(The Wall Street Journal) — Mutual funds are increasingly looking at a new way to pay for the research reports they use to help decide what stocks to buy and sell.These payment agreements could result in slightly lower costs (and better returns) for mutual-fund investors. More of a certainty is that they threaten the trading desks of Wall Street’s smaller brokerage firms.

Traditionally, mutual funds compensated brokerage firms for their research in an indirect way: Rather than simply paying for it, funds agreed to send some of their trading activity to brokerages — and pay inflated trading commissions — in return for access to their reports. The result: Some big fund companies would do their trading with as many as 100 or more brokerage houses to get their hands on each one’s research.

The practice has kept numerous small firms in the trading business. However, some question whether the mutual funds were getting the best deal on their trades.

Critics of “soft dollars” — the Wall Street term for bundling research payments with trading commissions — have long said it is impossible to tell if investors’ money was really being used to their benefit. This year, spending of soft-dollar commissions on research is expected to total $10.8 billion, according to consultants Greenwich Associates.

That commission spending directly reduces investors’ returns. In the past few years, the Securities and Exchange Commission has dialled up its scrutiny of how mutual funds do their trading, and has challenged them to prove that they were getting the best prices possible.

Now a number of brokerage firms are trying to cash in on these concerns. They are aggressively pushing mutual funds to sign deals that would lead to trading with fewer, mostly bigger brokers. In these commission-sharing agreements, a fund still uses soft dollars but consolidates some of its trading with a firm.

The broker and the fund company negotiate how much of the commission will be allocated to the cost of the actual trading (say, two cents a share) and how much will get put aside in a pool to pay for research (perhaps an additional two or three cents a share.) Then, instead of paying other brokers for their research by trading with them directly, the fund tells the brokerage firm with which it has the sharing agreement to cut the other company a check out of the commission pool.

The arrangements are being pushed by heavyweights including Bear Stearns Cos., Lehman Brothers Holdings Inc., Merrill Lynch & Co., and UBS AG. In the past year OppenheimerFunds has shifted about three dozen trading partners to the commission-sharing agreements. Franklin Templeton Investments says it is considering them.

This could benefit fund holders. Basing trading only on the quality of the transaction rather than on research could result in lower execution costs and thus improve returns. Plus, the commission-sharing agreements provide a clearer picture of how much funds pay for research.

“The biggest ‘pro’ for (commission sharing) is that you can trade with firms that are great trading firms and obtain research from great research firms — you don’t necessarily have to mix those things together,” says Richard Whitney, a fund manager who heads the committee overseeing commission allocation at T. Rowe Price Group Inc. T. Rowe is looking at their potential, but, he says, hasn’t decided to sign up.

Commission-sharing agreements are likely to gain in popularity, says Jay Bennett a consultant at Greenwich Associates. However, “it will be interesting to see if or how some smaller brokers push back,” he says, by for example, threatening to stop providing mutual funds with research if they pay indirectly through the commission-sharing agreements.

Some of those smaller and midsize brokers, whose trading desks are directly threatened by these deals, are furious. The new arrangements are “a travesty,” says Lisa Shalett, head of research group Sanford C. Bernstein & Co., a unit of AllianceBernstein Holding LP, and a critic of the commission-sharing agreements. Under those arrangements, “I no longer have a financial arrangement with my client — I become dependent for my revenue on my competitor.”

Fund-company executives also have some concerns. The biggest unknown is whether doing more trading at the big firms would provide valuable insight into the funds’ trading that the brokers might then pass on to the funds’ competitors.

The system also isn’t the only option available to fund companies. In 2005, Fidelity Investments sent ripples through Wall Street and the fund industry by taking a significantly different approach to paying for research. Fidelity began signing deals in which Fidelity Management & Research — which oversees the funds — pays for research instead of fund investors. Fidelity negotiated flat fees for the research and for the commission rates on the trading — a move known as “unbundling.” Fidelity says it has negotiated such agreements with “most” of its major trading partners.

But no other major fund companies have followed Fidelity’s lead, Wall Street and fund executives say. The main reason is that paying billions of dollars for research out of the fund companies’ own pockets would hurt their profits.

The commission-sharing arrangements aren’t a brand-new idea; Goldman Sachs & Co. has offered them since 2004, for example, and Fidelity has used them since the late 1990s (and continues to use them alongside the unbundling agreements). But the SEC had never made it clear they were allowable. Then this summer, as part of a 63-page report on soft dollars, the SEC publicly gave its blessing. “We recognise the benefit to investors of money managers being able to ... separate trade execution from access to valuable research,” the SEC said. Since then, interest has heated up, Wall Street executives say.