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2012 Regulatory Outlook: Cost of Compliance Starts to Climb


Regulatory reform is about to exact its price.

Whether it's capital surcharges for fund companies designated as "systemically important" or dealing with new fiduciary rules for advisors and brokers or the much-feared reform of money funds, the bill is about to come due-and get paid.

At a time when the overall inflation rate hovers around 2.2% a year, 36% of fund firm executives polled by Money Management Executive expect their organizations' spending on hardware, software, education, training, consulting, staff and other expenses associated with regulatory compliance to increase by more than 10% in 2013. Another 41% expect their firm's spending to increase between 6% and 10% and another 20% expect it to exceed 2%.

But it's not only in regulatory compliance where the impact will be felt. There will be a ripple effect on making sure that portfolio management and other operations follow through on and stick with establishment investment policies.

Thirty-three percent of executives polled expect to see spending on technology, training, staff and other expenses that go toward maintaining compliance with investment policies to increase by more than 10%. Another 36% put the increase at 6% to 10% and another 20% put it at more than 2%.

These are the findings of the 2012 Money Management Executive survey on the fund industry's regulatory outlook. In October and November, 158 chief executives, operating executives, compliance officers and other senior managers of mutual fund, exchange-traded fund and other industry funds responded to questions put to them by Lodestar Research of Princeton, N.J.

The reforms that concern them the most may be surprising.

Topping the ranks?

Money fund reform? Nope.

Cost-basis accounting on fund shares? Not even close.

At the top of the list: the Securities and Exchange Commission's review of the use of derivatives by mutual funds and exchange-traded funds.

The federal regulator has initiated a review of such funds' use of futures, options, swaps and other derivatives, whose use has increased significantly in recent years.

The SEC contends this is beyond the relatively limited use envisioned by the Investment Company Act of 1940, which largely governs fund operations.

The fund industry has contended that the use of derivatives gives its investors broader exposure to different types of investments, such as metals, agricultural products and other commodities, in addition to stocks and bonds. And, in turn, help limit investment risks.

Fully 45% of respondents listed the SEC review of the use of derivatives as one of their five biggest regulatory concerns.

Next up: dealing with efforts to align the fiduciary duties of advisors and brokers to the customers to which they sell shares in funds. That effort, still under way, is of concern to 44% of respondents.

Then comes the provision of the Dodd-Frank Wall Street Reform Act which will place a capital surcharge on mutual funds or other fund companies deemed by regulators to be "systemically important." That was cited by 42% of respondents, not all of whom belong to firms that could be considered, in the lingo of financial stability overseers, "systemically important financial institutions."

Then comes a flood of concern about money market mutual fund reform, which the industry thought the SEC had dropped in August, but has come back onto the front burner, also due to concerns about market stability. The Financial Stability Oversight Council re-introduced a series of proposals for letting the net asset value of such funds float or introducing capital buffers against runs on the fund. They are largely variants of the proposals that the SEC dropped, earlier in the year.

The biggest concern, cited by 37%, is that regulators might allow or require the $1 a share value of the assets in a money fund to float. That would formally "break the buck" promise made to investors, that led to a run in the first place in 2008. The foundation of such funds is the idea that an investor can expect to get $1 back for every dollar put in, like a bank account.

Of the executives polled, 35% feared what systemic regulators might do; and, 27% still worried about the SEC taking action. At this writing, it's not clear exactly which regulatory body will carry the cudgel, but it is the SEC which has rule-making power.

And never going away is the concern that change is coming to marketing and distribution fees that funds can charge. These fees once were considered to help lower costs of funds by helping achieve scale, but have become vehicles for paying commissions. Critics charge the fees do nothing to actually enhance performance of a fund.

Whatever the pros and cons, 37% of respondents say they are concerned about the elimination or restructuring of such 12b-1 fees.