MFS Investment Management and Morgan Stanley's announcements in March that they will no longer pay soft dollars to brokerages for third-party research might be the snowflake that causes an avalanche.
Many observers believe the announcements signal that a vital broker/dealer revenue stream is about to evaporate, with unknown consequences on brokers' pockets. While it's true that brokers “eat what they kill,” a poorer broker/dealer isn't a good thing. As one Raymond James rep puts it: “Whatever takes money away from my firm takes money from me.”
MFS, still stinging from a $225 million fine in February to settle improper trading charges, essentially moved to beat regulators to the next punch by self-banning practices it saw as likely to soon fall out of favor with industry overseers. MFS' move amounted to a challenge to other funds, and Morgan Stanley's asset management group was the first to answer the call (an ironic early adopter, to be sure, given that Morgan's bread-and-butter lies in businesses on the other side of the soft-dollar arrangements).
Both companies have taken a calculated risk. “Five years down the road, if everyone's still paying soft dollars, [MFS] is going see some huge problems,” says Rachel Barnard, an analyst at fund tracker Morningstar. That is to say, if no one follows MFS' and Morgan's lead, their insistence on not paying the soft dollars would surely cost them sales to funds with no such qualms. But given the growing concerns that funds pay the soft dollars not out of their own pockets but from their shareholders', and with the SEC considering the issue and expected to release a ruling in May, most observers think MFS and Morgan have made the right choice.
The risk to the brokerage firms, however, is immense. Last year, the top 50 fund families paid $1.5 billion in revenue sharing to broker/dealers, according to Boston-based Financial Research Corp. It's difficult to strip out exactly what percentage of that was soft dollars for research, but several fund firms estimate that the top 50 fund families pay somewhere between $25 million and $50 million each in soft dollars and directed trades.
“I would expect broker/dealers to be very cautious about this in the beginning,” Barnard says, adding that some might even try to send out feelers to other broker/dealers to see what they're saying their charges will be. “This could be a big, big deal. If brokerage firms lose the revenues that some of those soft dollars provide, they'd have a serious problem on their hands.”
Neal Nakagiri, president and CEO of Los Angeles-based Associated Financial Group, which employs 265 producing reps, agrees. “For those broker/dealers that use those moneys for who knows what, it's going to affect every program they have,” he says. “You'll see people cutting from broker education, recruiting, conferences, whatnot. You have to make up that revenue lost from somewhere, unless you're just comfortable with a smaller profit, which I don't think most are.”
If soft dollars and directed brokerage were banned or simply refused by other mutual funds the way they have been by MFS and Morgan Stanley, firms heavily weighted in the mutual fund arena — like Edward Jones, which takes 41 percent of its revenue directly from the mutual fund industry — could suffer considerably. (The SIA estimates that the industrywide average is around 27 percent.) “In a lot of cases, more than half their trading fees would be gone,” says Barnard. “That would be devastating.” Even before MFS' announcement, Massachusetts-based TowerGroup was estimating that soft-dollar spending would drop more than 11 percent over the next five years.
Still, despite MFS' move and the hovering threats from regulators, there are those who can't see soft dollars going away anytime soon. Many industry observers suspect that even if soft dollars and directed brokerage activities are banned, firms will find a way around it, perhaps offering incentives in fund packages that fall outside of whatever regulators determine as “research.”
Or, even if that doesn't happen, there could be a semirevolt amongst clients when, thanks to full disclosure, they see expense lines that weren't there before. (That's not to mention the possibility of fractured relationships between the mutual fund companies and brokerages, though MFS says so far it hasn't experienced any “backlash.”)
“We don't see it going away,” says Todd Buechs, research associate at Sanford Bernstein. “There may be a more stringent look at where the soft dollars are applied, maybe more reporting, but we don't think those firms want it to go away.”
But it's clear something is on the horizon. Other mutual fund companies have confirmed they're at least considering a move like MFS'. If a rush of regulation follows, it could be a very different world. “The worst case scenario is just a vacuum of dollars out of everybody's pocket,” Morningstar's Barnard says. “Less money will be spent, and everyone will feel a serious pinch. It's a very real possibility.”
Likewise, it's a real possibility that brokers end up shouldering their share of the financial losses. “Listen, my firm could have a whole segment of income just go away. Who do you think is going to end up making up for it?” asked one A.G. Edwards broker.
“Me, that's who.”
