Mutual fund companies already beset by poor performance in a lengthy bear market and competition from hotter products like managed accounts and exchange-traded funds now face hits in revenues and costs as regulators tighten the screws, and smaller companies may be forced to sell or liquidate, observers say.
The Securities and Exchange Commission's vote Wednesday to ban fund companies from directing business to brokerage companies that promote the companies' funds was the most recent of the moves that are expected to impose an aggregate 14% increase in costs on the fund industry and trim revenues by 10%, according to Financial Research Corp.
These changes in the industry's revenue and cost structures would have reduced the $12.7 billion aggregate profit in 2003 to $6 billion, Financial Research said.
"These reforms will speed up the process of change that is going on in the industry," said Art McPherson, an editor at FRC. "The margin squeeze has been there. These reforms are just tightening the vice a little more rapidly. When the money gets tighter it is hard to try a new fund, it is hard to hire, and you have to look closely at the money you spend."
The SEC estimated that the 54 million U.S. households that invest in mutual funds would each pay more than $55 per year to defray the cost of the regulations, and the Securities Industry Association predicts the cost could be as high as $125 per household per year.
Merrill Lynch & Co. analysts estimated that discontinuing deals for shelf space, marketing fees, and directed brokerage would cost the fund industry $1.2 billion.
The issue of directed brokerage came to the forefront this year when Massachusetts Financial Services agreed to pay a $50 million penalty for failing to disclose payments to brokers for promoting its funds.
Gavin Little-Gill, a senior analyst at TowerGroup, said the end of directed brokerage is not good for the fund industry as it tries to regain its footing after the bear market and trading scandals.
"No one thinks it is awful for Wal-Mart to negotiate pricing deals with a Chinese toy company," Mr. Little-Gill said. "No one minds frequent fliers receiving perks and upgrades. There is not a fundamental difference between these and deals in the fund industry. We have to provide the best customers with premier services."
Geoffrey Bobroff, the president of Bobroff Consulting in East Greenwich, R.I., said all that Wednesday's SEC vote accomplished was to force fund companies and brokerage firms to come up with new arrangements. Brokerage firms can still take hard-dollar revenue sharing payments, he noted.
"Revenue sharing still exists; the SEC hasn't outlawed fund companies' paying brokerage firms; they have just eliminated a way to make a payment," he said.
Mr. Bobroff said the directed brokerage ban could, however, affect the financial ability of midsize and small firms to compete with larger ones that can pay for shelf space. And this should lead to more consolidation and liquidation, he said, though most small firms continue to hang on.
Stuart J. Kaswell, a former senior vice president and general counsel at the Securities Industry Association and now a partner in Dechert LLP's financial services group, said the new regulations are appropriate because companies would rather comply up-front than face the possibility of an enforcement action.
"There are standards that the securities industry and the fund industry are held to that no one else must follow," he said. "We are held to different standards because we are talking about people's money ...Brokers should be recommending funds that are good for you, not just good for their pockets."
Both the Investment Company Institute, the trade association for the $7.6 trillion mutual fund industry, and the Securities Industry Association, the trade group for the brokerage industry, supported the directed brokerage ban, but other analysts worried that the impact of this and other regulations could handcuff the fund industry.
Since New York Attorney General Eliot Spitzer announced action against fund trading abuses last September, the SEC has proposed 13 regulations and voted on 10, approving six. SEC Chairman William Donaldson said Wednesday that he expects the commission to decide on the remaining three proposals this year.
In December, the SEC adopted a regulation requiring fund providers to develop comprehensive compliance policies. These policies, which must be in place by Oct. 5, would require registered investment advisers to appoint a chief compliance officer, enforce policies and procedures to prevent and detect violations of applicable securities law, and evaluate their investment programs annually.
Mr. Little-Gill of TowerGroup said smaller banks and fund companies may not be driven out by the costs of new regulations but rather by the reputational risk.
"If I am small firm and mutual funds are 10% of my business, you have to look at the reputational risk of selling funds," he said. "Firms have to stop at some point and say, 'This is just too scary. If this 10% goes down the tube I run the risk of losing the other 90% of my business.' That could drive people out of the business."
Mr. McPherson of Financial Research Corp. said cost has been an issue for small and midsize fund managers for a long time. The regulations may level the playing field, though, he said.
"In an environment like what we had three years ago, some smaller companies couldn't compete on price, but they can always compete on performance," he said. "As firms can no longer create breaks with brokerage companies and can't reduce fees based on volume, the emphasis is on performance, and that is beneficial for smaller companies."
The reforms may not lead to a complete upheaval in the mutual fund industry, Mr. McPherson said, but executives should be prepared for "semi-major" changes in the next three years. "There is going to be a financial impact that will impact fund companies' profit margins," he said, "and that is going to affect who will stay in this business and to what extent."
Companies will merge some funds, liquidate others, and look to subadvisers to manage portions of their business, Mr. McPherson said.
"It will be hard for every fund company to have the fund for every person," he said. "The money just isn't pouring in anymore. We have managed accounts, exchange-traded funds, and multiproduct platforms. Everyone is aiming for the same customer, and running mutual funds is becoming more costly. Everyone needs to change their approach."
Large companies like Bank of New York Co. have improved the transparency of their fund operations in response to regulatory pressures. On Wednesday, Bank of New York enhanced its commission management portal to improve reporting transparency.
