This is the first of five blog posts in our industry trends series. In this series we will look at the top five key trends driving the fund industry in 2014.
Most industries have been actively cutting out the middleman and selling directly to consumers in recent years. The opposite is true in the fund business. Intermediaries have gained increasing influence over fund distribution, namely on which products and services get distributed where, at what price, and to whom.
What does this shift mean for the economics of our business, for regulatory oversight, and for the traditional relationship between the fund company and their underlying investors?
Before examining these questions, it is worth asking how this all came about. How did we move from fund companies owning proprietary distribution channels to the intermediary model?
From Networking to Omnibus Accounting
Broker/Dealers (BDs) have played an integral role in growing fund assets. The industry adopted networking to efficiently administer trades and customer accounts for BDs. Networking uses transfer agent systems to drive fund rules and compliance logic throughout the trading process, providing a single source of information for all parties.
BDs realized the benefits of moving network accounts onto subaccounting platforms. This aggregated investor accounts with BDs into single positions at the fund company. It allowed BDs to perform TA functions, such as following fund prospectus rules, shareholder servicing, etc. Subaccounting became a competitive service that provides efficiencies and can result in a more cost effective model. These benefits ignited a steady movement of networked accounts into omnibus positions, and in 2003, omnibus accounts surpassed networked accounts.
This movement towards omnibus shifted market dynamics and realigned the responsibilities of fund companies, transfer agents and BDs.
Growth in Fee-Based Programs
In part, the growing importance of distribution partners can be linked to the increasing popularity of fee-based products. Fee-based programs have emerged as the preferred alternative to the commissions-based model.
Wrap programs (or managed accounts) have been particularly embraced by today’s investment advisors. Wrap programs eschew commissions, instead charging a set fee for asset management. Total managed account assets at year-end 2011 reached $2.4T, from $790B in 2001, a nine percent annualized growth rate.
Fee-based RIAs and Independent Broker/Dealers (IBDs) have grown their assets eight to nine percent annually from 2004 – 2013. Over three quarters of these fee-based advisors now use a managed account solution within their practice – totaling an average of two-thirds assets under management. Shareholders largely communicate with RIAs and IBDs directly, instead of the fund companies.
The exponential growth of fee-based advisory programs since 2000 has helped propel mutual fund industry assets from $6.9 to well over $13 trillion.
Impact on Fund Families
So what does all this mean? The answer depends on whom we ask. Intermediaries, fund companies, and investors have been impacted in different ways, but we believe that fund companies face the greatest challenges. Why? Because the reputational and financial risks associated in the potential failure to comply with legal and regulatory requirements, fiduciary responsibilities, and customer loyalty are the greatest.
Under this new model, fund companies rely on intermediaries to provide timely and relevant information to monitor risks. In a recent survey conducted by Boston Financial, 98% of fund companies suggested that “legal and regulatory risks” related to the lack of intermediary oversight was a major issue. Increased scrutiny from the SEC and fund boards has intensified these pressures. Oversight of these processes presents operational and logistical challenges. Only 74% of fund companies believe their company “has formal policies and procedures in place to oversee intermediaries.”
Financial oversight is a concern as well. A majority of new fund assets are coming from intermediary channels, commanding a growing ratio of total 12b-1 fund expenses. Traditional financial controls must evolve to monitor this shift in economics. A recent study by McKinsey and Company supports this concern — “financial institutions now have a strong incentive to broaden and deepen the way they manage these (sic., third-party suppliers) relationships.” The study suggests a variety of mechanisms (i.e., looking at net and gross inflows, focusing on the profitability of distributor and advisor relationships) fund companies are putting in place in response.
The greatest potential loss may be the direct link between the fund families and underlying shareholders. With a majority of accounts now in omnibus positions, fund companies are increasingly distanced from their shareholders. At best, communication paths flow indirectly through intermediaries. In the absence of direct ties, sustaining customer loyalty is difficult. Product development and marketing staffs must in tune with the pulse of the marketplace. The dual challenge for fund companies is to establish closer working relationships with intermediaries while reengineering shareholder contact.
Strong intermediary relationships are more important than ever, they are key influencers in the distribution and servicing of fund companies products. We believe it is vital for fund companies maintain a comprehensive oversight program while continuing to nurture their universe of distribution partner relationships.