More Mergers, Competition and Expenses
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Tuesday, September 14, 1999

More Mergers, Competition and Expenses

The fund industry is in for more competition, slowing growth, and more mergers, according to speakers here at the ICI's Tax and Accounting Conference in San Diego. They had mixed opinions about whether new products such as tax-advantage funds and market neutral funds will move beyond niche products. They also see exchange-traded derivatives such as SPDRs as genuine competition to the highly successful index fund market.

Speakers on the panel included Robert Leo, vice chairman of MFS Fund Distributors; Hugh Fanning, vice president product development and management at Advisor Funds, Fidelity Investments; and Jeff Lyons, senior vice president, mutual fund relations, operations and marketing at Charles Schwab & Company.

Pulling out the crystal balls, the speakers gave their predictions for the next five years in the industry.

"Funds will continue as the vehicle of choice for most investors," said Lyons, throwing red meat to the audience of about 1,000 fund professionals. Not surprisingly he predicted that advice will grow in importance and become more sophisticated. Many of these tools will be on the net. "It is not just about tools," he said. More important, he added, is "how to bring the tools and your people together."

He also foresees "more and more migration from paper" and the blurring of the load and no-load sales channels. At the same time there will be less new product and more mergers -- both of fund complexes and within fund complexes as they trim their number of offerings.

Leo agreed that there will be more consolidation and mergers.

He predicted that the differences between the direct and indirect sales channels will more than blur, though.

"We'll see some company use the same title to go both direct and indirect," he predicted. He pointed out that Fidelity is now the only fund company successfully doing this. Others, such as Amvesco use different brands to attack these two sales channels. [Amvesco sells load funds through AIM and no-load through Invesco].

He also see more need to focus on distribution of assets rather than on accumulation of assets as the Baby Boomers retire. One way to build assets: focus more on affluent and wealthy investors.

New products, new competition

Unit investment trusts (UITs), separate accounts, hedge funds, and exchange traded products are among the non-fund products that will edge into the fund's arena, the panel predicted. As fund companies face this increased competition, they must compete for share of mind and product with managed and unregulated products, predicted Fanning.

UITs are now 5-8% of the broker business, said Leo. "UITs are a big product now at wirehouses." He added that they are migrating from their historical role as a vehicle for bond investing into more stock products. One example is PaineWebber's ABC "Analyst Best Choice" product. "This is out there and big business," said Leo.

He sees similar developments with brokers using hedge funds for high net worth clients. "It's amazing how many big companies have gone to wirehouses and said 'how about a hedge fund?'," he said. The wirehouses are using hedge funds in the niche formerly occupied by limited partnerships, providing competition in the upscale market.

Wirehouse brokers are also turning to separately managed accounts to keep there hold on their clients. "It now takes as little as $100,000 to open up an account," said Leo. Assets in separate accounts grew 100% last year versus 5% for funds. "This is a very, very strong area," he concluded.

Fanning agreed that there is clearly a trend to separate accounts both in the high net worth and retirement distribution channels.

"Money Market Institute research showed that defined contribution separate accounts growth at a 40% rate from 1997 to 1998 compared to 28% growth for the fund business. They grew 46% from 1996 to 1997 compared to 27% for funds. Also Pension & Investments showed that separate account growth outpaced that of funds 17%-16% last year -- the first time this has happened in a decade."

Fidelity is also hearing more about separate accounts, Fanning revealed, especially from larger plan sponsors. He wondered how big a threat these are to funds though.

"Individual investors and participants are comfortable with funds [that they are listed in the paper and have recognizable names]," he explained. Many fund companies will get into the separate account area to offer a choice customers, he added.

"Half of the separate account business is in the non-retirement market," Fanning added. They are sold on the basis of tax efficiency, and a custom portfolio. "I have heard brokers explain to clients that they [separate accounts] take them to the 'next level', one step beyond funds," Fanning shared.

Mature fund market

Most growth is now occurring through asset appreciation rather than asset gathering, said Leo. This has been a "challenging year" for the industry he said. It has been the worst year since '94. Not a disaster. Not so good as recent years," he explained.

What has happened. The fund business was the second fastest growing industry over the past 15 years after the software industry -- growing at rate of 22% annually, Leo pointed out. Now the industry is running into the law of large numbers.

The symptoms of this are a consolidation in the number of objectives, funds and fund companies attracting assets. "Ninety-six percent of net flows are to ten companies," he said.

Fanning agreed, noting that investors are moving more quickly from underperforming funds. Some is from investors taking funds completely out of the market, he noted. Their is also a concentration of assets into a limited number of funds. He underlined this point with some striking numbers from Financial Research Corp. (FRC).

  • In 1998 the top three objectives took 45% of new assets. In 1999 they took 88% of new assets. Flows into Growth & Income funds have dropped significantly and people have chased Growth funds he said.

  • The top three companies took 29% of new assets in 1998. So far in 1999 the top three have taken 66% of new assets.

  • The top 10 funds took 23% of assets in 1998. This year their share has swelled to 44%.

    "A lot of money is flowing into fewer companies, fewer sectors, and fewer funds themselves," he concluded.

    Changing distribution

    As competition squeezes financial services and information flows more freely the expectation and role of the distribution channels are changing.

    The new reality of strategic alliances is higher expenses, Leo shared. "Distributors are saying 'If you want to come in our branch (or access our data), we need to get basis points on assets and sales.'" It used be only wirehouses making this demand. Now banks, insurers and financial planners also have their hands out.

    The costs are also climbing because the form of revenue sharing is changing, said Leo. Fees used to be soft dollars, he said, but the SEC has effectively ended that. "We are talking about tens of millions of dollars for MFS, he shared.

    It is not only getting more expensive to service the broker-dealer market. Fanning pointed out that the direct sales channel is also getting more expensive as shareholders expect a lot more in services, such as24 hour phone reps, Web access and planning tools.

    Not only are expenses rising, but they are also changing their form. Typifying the change was Merrill Lynch's announced move away from transactional fees. Fanning sees this as a significant step.

    He argues that the changes are taking away the sales charge, which is somewhat buried, and moving to a explicit fee. This is a much broader change than just changing the way securities are priced, he said.

    Vendors now have more choices in how they offer products, he explained. They can offer service in person, by phone, online. They have choices in level of investment advice (Full-service, or just research). Investors, on the other hand, can choose how to pay.

    The ultimate effect is the continued blurring of the distribution channels, he contends. "A rep may sell load and no load funds," he predicted. He also foresees more increase in the use of "B" and "C" shares in the short term.

    "In the long term there may be a need to explore alternative type structures," he told the audience. These may be structured around asset-based fees, but he would not take a guess as to what they will look like.

    These changes in compensation may also lead to more velocity as reps feel more need justify their fees.

    So far in 1999 30% of MFS business is in "C" shares," Leo shared. "This is a freight train." He predicts more wirehouse products like PruAdvisor and more investors going to the Net trade stocks, bonds, and funds. "There will be no barrier to liquidation," he predicted. This will create an environment of "What did you do for me last quarter?".

    Fund companies will have to fight of share, Leo continued. "You have to tell your story and have to tell it a lot. It used to be four visits to brokers. Now we require visits no less than 6-8 weeks apart."

    Funds must also differentiate themselves by training advisors (how to get referrals, for example), and providing tools for areas such as asset allocation and time management. They can provide high level speakers and proprietary programs to help the broker build the relationship with clients.

    To keep assets more funds putting in back-end redemption fees, Lyons pointed out, and he sees that trend continuing. "Distributor must control behavior that is not in the fund investors' interest," he said.

    Fanning predicted that fund companies will respond by increasingly tracking trading activity at account level, although to do so will be a challenge. They will use this tool to find investors and advisors churning accounts and then enforce prospectus guidelines against churners. Today, though, many fund companies are not able to do this, he said.

    "A lot of the companies we do business with can't tell us who we did the business with. As a result, relationships with the advisors is in jeopardy."

    Lyons admitted that distributors have to add value to the fund companies. There is a growing perception that fund companies have "no face to their customers," he said. "Distributors have to do better enabling contact."

    New Products

    Not surprisingly, tax-managed funds came up as a possible next wave product. Fanning believes that these funds will be significant chunk of the business. "They will be an important niche, but I doubt the fund market will end up like bond market -- split between taxable and tax-managed.

    Still, there is no doubt that tax-managed funds have claimed a niche already. Strategic Insight has tracked 40 tax-managed funds, according to Fanning. In 1995 they held $2.4 billion in assets. By July this number swelled to $26 billion. Cash flow for these funds has gone from $433 million in '95 to %5.2 billion year-to-date.

    As with most of market those flows and assets are very concentrated -- 85% is in the largest four funds, said Fanning.

    Despite this growth, the role of these funds may be effected by a bear market, said Fanning.

    Leo contended that tax-managed funds are "more marketing than substance." "The Government gives a good long-term break," said Leo. "We want to manage to maximize the return."

    Products that they do not see a lot of demand for include market neutral funds and funds being priced more than once per day.

    Market neutral funds are now possible because of the repeal of the short-short rules. But that does not meant that there is a market for them.

    "There is a lot of misperception about what they provide," said Fanning. "They don't take out the risk that people think they do. Also, underperformance now an issue."

    Leo added that wirehouses are also worried about the suitability issue for market neutral funds.

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