Part of the fallout from the regulatory onslaught of the past three years has been a drastic overhaul in how mutual funds are sold. Regulators exposed longstanding marketing practices that quietly boosted the profits of money managers and financial advisors — but which most clients had no clue about. As a result, proprietary funds are disappearing and ‘B’ shares are all but extinct. So, too, are familiar fund-marketing tactics, such as treating institutional brokers to lavish junkets and foursomes at upscale golf courses to win distribution. Meanwhile, after years of so-so performance, actively managed funds are feeling more pressure from low-cost alternatives — index funds and ETFs.
As a result, heading into 2006, the money-management business is entering a new era of price competition and consolidation. Fees have come down: The median, diversified U.S. equity fund's total expense ratio was about 1.45 percent at the end of June, down from 1.5 percent at the end of 2003, according to Lipper. With more than $4.66 trillion invested in U.S. equity funds, the fee cuts represent “millions of dollars” in cost savings for fund shareholders. Some fund shops have even instituted performance-based fees to curry favor with investors, while others have added load shares to woo advisors.
Meanwhile, merger and acquisition activity is nearing historic highs with a flurry of transactions taking place, as asset managers look to rationalize their product lines. And fund families have recognized one truth: Fund manufacturers need financial advisors more than ever to grow, since most fund transactions are guided by an FA. That's a big change in thinking from the 1990s, when the direct-sold business model was thought to be a threat to the very existence of the financial advisor.
It makes it tough on asset managers who are then faced with higher distribution costs on top of downward pressure on fees; their profit margins are being squeezed. Few firms are willing to cut payouts to financial advisors — at least for now — because reps have become more crucial to increasing assets than ever before. “So far, asset managers have sucked it up and borne the brunt,” says Neil Hokanson, an independent financial planner in Solana Beach, Calif. “But I don't see how they could take fees any lower.”
Death of the House Brand?
In the post-Spitzer environment, brokerage firms are rethinking strategies for in-house funds. Citigroup opted out of the business entirely, swapping its asset-management business for Legg Mason's retail brokerage operation. In December, Merrill Lynch announced that it will rebrand its funds this spring; is it a prelude to divesting Merrill Lynch Investment Management entirely? The move will affect the company's 70 mutual funds, as well as separately managed accounts and closed-end products sold under the Mercury name. Meanwhile, American Express Funds became RiverSource Funds with the spinoff of AmEx's financial-planning unit, Ameriprise Financial.
“It's no longer an advantage to have a proprietary fund business,” says Darlene DeRemer, a partner at consulting firm Grail Partners in Boston. “Pre-Spitzer, firms like Smith Barney and Morgan Stanley grew proprietary share up to 70 percent of total funds sales. Today it's under 15 percent. They used to pay reps an incentive to sell the inferior house brand. Today's playing field does not allow those incentives.” With predictable results: Proprietary sold funds suffered net outflows of $12.7 billion in 2005, according to FRC data.
The more stringent regulatory environment has also put pressure on pricing. Recently released research from Lipper reveals that 239 funds reduced fee levels in 2003, followed by a much more robust rate of markdowns in 2004: 856 cut fees, representing 15 percent of all mutual funds. The number of funds that slashed fees in 2004 was the most in more than a decade, according to Lipper. In 2005, roughly 10 percent to 12 percent of funds trimmed fees.
Ameriprise, Evergreen, Janus and USAA have all recently introduced performance-based pricing, joining the ranks of Fidelity and Vanguard, which comprise 85 percent of these merit-driven funds. Under these schemes, the manager is paid a base fee that is subject to an adjustment, up or down, depending on the fund's performance relative to a benchmark. Essentially, the wider the gap between the fund's returns and the benchmark, the larger the adjustment. These pricing moves are designed to win over investors and regulators by tying the firm's revenue more closely to performance.
In the case of Fidelity, its flagship Magellan has returned $89 million to investors on a net advisory fee intake of $270 million from March 2004 to March 2005. In the previous year, Magellan returned $49 million on $321 million in fees. A bulk of these moves were made when the market was gathering steam; in a downturn, fee-cutting could intensify, says Don Cassidy, senior analyst at fund researcher Lipper, forcing small fund managers to match price cuts “to stay competitive looking.”
They're still in good shape, though. Money management remains a very lucrative business — for the top players. Pretax profit margins for publicly traded asset managers have historically been about 34 percent as compared to retail brokerage, which is in the high teens, according to Merrill Lynch research. But overall growth is slowing, which sets the stage for a Darwinian cycle of consolidation.
The big fund managers like American Funds have massive distribution in the advisor channel and are well positioned for further growth. Top-performing boutiques are in hot demand, too, but they may need to merge to afford increasing compliance and distribution costs. Federated Investors has snapped up a bevy of small funds in the last 18 months, mostly from banks. But there is a vast middle market of undifferentiated fund families that have neither outstanding performance nor marketing clout. That's where the consolidation will begin, say industry insiders. “There will be a lot of confusion and a lot of change of ownership,” says Jim Stueve, national director of retail sales at AIM Investments.
Even now, M&A activity in the money-management business in terms of assets acquired is approaching the all-time high of roughly $1.3 trillion, set in 2000. Through Dec. 1, money-management firms, mostly banks and insurers that now see asset management as noncore, sold nearly $1.2 trillion in assets. These companies are “fed up with the regulatory environment,” says Grail Partners' DeRemer.
Most recently, American Century acquired the $1.9 billion Mason Street Funds, a 10-fund lineup that will be merged into new or existing American Century funds or co-branded — with Mason Street staying on as a sub-advisor. Six of the newly created funds will carry a sales load.
For the most part, the acquisitions will be on the smaller side in the near term, says Cassidy of Lipper. Nothing dramatic will happen “until the next market downturn” but look for bigger deals if the market goes south, says Cassidy. “This is a maturing industry and, so, some degree of consolidation is natural,” he adds. While consolidation will continue humming along, don't expect the number of fund complexes to dwindle due to this strategic maneuvering, says one industry consultant.
The regulatory changes have also hampered innovation for fund managers. “Product development is down,” says Cassidy. The total number of equity portfolios created in 2005 as of Dec. 15 was 209 compared to 243 in 2004. Cassidy predicts that, beyond some new hedge funds of funds, the market will see few new product types introduced in 2006.
Look for growth in categories such as life-cycle and life-stage funds, which have become popular in 401(k) plans because of their automatic diversification and rebalancing. Life-cycle funds employ target dates on their portfolios corresponding to future retirement dates whereas life-stage funds retain their allocation over time so that investors would have to switch to another fund with age.
Another hot hand, exchange-traded funds, continue to gobble up market share. ETF assets passed $260 billion at the end of October, up from $150 billion at the end of 2003, according to the Investment Company Institute. While growth of ETFs is expected to continue, Cassidy predicts it will slow as the proliferation of new variations winds down. In 2005, a number of new ETFs came to market, some of which are based on obscure indexes and have very limited track records, like the narrowly-focused PowerShares Dynamic Food & Beverage.
Despite promising growth projections for those two asset classes, pitching hot products will not cut it anymore; the market is already filled to the brim with choice. As the money-management industry sorts through its various challenges, its reliance on financial advisors is likely to increase. Some fund families that made their fortunes selling directly to consumers have added advisor programs to attract more assets. Janus, Strong, Scudder and T. Rowe Price are the most recent fund houses to have introduced load-bearing shares, including R shares available through 401(k) plans. Even low-cost index maven Vanguard has buddied up with advisors in the last year. According to FRC's annual client survey, 65 percent of asset managers polled cite enhancing existing distribution or developing new distribution as their No. 1 business initiative for 2006. So advisors can expect more love from asset managers this year.
|General Equity Funds||Median Expense Ratio|
|Second quarter 2005||1.450|