FUSE Blog

Here is a quick take on the proposed changes to 12b-1 fees by consitituency:

• Fund Companies – Fund share class types span the alphabet to cater to investor and distribution channel preferences. Should the proposed ruling take effect in its current form, the fate of a handful of share classes which cater to the retirement channel will be put in question. These costs won’t disappear but will instead be re-routed and re-labeled in an attempt to transform embedded costs to explicit ones. Charging for services at the client/plan sponsor level will require new plumbing but will introduce even more pricing variability and free asset managers from the share-class pricing burden that impairs competition and the “free movement” of prices. However, it remains to be seen whether distributors will take on the responsibility of charging the client or simply demand the same level of support from asset managers without taking on pricing responsibilities.

• Advisors – A small segment of the advisor population does a majority of its business in C-shares. Some advisors use C-shares to transition their book of business to a fee-based model, others use C-shares to “hide” the costs of their services on monthly client statements. The rule will help alleviate the latter use of C-shares and will drive this business towards advisory platforms which often use load-waived shares and clearly disclose the cost of advice.

• Broker-Dealers - As assets migrate from C-shares to converted A-shares or advisory platforms, we should expect more price competition at the broker-dealer level. Competition will increase as BDs market competitive commission rates and advisory pricing schedules. However, clients will be hard pressed to compare and contrast pricing options as the data will be largely unavailable or difficult to obtain.

• Operational Concerns – We assume that if other individual investor data such as redemption activity and Patriot Act related data can be tracked, than 12b-1 fees can also be accounted for at the shareholder level. That said, we expect the majority of the burden and accompanying costs of tracking this data will likely be subsidized by asset managers.

The unprecedented asset shift to fixed-income is potentially at risk given the odds of interest rate and inflation increases. This fact will challenge fund companies to proactively arm their distribution teams with the right messaging and advice to their advisor constituents. We believe the following broad themes would be beneficial to most fixed-income marketing campaigns going forward:

• Inflation risks aren’t geography neutral – Emphasize global and international fixed-income strategies that monitor inflation trends globally. The evaluation of country-specific credit and fiscal risks on a global basis will help investors avoid emerging pockets of inflation and take advantage of the low correlation of bond performance that can occur across countries. That said, expectations of inflation continue to be pushed out into the future.
• Multi-strategy, dynamic approach – If everyone knew the answer to fighting inflation, it would no longer be the question. Taking a multi-asset class/strategy approach (high yield, convertibles, securitized, commodities, FX, global TIPS) to inflation fighting makes the most sense for fund companies playing the percentages. A strategy of this type will naturally limit the number of fund companies that can credibly offer such an approach to those larger in scale and those tapping sub-advisors or affiliates.
• Emphasis on credit-specific research ­– All the macro talk can prompt advisors to forget the importance of security selection and that certain credits will outperform others regardless of the interest rate or inflation scenario (i.e. specific risk). Of course, demonstrating actual evidence of alpha-producing credit research would be helpful.
• Yield is on your side – Relative to treasuries, higher yielding corporate credits can better offset interest rate increases as the greater yield compensates for capital losses resulting from interest rate increases. The emphasis here is on total return and highly dependent on our third bullet point.

ETF sector assets have grown on a compounded basis at 37% over the past five years while mutual fund sector assets have posted negative growth of 4% over the same time period. Over time ETF sector fund launches have been negatively correlated with fund sector launches due to a number of reasons including: 

• Fee sensitivity among all classes of fund buyers has increased 
• The presence of institutional and hedge fund buyers that were not traditionally mutual fund buyers has brought a new source of assets and demands for more specialized/niche ETF offerings 
• Growth of ETF managed account programs that rely on sector ETFs as building blocks 
• Troubles in the closed-end market (ARPs, persistent discounts) has caused product manufacturers to reroute new strategies into the ETF chassis.

Net sales totaled a modest $3.1 billion for the week ended June 16, as Fixed Income inflows were offset by net redemptions from Equity products. Taxable Bond continues to dominate the net flow charts, as the category produced $4.2 billion for the week. The other fixed income broad category, Municipal Bond funds, were largely flat for the week ($242M in). Conversely, Domestic Equity funds sustained net redemptions of $1.8 billion, while Foreign Equity were flat and Hybrid funds produced modest inflows.

Overall, economic uncertainty continues to impact the equity markets and mutual fund investors are looking for safety.

Source: Investment Company Institute

Long-term mutual funds captured net inflows of $2.1 billion for the week ended June 9, as $4.3 billion in net inflows into Taxable Bond funds were largely offset by net outflows of $3.7 billion from Domestic Equity products. The three remaining broad categories were largely flat, as Foreign Equity, Hybrid, and Municipal Bond funds captured net inflows of $1.4 billion. Market uncertainly continues to drive dollars away from Domestic Equity, while the tiny yield of cash products has shifted money into short- and intermediate-term fixed income products.

Source: Investment Company Institute

In general, quant funds are poorly understood among many retail buyers. The fact that some well known quant shops have experienced recent bouts of underperformance has not helped the industry to frame positive conversations around quantitative investment processes. That said, we believe managers should be proactively clearing common misconceptions and biases which exist in certain segments of the retail market:

• Misconception #1 - Quant funds underperform fundamental strategies 
  • Quantitative and fundamental strategies have tended to produce alpha in cyclical patterns and one could make an effective case for blending the two for added diversification purposes. 
  • Many quant models are based on fundamental factors, which are based on rational economic theory. A simplistic example based on mean reversion theory - low p/e stocks tend to outperform high p/e stocks over time.
• Misconception #2 - Quantitative funds invest via a “set and forget it” black box engine 
  • Quantitative models are not static – quantitative researchers are constantly adding and deleting factors in an ever evolving process. Often times, quants are refining their models based on the latest in investment theory and academic research. 
  • Managers should emphasize the discipline inherent in quant models. For example, consider a fundamental and a quant strategy that underperform over a quarter. The quant manager can point to specific factors that either contributed or detracted from performance while the fundamental managers must rely on “softer” reasons for underperformance that is often linked to stock-specific events.
• Misconception #3- Quant funds are all the same 
  • Quant funds come in all shapes and sizes. While some funds may exhibit some commonality of factors, the weightings of factors within models can vary dramatically. 
  • Increasingly, more firms are combining quantitative and fundamental processes. Today, T.Rowe, MFS, INVESCO, Vangaurd, and Goldman all offer some variant of a “quantemental” strategy.

Net sales turned positive during the week ended June 2 with net inflows of $3.8 billion, which is a reversal from the previous week when net outflows totaled $16.6 billion. Domestic Equity products were negative for the fifth consecutive week, while the remaining four broad categories produced net inflows.

YTD net sales results are solid. In total, long-term funds have captured $159 billion YTD. Fixed Income products accounted for 90.6% of long-term net flows ($144B), Foreign Equity ($25B) and Hybrid ($13B) were also positive contributors to industry flows. Only Domestic Equity funds have sustained net outflows in 2010, as YTD net outflows total $23.1 billion. 

Source: Investment Company Institute

The drive to launch alternative funds in the ’40 Act structure is completely rational. On the demand side, investors and advisors are seeking new strategies in response to once in a lifetime market events and in preparation for longer retirements. From a supply perspective, fund companies are feeling margin pressure, as ETFs take share from core products and asset gathering in general has becomes more difficult. That said, FUSE believes that many fund companies are faced with a few structural challenges that may be too difficult to overcome. 

• Fees and culture – The hedge fund industry isn’t dead and neither is the lucrative 2 and 20 fee structure that many funds charge their HNW and institutional clients. Additionally, many portfolio managers worth their salt still prefer the owner operator model to the life of an employee at a compliance/beaurocracy heavy mutual fund shop. 
• Brand – If you build it will the assets come? It’s hard to say. Most fund companies with a vanilla long-only fund brand will be hard pressed to credibly present their alternatives prowess in a market that is increasingly being populated by “real” alternative managers that have proven their worth in the private fund market. The multi-boutique shops with alternative focused affiliates will have the competitive edge over traditional players. 
• Justifying Fees – When you launch a fancy new fund with a TER that may be a multiple of existing long-only strategies, expectations among fund buyers will be set accordingly. After reviewing a few fund company lineups and comparing their alternative funds to their balanced funds, we suspect some creative justifications for fee charges may be in order.

While unaffiliated sub-advisory relationships can fill the alternatives gap for some, we believe that the majority of fund companies would be better served focusing their resources (monetary and human) towards investing in existing strategies and re-engineering out-dated distribution infrastructures.

The week of May 26 marked the largest period of net outflows in 62 week. Net redemptions totaled $16.6 billion, as equity (both foreign and domestice) and hybrid products sustained net outflows of nearly $20 billion. Taxable Bond funds were once again positive at $2.4 billion, while municipal bond funds netted $459 million in inflows.

Over the past three weeks equity and hybrid products have lost nearly $31 billion. The breakdown was:

• Domestic Equity - ($21B)
• Foreign Equity - ($7.3B)
• Hybrid - ($2.1B)

 

Source: Investment Company Institute

After a 60 week run of positive flows, net sales turned negative for the week ended May 12. Net redemptions totaled $14 billion during the week, as four of the five broad objectives sustained net outflows.

• Domestic Equity funds were the biggest redeemers with net outflows of $8.6 billion. It marked the 2nd consecutive week of net outflows, and during the two weeks ended May 12, net redemptions totaled $10.9 billion.
• International Equity were in the red for $3.7 billion. It marked only the 2nd time in 2010 that International Equity products sustained net redemptions for a weekly period.
• Taxable Fixed Income were shockingly in the red for the week. Net redemptions totaled $1.5 billion from the category. During the previous 52 weeks, net flows averaged $6.9 billion with zero weeks of net outflows.
• Both Hybrid and Municipal Bond funds were largely flows with net outflows of $700 million from Hybrid products and net inflows of $550 million into Muni funds.
• Retail money market funds picked up nearly $16 billion during the week, as retail investors moved a significant chunk of money from long-term funds to pure safety.

Source: Investment Company Institute

After applying a commonly used industry concentration ratio to several segments of the retail investment industry, a couple of broad realities surfaced: 

1. Passive ETF assets are very concentrated. While some firms may see an opportunity to steal market share others won’t waste their time competing against firms in an oligopoly that protects market share through price and product development efficiencies. 
2. After considering the exchange-traded marketplace, the opportunity set appears refreshingly broader in the traditional fund and sub-advisory spaces.

After a resoundingly successful initial public offering in March, Financial Engines recently filed its first 10-Q in which the firm reported a revenue increase of 40% to $24.3 million for the first quarter 2010 compared to $17.4 million for the first quarter of 2009. Beyond the numbers, we pulled a few interesting points from this quarter’s filing (quotes in italics).

Concentration of revenue…
For the three months ended March 31, 2010, 19%, 7% and 7% of our total revenue was attributable to JP Morgan, ING and Vanguard, respectively, the three retirement plan providers with whom we have subadvisory relationships. Revenue attributable to these three plan providers includes subadvisory fees they pay to us directly, as well as revenue from certain plan sponsors that work with these plan providers but pay us directly. JPMorgan, Vanguard and ING directly accounted for approximately 18%, 7% and 7%, respectively, of our total revenue for the first quarter of 2010.

Penetration within client base…

**We measure enrollment in our Professional Management service by members as a percentage of plan participants, and by AUM as a percentage of Assets Under Contract (“AUC”), in each case across all plans where the Professional Management program is available for enrollment, including plans where enrollment campaigns are not yet concluded or have not been commenced. In addition to measuring enrollment in all plans where the Professional Management program is available, we measure enrollment in plans where the Professional Management program has been available for at least 14 months and in plans where it has been available for at least 26 months.

Thoughts on the competition…
We operate in a highly competitive industry, with many investment advice providers competing for business from individual investors, financial advisors and institutional customers. Direct competitors that offer independent portfolio management and investment advisory services to plan participants in the workplace include Morningstar, Inc., GuidedChoice and ProManage LLC. Plan providers that offer directly competing portfolio management and investment advisory services to investors in the workplace include Fidelity and Merrill Lynch. We currently have a relationship with Fidelity that allows us to provide our services to plan sponsors that elect to hire us, for which Fidelity is the plan provider. We also face indirect competition from products that could potentially substitute for our portfolio management services, investment advice and retirement help, most notably target-date retirement funds. Target-date funds are offered by multiple financial institutions, including BlackRock (formerly Barclays Global Investors), T. Rowe Price, Fidelity and Vanguard.

According to data from MassMutual, retirement plan participants are gradually shifting assets back into equity products. During the second quarter the allocation to equities increased from 35.1% to 38.7%, while the stable value allocation dropped from 36.3% to 31.7%. It is a reasonably subtle shift, but still an important trend, as both the tax status of the plan and the typical long-term investment horizon of a retirement plan participant both favor substantial allocations to equities.

Our analysis of weekly flows has not shown much of a shift in mutual fund sales from fixed income to equity products with the exception of last week. We'll be curious to see if flows into equity products continue to pick up or if fixed income remains dominant.

Check back later this afternoon or tomorrow morning for our weekly net flows analysis.

Claymore announced a change to its Great Companies Large-Cap Growth Index ETF. Was it a shift to Large Cap Core strategy? No. How about All-Cap Growth? No. Instead Claymore has reengineered its Great Companies Large Cap Growth Index ETF into the Claymore/BNY Mellon International Small Cap Select LDR ETF. Claymore indicated the new strategy "expands our offering into an opportune space for long-term growth oriented investors: international small cap companies."

It is highly unusual for a firm to reengineer a fund into a completely different strategy, shifting both the market cap (Large Cap to Small Cap), as well as the regional focus (predominantly Domestic Equity to International Equity) of the product. So, while there are extenuating circumstances for this product shift, which include a very small asset base (~$3.8 million) and a willingness by Claymore to drop the management fee by 20 bps, we are more than a bit surprised the move received board approval.

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