreak havoc” on all aspects of the financial services industry. Boston-based Financial Research Corp. estimated that $1.5 billion in revenue sharing was paid by the top 50 fund families to broker/dealers. Meanwhile, an SEC official said 12b-1 fees totaled $13 billion in one year.
One executive at a nationwide broker/dealer says the loss of 12b-1 fees could be devastating. “We think it could be a major disincentive for brokers to sell A-share funds, which are often what are best for the client,” he says. “Without those fees, [reps] might be forced to move assets to places that aren't ideal.”
Where's My Money?
Banning directed brokerage won't kill the industry, but it will register at brokerage firms. Broadly speaking, broker/dealers collect around 20 basis points on annual sales from mutual fund companies and collect another 5 basis points or so trail on assets sold by broker/dealers' reps. That translates into millions of dollars annually paid by fund companies.
Industry analysts say that because the payments are not visible, quantifying industry averages or an individual fund company's total expenditures in this area would be extremely difficult. Analysts believe that 12b-1 may survive, but with enhanced disclosure, while directed brokerage is likely to be eliminated. “I think the SEC is going to do away with it,” says Andy Laperriere, managing director in policy research at the ISI Group in Washington.
“Directed brokerage is by far the most significant proposal made so far,” says Ted Siedle, president and founder of Benchmark Advisory Services, a consulting firm to institutional investors. “Directed brokerage is absolutely integral to the marketing of all financial products. If it goes, either brokers will make a lot less money selling funds, money managers will pay out more money from their own pockets or commission rates on institutional mutual funds will drop significantly.”
The SEC's proposal to ban the practice has come about, says Paul Roye, the SEC's director of the Division of Enforcement, because “the intense competition for shelf space” has created “conflicts of interest that have become unmanageable.” Furthermore, the disclosure requirements regarding directed brokerage are not working, because they're not uniformly obeyed, he says.
Meanwhile, in Congress, legislators are charting their own course to reform. Specifically, Senators Peter Fitzgerald (R-Ill.), Susan Collins (R-Maine) and Carl Levin (D-Mich.) intend to introduce legislation to get rid of 12b-1 altogether. For many, eliminating 12b-1 would represent a sizable loss in yearly income. One rep at UBS estimated that any broker with more than $50 million in assets under management would have 20 to 25 percent assets in some type of mutual fund. “If you have $10 million in just ‘A’ share mutual funds, that's $25,000 a year [25 basis points]. Thirty or 40 percent [payout] of that means you'd be losing $6,000 or $7,000,” he says, adding that ‘C’ shares paying 100 basis points would make the figure much higher.
A white paper on Fitzgerald's Web site says two-thirds of 12b-1 fees “end up in the hands of brokers. In other words, 12b-1 fees have become disguised loads.” Experts say the lost income will be recouped in some form. “If you get rid of 12b-1 fees, front end loads may simply go higher,” says Max Rottersman, president of FundExpenses.com, a New York research and education firm.
Meanwhile, though many reps think increased disclosure is beneficial, it is not surprising to find they share little optimism about other reforms.
“Brokers may start churning accounts to recoup lost 12b-1s,” said one Smith Barney rep, noting that switching from one fund to another is easily justified in many ways to the average mutual fund investor. “Or, they may put small investors in individual stocks…if there's no money for brokers in buying and holding mutual funds, the business will have to go somewhere else or die.”