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Fund House: Right Ranch, Wrong Horse

Dodd-Frank will change the way asset management products are created and generate more work for financial advisors. There will be some good consequences and some bad.

We are now living in the land of product management by legislation. Our recent review of new regulation, both proposed and passed, turns up work on all of these issues: 401(k) fee disclosure; money market funds; public pension plans; transparency of derivatives trading; 12b-1 fees; RIA, hedge fund, and private equity advisor registration with the SEC; tax treatment of carried interest; target date fund disclosure; oversight of indexed annuities; and universal fiduciary standards. This list will grow. We are as sure of this as we are of the existence of death and taxes.

Proposed regulation in each of these areas is documented by hundreds of pages of notes that demonstrate legislators' lack of insight into the industries the regulations would impact. Hundreds more pages will be produced as each agency and committee works through the details. So we'll save you the trouble of reading all of that and outline specifically how we see all of this actually touching the lives and businesses of financial advisors and their clients.

The bottom line? There isn't as much meaningful change at the consumer level as we might have expected. None of the new proposed regulations addresses creating and communicating (and perhaps rating?) higher risk/return products, or what total fee/commission levels are actually appropriate for different types of products and asset classes, for example. I think these would have more impact than “Financial Literacy” — part of the Dodd-Frank bill — and something industry pros know simply does not work.

So Much Legislation, So Little Time

A few of the proposed measures will certainly have wide-ranging impact. In the accompanying chart below you'll find a summary of some key elements of the legislation currently under way and how they could impact financial advisory clients.

The law of unintended consequences suggests that despite everyone's best efforts, and sometimes because of them, the new rules will solve certain problems but create new ones. We'll all find out about this together in real time.


Regulation changes for Nationally Recognized Statistical Rating Organizations (NRSROs) in the Dodd-Frank bill — calls for methodology disclosure, management of conflicts of interest, SEC de-registration authority, reduces requirements to use ratings, adds independent boards, development of a new mechanism to prevent “shopping” NRSROs for the best ratings.

Changes to SEC Rule 2a-7, which governs the investment standards and operational requirements for money market funds. Proposed rule changes call for increased credit quality, anticipation of liquidity needs, shortening of duration, ability to process trades at dollar amounts other than $1.00 (allowing funds to break the buck by design). A contradictory measure suggests there is no need to rate ABS securities.

Rule 12b-1 changes — The proposed rule changes actually eliminate 12b-1 and create Rule 12b-2. The new rule allows for an asset-based fee for distribution with a maximum of 0.25%, and constrains the total cumulative sales charges investors will be allowed to pay for a fund share class.

Potential Impact

This area of regulation could actually drive a lot of change. Forcing a higher quality process for rating securities will in turn drive the development of products that need to survive and thrive under more stringent review. We see product quality improvement for rated products as a potential outcome.

On its face this seems to be a sensible approach to reducing risk in money market funds. Ultimately this will drive yields down (remember yields?) for money market funds and may prompt the development of shorter duration, high quality bond funds.

Lots of noise about this one, but we see it having broad impact in only a few select areas. There are certainly plenty of 12b-1s over 25 bps (R Shares are the best example, which are generally in the 50 bps range to cover advisor support for retirement plan participants). Those will have to go away and be replaced by another way for advisors to be paid, and/or will drive a change in business model for the distribution of retirement plan advice. The new constraints on the total cumulative sales charges will take long-term use of C shares completely off the table. They also create a fairly massive operations project for fund complexes - there are some timelines and grandfathering provisions to allow for implementation. We wonder if the regulators will also see the opportunity to review total front-end sales charges on certain other types of products (think insurance, closed end funds, etc.). Overall, this change continues the ongoing march to narrower margins available to pay for financial product distribution.

Writer's BIO:

Lisa Cohen, CEO of Momentum Partners, is a founding member of the RepThinkTank, a consultancy joint venture with Registered Rep.

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