How much will the fund industry reforms now being considered by regulators cost? A report written by a pair of Merrill Lynch analysts released Monday estimates that reform-related costs will slice operating margins up to seven percent. However a three percent hit is the more likely scenario, wrote sell-side analysts Guy Moszkowski and Cynthia Mayer.

In their 40-page report, Moszkowski and Mayer predicted the likely outcome of SEC reforms and calculated the cost to the fund industry.

Their conclusion? Possible fee reductions are the biggest variable. Managers at scandal-tainted firms will be forced to lower fees, but the pressure to the rest of the industry may be more indirect. Those reduced fees could take the form of increased disclosure and more independent directors.

"Despite these pressures, we think most investors will continue to focus on performance and brand first, and fees only secondarily if at all, and this will relieve asset managers of one key pressure point" the analysts wrote.

In their hypothetical worst-case scenario, the analysts estimated that industry operating margins could drop by as much as seven percent. A decline of that magnitude would leave margins at 27 percent, down from 34 percent today.

The worst-case scenario includes cutting back on some uses of 12b-1 fees, such as advertising. Cuts in that area used in the scenario reached $340 million to $500 million. Other hits include a $200 million to $400 million decline caused by eliminating soft dollar practices; $200 million in increased legal and compliance costs; and $300 million for abolishing "pay for play," or directed brokerage. The analysts assumed fees reductions on par with those in the Alliance settlement (three to 10 basis points). All counted, those reductions would result in $1.6 billion to $5.5 billion less revenues for fund firms.

They also presented a rosier, or less pessimistic scenario. In that one the analysts assumed operating margins are reduced three percent at most. They also predicted fee pressure on some funds, disclosure of 12b-1 fees rather than elimination of them, cuts in soft dollar use, and outsourcing in response to increased compliance demands.

Who will be the winners and the losers? The analysts identified some fund firms well positioned to weather the scandals and ensuing regulation. The list of winners included T. Rowe Price (the Baltimore firm will benefit from its low fees, direct distribution, and scandal-free status) BlackRock and W.P. Stewart, both of which have low amounts of retail mutual funds assets.

T. Rowe also stands to benefit if unbundling is mandated because it has a large research staff, wrote the analysts.

Possible losers could include Franklin Resources and Federated Investors. The pair is vulnerable due to third party distribution and market timing issues. The analysts also pegged Federated's above average fees as a potential problem.

Both Federated and Eaton Vance are also at risk as publicly-owned managers with most of their eggs in the mutual fund basket.

The analysts then narrowed the field to include only the type of funds likely to be affected by regulation -- long-term open-ended funds -- and concluded that Eaton Vance and Waddell & Reed are the most at risk, with more than 60 percent of assets under management in targeted funds. 

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