The mutual fund scandal seems likely to usher in regulatory reform that goes beyond the late traders and market timers, beyond the hedge funds and fund managers who enriched themselves through insider trading, and beyond the fund companies themselves that were complicit in unethical behavior. The scandal seems likely to change the way independent broker/ dealers conduct their business, and it is likely to affect the way many B/Ds price themselves to reps, i.e., your payouts.
Like it or not, undisclosed dealings between B/Ds and fund companies are going to end. The dirty little secret of the independent broker/dealer business, which is arguably not so secret, not so little, and not so dirty, is that independent B/Ds derive much of their revenue from mutual fund company shelf space arrangements. In fact, that idea--of making money by giving marketing access to a field force of reps--is commonly applied beyond funds to other products and services that reps need, separate account platforms, software vendors, and other services and products. These arrangements help allow a B/D to offer 95% or 100% payouts. The B/D, instead of relying totally on money paid to them by their reps, also relies on revenue from these marketing deals. These marketing arrangements subsidize rep payouts.
Regulatory reform that many observers expect to be imposed as a result of the spreading fund scandal, however, seems likely to spell an end or, at a minimum, a curtailment to these undisclosed payments fund companies make to independent B/Ds. B/Ds and fund companies are likely in the future to be required to disclose these arrangements. That dose of transparency could lead to a repricing by B/Ds. If they can no longer get revenue on these fund company marketing deals, a key revenue source for many B/Ds, then they'll need to lower payouts and, effectively, raise the price reps must pay for their service.
B/D executives, while acknowledging that sweeping reform and greater disclosure are likely, make a strong case that it's unfair, and that it won't even help investors. It's fair to say that many B/D executives and reps would not welcome reform, but their voices are likely to be drowned out by the cry for fuller disclosure.
The Shape of Reform
As regulators and lawmakers contemplate reforms to be enacted, even as the fund investigation widens and ensnares more firms, a public discussion about the shape of the reforms and how they might affect the independent advisor industry is wise for B/Ds and reps. Personally, I think fuller disclosure of these marketing arrangements is a good idea. But that's my personal bias. I'm a reporter. I like everything out in the open. I believe that advisors can't build trust and long-term relationships when a part of the terms with their customers is not disclosed, and that advisors should be on the same side as investors and investor protection. Those notions are probably a lot more reflective of where rulemakers are headed and what the public will demand in the coming weeks and months as the cries for reform grow stronger. This column should facilitate that public discussion, even if it agitates some of my friends in the industry.
First, it must be said that, when it comes to ethics, independent B/Ds own moral high ground that the wirehouses generally cannot yet reach. Independent reps can be proud of that fact, and leverage it in marketing, sales, and trust-building.
Wirehouses sell house brands, their own mutual funds, rather than other fund families. They double dip, making money not just on the sale but on the management and operation of the fund. That's best for the brokerage house. Often, when the wirehouse makes more by selling one product, the broker also makes more on the sale. Wirehouses also cut lucrative deals with fund companies to sell their products, and as part of that deal a broker's compensation may be materially higher for selling those favored funds than it is for sales of other funds. And then there are directed brokerage commission deals that fund companies give to wirehouses. These are key differences between independent reps and wirehouse reps, and customers would seem to have a right to know about these differences.
For independent B/Ds, fund company marketing deals are not as objectionable but do raise some questions. Some of the fund companies pay B/Ds an annual fee based on assets under management with the B/D's reps. In some cases, the B/D gets paid by a fund company to sponsor a conference, a golf outing, or a luncheon speaker. Ads in newsletters, ads in e-mails, and easy access to the reps at B/D gatherings--fund companies thus buy influence. Is that okay? Should that be disclosed to clients? In fact, should those terms be disclosed to reps?
Most executives at independent B/Ds make a case against it. And I have to admit that, despite my personal bias toward full disclosure, they make a convincing case.
Jeff Auld, for instance, president and CEO of NEXT Financial Group in Houston, is clearly an honest man trying to do the right thing in running his B/D. "NEXT has selling agreements with 110 fund companies," says Auld. "And if an advisor comes to me and tells me that we are missing a good fund, we'll have 111. With anything that we do in terms of commission payout or payments, never do we bias or in any way influence the sale of one product over another."
Joe Deitch, chairman and CEO of Commonwealth Financial Network in Waltham, Massachusetts, says there are practical reasons the industry has moved to shelf space deals, and there is nothing deceptive about it. "Say a brokerage firm with no intention of being deceptive or unfair is having a conference for its reps, and there is booth space for 10 fund companies," says Deitch. "There are thousands of funds and hundreds may want space at a booth. Do you give it to the biggest funds? The ones with the best three-month track record? The best three-year record? Do you sell the booths to the highest bidders? Should there be a lottery?"
As a consequence, Deitch says, B/Ds must come up with a short list of fund families. "It's just a matter of being practical," he says. "Ultimately, though, it comes down to good judgment and not abusing the system."
"Is the brokerage firm merely selling space to the highest bidders or is the B/D adding other incentives?" he says. "That's the issue: Where does the B/D draw the line?" And Deitch says the "truly" independent B/Ds are not the problem. "Brokerage firms and other institutions owned by product manufacturers who influence their agents and customers, overtly and covertly, have more serious disclosure issues," he says.
Access, Not Guarantees
Auld says he understands why fuller disclosure might be needed when a rep gets compensated better for selling one fund than another. But the marketing deals NEXT makes with fund companies is totally different.
"I would like to be able to tell a fund company to sponsor our conference or advertise in our newsletter and that they'll be the best-selling mutual fund in our firm," says Auld. "But the truth is, it isn't necessarily so. And I can show you where a fund company that has almost made no effort to get a booth, sponsor anything, and that spends the least amount of marketing dollars with NEXT, is the number-one-selling fund company with our advisors."
"I can no more guarantee that being a sponsor of my conference or advertising in my newsletter will give the mutual fund company results than your magazine's ad sales department can guarantee that running a full-page ad on the inside cover of your magazine will create direct results," Auld says.
The argument is convincing, but why would fund companies keep doing the marketing deals with B/Ds if they did not show results? If such arrangements were not effective, fund companies wouldn't be doing them. So, if they do help influence sales, should they be disclosed?
Auld argues that it is unfair to require disclosure because it is just advertising. He says a double standard is applied to no-load funds versus funds with loads. "Look at what no-load funds spend on advertising," he says. "Doesn't that affect an investor's decision about how much to put into his 401(k)? Of course it does."
"So if a fund spends more with Money magazine and more investors buy shares in that fund because they see that ad or the fund company has brand recognition, are we going to have more disclosure about the fact that that no-load fund company spends so much at Forbes, and so much on TV ads? At what point will the rules say that a fund company has spent too much and bought too much influence through its marketing?"
Auld makes a good point, although sales of no-loads are self-directed. A consumer is actively picking up a phone and buying something on his own. That's different from a rep selling an investor a fund.
One of the other arguments I heard from B/D executives against greater disclosure is that auto salespeople don't have to tell you about their commission arrangements. For some reason, the auto industry was mentioned repeatedly. But is that a good analogy? Yes, cars are expensive, but when you go to a financial advisor, your entire life savings could be on the line. Moreover, the government, i.e., Congress, has set rules and regulated the financial services industry. And from the very start of securities market regulation in the post-1929-market-crash era, along with the creation of the Securities & Exchange Commission in the Securities Act of 1933, mutual fund companies were explicitly required by law to be publicly registered with the government. Selling cars just wasn't the same as selling investments, Congress figured, after investors lost 50% of their wealth in the Great Crash and so much of the middle class was left homeless by the Great Depression.
Successful B/D executives like Auld and Deitch know all this, and know that the current fund scandal is likely to change the business. "There will be more disclosure," says Deitch. "I think it's reasonable to assume that." So the next question is what form will it take? How will it change the independent advisor business?
Regulation Equals Lower Revenue
"Revenue will decline in direct correlation to the amount of regulation added," says Auld. If the reform brings burdensome disclosure rules, the effect will be amplified. For instance, say if fund companies and B/Ds have to provide all investors with printed notification annually about the fund companies they have sales agreements with and the terms of those agreements, and that they will be required to mail that disclosure to every customer every year, and track the notifications and the changes to marketing deals, the financial burden may spur the fund companies to spend their marketing dollars elsewhere. The B/Ds would likely lose an important source of revenue, says Auld.
If you consider that as the worst-case scenario, the impact on the independent advisor business would be significant. B/Ds would stop offering 90%-plus payouts and have to charge reps for their services in other ways. Undoubtedly, B/Ds would adjust to a new pricing model.
Doug Durrie, a VP at QA3 in Omaha, Nebraska, says some independent B/Ds have in recent years already moved away from the high-payout pricing model and made their businesses less dependent on marketing deals. In fact, Commonwealth and NEXT do not market to reps based on high payouts, and emphasize value-added services.
"When a B/D competes based on payouts, it commoditizes itself and there are no margins because you cannot differentiate yourself," says Durrie. Durrie says the trend for B/Ds to provide value-added services is likely to accelerate if reforms weaken the revenue B/Ds receive from fund company marketing deals.
"With the service model, B/Ds compete by offering practice management support to help the advisor build his practice," says Durrie. "Independent advisors don't have people to collaborate with. Their expertise is not in building a small business but in selling and in financial advice." Durrie's firm, ironically, was founded by Steve Wild, who was one of the first to market the 100% payout price model to advisors after he founded Securities America in 1985. (Securities America, which is now owned by American Express, no longer offers 100% payouts.)
B/Ds hooked on high payouts for attracting reps and that are competing on price have a difficult time switching to the service model, says Durrie. It requires a change in a B/D's support staff to acquire experts in practice management and financial planning instead of experts at processing business efficiently. That's an up-front investment B/Ds need to make while cutting payouts to their reps, a tough business transition that could take many months.
Durrie says most independent B/Ds combine the price and service model already, but expects more firms to move toward the service model as a result of the fund scandal and reforms. "You're already starting to see some changes in that direction in the last few years," he says.
However, because of the fund scandal and likely reforms it will inspire, change is likely to be industrywide. If greater disclosure threatens an end to the high payout model used by a B/D, all of the B/Ds will suffer the same disadvantage. "That should actually make it easier for them to move payouts lower without losing competitive ground," says Durrie.
My guess is that any new disclosure rules will not be so burdensome and will not cause a total overhaul of the B/D pricing and payout model. But some change is likely and it could be disruptive. Small B/Ds that can't make the transition to a new pricing model could be gobbled up, and the B/D consolidation wave of the late 1990s may gain renewed momentum. You may have to pay more for your B/D relationship, and B/Ds may need to provide more services to reps to differentiate themselves. Other changes in the business are impossible to predict but reps and B/D executives probably need to think through what it will do to their businesses.
On the bright side, fuller disclosure could make some reps feel better about their client relationships and create more trusting relationships with clients. Reps will be better able to compete with fee-only advisors, who can today use nondisclosure of such deals in marketing. Investors will simply have greater transparency about the way you charge for your advice service, and that is probably a good thing. In fact, reps will have better transparency about the way their B/Ds charge them for services. So even though the headlines about mutual fund abuses keep coming almost daily, it's probably going to be just fine for all of us.