Summary

“Is mutual fund direct business a viable option for our firm?” remains an important question for broker-dealers to ask. This article provides a framework to help find the answer.

Simply put, direct business involves transactions between a broker and a mutual fund company. In recent years, broker-dealers have limited — even discontinued — this practice, and have consolidated fund assets onto brokerage platforms. This industry-wide shift was largely a reaction to DOL Fiduciary Rule hysteria, which, although the regulation was struck down, many firms proactively made significant changes to their business models in order to comply with the rule.
Yet, mutual fund direct business is not a well-understood model within the industry, and firms should understand their service options. Direct trading can reduce costs, help attract and retain top-performing advisors, and improve the bottom line. As your firm examines current costs, advisor compensation plans, and business models consider (or reconsider) whether direct trading is a viable option. This article covers the basic mechanics of how direct business works, looks at the benefits and costs, and concludes with key considerations.

Direct trading can reduce costs, help attract and retain top-performing advisors, and improve the bottom line.

How Mutual Fund Direct Business Works

On the surface, mutual fund direct business is simple. On behalf of their client, the broker buys mutual fund shares directly from fund companies. These assets are held directly at fund companies versus a brokerage account. Typically it is carried out in the following ways:

  1. Check and App  This is the “old fashioned” method. The advisor completes a paper application, then the investor signs the paperwork and writes a check. Then the paperwork and check are sent directly to the mutual fund company.
  2. Wire Transfer  The broker-dealer arranges for an electronic transfer from an investor’s account to the mutual fund. In some cases, firms use a special holding account for all transfers. Typically, the paperwork applications are transmitted when the funds are transferred.
  3. Fund/SERV  Although Fund/SERV clears mutual fund transactions and is not a pure direct business option, it deserves mention here because broker-dealers can use it to manage their mutual fund transactions. It is a basic platform for mutual fund transactions offered to NSCC members, which is compatible with other NSCC services.

Most broker-dealers use some or all of the above mechanisms, along with clearing firms, for managing mutual fund transactions. The complications associated with directly held mutual fund accounts — which prevent some firms from expanding direct business or even considering the option to use it — revolve around managing the numerous reporting and compliance requirements that are normally handled by a clearing service.

Benefits of Mutual Fund Direct Business

  • Direct access to mutual fund’s customer services.
    Clearing firms often hold “omnibus” accounts for mutual funds, which means that individual investors officially have accounts with the clearing firm, not the mutual fund. In such cases, investors — and their advisors — usually don’t have access to a mutual fund’s customer services. Direct trading, which establishes an individual account at a mutual fund for each investor, gives the broker-dealer secure access to that fund’s customer service for the investor and advisor.
  • Tax reporting responsibility.
    The fund company generates and sends out tax statements, which means that the broker-dealer does not have to pay the per-mailing fee charged by a clearing firm.
  • Simplicity for advisors.
    Direct trading allows advisors to set up accounts directly with mutual funds and thus bypass the extra steps involved in setting up an account with a clearing firm, which is especially helpful when establishing smaller and simpler mutual fund accounts.
  • Smaller fees.
    Postage and wire transfer fees are the most significant direct expense associated with direct business mutual fund transactions. However, these fees are often much lower than a clearing firm’s per-transaction fees. Direct business also frees broker-dealers from costs associated with maintaining accounts with clearing firms.
  • Less ongoing costs.
    Committing to a clearing firm for mutual fund processing means committing to their fee hikes or the expense (and hassle) of switching providers.

Costs of Mutual Fund Direct Business

The central cost of direct business to broker-dealers is a technology platform and a back-office system that carries out functions customarily done by clearing firms. They need, in other words, to utilize a financial technology solution that does the following:

  1. Interfaces with multiple mutual fund companies.
  2. Tracks commissions, advisor information, and dozens of other data points associated with mutual fund transactions.
  3. Aggregates account data.
  4. Generates reports, notifications, and alerts for ongoing monitoring and internal and external audits.

Purchasing, installing, maintaining, and updating such a system in-house is, of course, capital intensive, both in terms of dollars and employee hours. By contrast, a technology outsourcing partner furnishes access to a turnkey product. Subscribing to a hosted service usually does not require much of up-front capital investment. However, ongoing payments, need to be taken into consideration. A firm conducting direct business also needs to train advisors to use different investment platforms, even in the process of serving a single investor. In addition, direct business requires a stable relationship with an established financial technology solution provider.

Key Considerations

Our research has shown that the following three broad questions are common among firms who have considered conducting direct trading for some portion of their mutual fund business:

Is mutual fund direct business even possible for our firm?

Do you have the industry expertise to utilize it effectively?
What is your level of confidence in your internal systems?
These are probably the most critical questions. Today’s regulatory environment — and, in all likelihood, tomorrow’s as well — leaves a tiny margin for error when it comes to breakpoints, suitability reviews, and other compliance mandates associated with mutual funds. The consequences of inaccurate data or deficient supervisory processes can dwarf any advantages gained by direct trading.

The consequences of inaccurate data or deficient supervisory processes can dwarf any advantages gained by direct trading.

How much does direct business cost in real dollars?

The answer primarily depends on the number and size of mutual fund transactions a firm handles each year. In general, a large number of smaller mutual fund transactions may make a clearing service exceptionally expensive. But services to advisors and customers also need to be considered. Clearing firms can manage mailings and other notifications, for example, but at a price that can be higher than the postage and employee-hours a firm would have to pay.

We’ll note here that it is difficult to find comparative pricing information for clearing services outside of direct negotiations with clearing firms themselves. Fees for bank services, mutual fund accounts, wealth management advice, and many other financial services are accessible, but expenses associated with clearing services remain opaque at best.

How much does direct business cost in employee hours?

Direct trading requires not only a reliable provider of financial technology solutions, but adequate personnel that understands the trading platform, reporting systems, compliance requirements, and other details intrinsic to mutual fund transactions. On the other hand, broker-dealers using clearing services need to manage clearing firm accounts and provide customer service that a mutual fund would generally provide. In terms of compliance, regulations require that firms offer the same suitability oversight for both options, so neither is a time-saver.

Conclusion

When considering direct business, a firm also has to factor in its goals for mutual fund transactions and its overall business plan. In some cases, using direct business for more mutual fund transactions can free up capital to invest in marketing and new services for investors. In other cases, using (or staying with) a clearing firm for the majority of mutual fund transactions ensures that staff can invest time in generating new business among existing and potential customers.

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