Cerulli Says Change Ahead, Needed for Revenue Sharing Practices

February 8, 2005 (PLANSPONSOR.com) - Although it has faded from the headlines of late, current revenue-sharing practices remain a concern of regulators, and seem likely to undergo change in the near future.

A recent report from Cerulli Associates, titled “Mutual Fund Revenue Sharing:   Current Practices and Projected Implications,” explores the manner in which various firms are preparing for additional transformation to current revenue sharing practices.   Change is already underway, of course, though Cerulli says asset managers and distributors are making changes for a variety of reasons.   Some have done so due to regulatory enforcement activity, while others have undertaken voluntary proactive measures, and still others have “succumbed” to critics and media pressure, or made the same adjustments as their peers to stay competitive.

Cerulli notes that most asset managers feel compelled to pay revenue sharing, although a minority feels it helps reward their top distributors, and even—in some cases—motivates weaker distributors to sell more of the vendor’s funds.   In fact, according to Cerulli, more than half of advisors place at least 11% of their assets – and often more – with their broker/dealer’s”preferred” or “strategic” partners, raising concerns about a pay-to-play environment.

Cerulli notes that competition for spots on shortlists among distributors is “intense,” with the majority of such subsets holding less than 30 funds, each of which can expect to receive, on average, three times the inflows realized by funds excluded from the shortlist.   Cerulli says that in some cases flows can multiply tenfold.

Disclosure Closure?

With disclosure widely touted as a potential panacea for the perceived “ills” of revenue-sharing, some firms have moved to proactively disclose those arrangements.   Cerulli notes that, “…significantly, 47% of advisors said they would be reluctant to sell ‘preferred’ funds if regulators required disclosure of that status.”   However, so long as disclosure stops short of spelling out the exact remuneration on one fund versus the next, investors will not fully understand the conflicts of interest, Cerulli asserts.   In fact, Cerulli says the “situation may be more serious in the 401(k) world, where 85% of plan sponsors say that disclosure is not enough—they want their providers to be free of conflicts of interest entirely.”

The report also says that asset managers “grudgingly admit” that some revenue sharing payments do pay for the distributor’s support services, the most valued of which appear to be investor education initiatives – and that broker/dealers wisely have moved these to the front of their arguments to charge revenue sharing.

In fact, Cerulli says that revenue sharing in the defined contribution world may be more defensible than in the retail world, as servicing costs are much higher – and ERISA and fiduciary concerns might drive the retirement marketplace to change faster or further than the retail world, according to the report.   CA research shows that consultant usage has grown at a 34% rate during the past five years, and their familiarity with these arrangements means that they can help plan sponsors dictate the terms of the relationship and choose the investment lineup, according to Cerulli – though there is some evidence to suggest that consultants also have come up short in terms of disclosure, especially regarding preferred managers and conference revenues (see  Mercer Investment Consulting Ends Global Membership Group ).

Cerulli notes that, even though industry critics are quick to pass judgment on the industry's ethical practices, such decisions have been difficult to make, especially in the absence of comprehensive studies.   Still, the firm cautions that lawsuits over different management fees for different client types should be watched closely, and notes that evidence that revenue sharing raises expense ratios may be overstated.   The latter, Cerulli says, is especially true if some institutionally-priced funds pay some level of revenue sharing.   In fact, the report says that "The cost and scale of revenue sharing through intermediaries likely would be dwarfed if fund advisors had to build out their own direct-sales arms."

Additionally, small retirement plans stand to lose if revenue sharing or 12b-1 fees are "compromised" - a situation that Cerulli notes would be "a widespread problem, as 75% of plans have less than 50 participants."   Moreover, sponsors of small plans wear many hats and are much less sophisticated than their large plan counterparts - and thus "are more susceptible to pricing increases," according to the report.   Both "quality of service and investment choices stand to suffer as many vendors would seek to shed themselves of unprofitable small plans," according to Cerulli.

All in all, Cerulli opines that shareholders will see a rise in expense ratios and hard-dollar fees as a result of the current focus.   Moreover, the report cautions that disclosure "…could become somewhat onerous, causing investors to seek other products or give up on investing entirely."

As for the road ahead, Cerulli says, "The future is now: especially in the area of disclosure."   While the report says Merger and Acquisition activity should increase, Cerulli notes that, "While some firms have been forced out of the business, this has been due not purely to compliance costs, but also due to poor performance, lack of brand name, or lack of distribution," and that some "…will not exit the business but pursue subadvisory relationships or fund adoptions."   Cerulli says that the business is highly concentrated, to what the firm terms "an unhealthy degree," with the top four firms accounting for a majority of inflows.   While the reasons for this are varied (good performance, good reputation, and skittishness on the part of investment advisors), Cerulli says that potential regulatory changes to revenue sharing, 12b-1 fees, and preferred lists would have "different effects on each of these top firms."  

Additional disclosure also should make revenue-sharing payment levels converge, but a sudden sea change toward equality is unlikely, according to Cerulli.   "The rise of R-shares demonstrates that certain accounts or channels require different rates of remuneration," according to the report.   Ultimately, Cerulli notes, "Might makes right: Larger asset managers may resist this convergence."  

Cerulli suggests that potential changes to business practices could include the following:

  • Shortlists may be severely compromised, and disclosure will be mandated, not only in terms
  • of compensation arrangements, but possibly in terms of their influence on fund flows.
  • Firms will employ more vigorous profitability analyses, and asset managers have more incentive to employ such analyses
  • Asset managers and distributors need to develop a better understanding of each other's problems, since distributors tend to ignore the economic feasibility of asset managers' revenue sharing payments.
  • Finally, with compressing margins among distributors and a greater regulatory focus on
  • due-diligence meetings, the quality of research offered to shareholders may suffer.

For more information on the report, contact Ben Poor at 617-437-1098 x148, or bpoor@cerulli.com