Carving out a piece of Europe's retail third-party fund business can be an expensive undertaking, as companies that rely on distributors to sell their funds pay an average of four times more for sales and marketing than the rest of the asset management industry.

According to a recent study published by Financial Research Corp. of Boston, new entrants into the European marketplace pay a handsome price to banks and other fund distributors - roughly 16 basis points of their assets - to get their products out to the masses. That amounts to more than $1 billion spread across the third-party fund marketplace, which represents 21% of the overall fund industry in Europe.

"This is not a business for the faint-hearted," said Magnus Spence, an independent fund analyst in London who authored the report for FRC. He noted that the amount of investment required in sales and marketing and the amount that has to be paid to keep distributors happy in order to maximize profits is high because firms need a significant number of people out in the field trying to persuade the intermediaries to put their products on the shelf

Indeed, recruiting talent for marketing executive positions and hiring the necessary sales force makes up a significant chunk of those expenses, representing 63% of total sales and marketing costs, the study showed. Perhaps the biggest driver of increased spending is salary inflation, according to the report. The number of persons working in sales and marketing has risen 4% since 2003, but the cost of employing them has risen 16% on average.

One survey respondent noted that there is a "war for sales talent" and that good salespeople are hard to find. In an effort to cope with an increasingly competitive recruiting environment, many firms are forced to look internally, offering entry-level sales jobs to customer service staffers. Another tactic being used is recruiting folks from the insurance business and training them on mutual funds.

Regulatory compliance is another drag on spending, albeit a necessary one, as new rules continue to come down the pike. This can add considerable legal fees, prompt back-office system upgrades and the need for internal auditing. Some participants identified building a strong brand as a costly endeavor. Others noted that increasing the number of countries where funds are sold and adding new distribution channels piles on additional costs.

But while the costs of making a dent in the third-party fund business are robust, so are the rewards. Net income for many of these firms can be as high as 1% of assets, or 100 basis points. With sales on the rise and redemptions under control, the marketplace is investing more in sales and marketing, a sure sign of its confidence, Spence said. He noted that growth in 2004 has been "stellar" for many firms, with gross sales up an average of 51% since 2003. Net sales have also "grown sharply," he said, with average growth across all participants up 56% year-to-date. In addition, retail assets under management have ballooned by an average of 45%.

The study revealed that those firms that invest most in sales and marketing are also the ones that deliver the best performance. Specifically, they achieve higher sales productivity, fewer redemptions, higher prices and don't have to fork over as much cash to distributors as part of any revenue-sharing agreements.

In the third-party retail fund business, as one would expect, reaching critical mass is the name of the game. Large firms tend to have less than half the expenses of their smaller competitors. To wit, large firms incur sales and marketing expenses that represent only 15% of their net income, while second-tier firms pay up to 22% and third-tier firms pay as much 38%.

Very small firms certainly struggle because sales and marketing can consume more than a third of their net income, but they do have some advantages over bigger companies. For example, they have greater flexibility when it comes to reshuffling their product mix and don't encounter the headaches of running large institutional sales teams, Spence noted.

Medium-size firms, perhaps, are faced with the most challenging position in that they do not have the flexibility of a small shop or the performance and cost benefits of being large. "This business is not a comfortable place for those that sit in the middle of it," Spence said.

The amount invested in sales and marketing can also vary from country to country. In France, firms generate 114 euros in gross sales for every euro invested, while Spanish firms produce 617 euros for every euro invested. The French teams' gross fee income represents an average of 147 basis points, topping all other countries except Switzerland, which boasts 159 basis points. Spain showed the lowest number with 119 basis points. "The acid test is the level of net fee income that remains after paying off distributors," Spence said. France puts up the best numbers in that department, posting an average net fee income of 99 basis points of assets.

Another key trend uncovered in the study was the fragmentation of distributors. Each segment of the marketplace places a different set of demands on their suppliers. For example, the institutional buyers of third-party funds want their suppliers to fill out time-consuming forms prior to the sale, which tacks on another layer of cost. "The industry is collectively having difficulty in segmenting its distributors coherently, which makes our job as industry commentators very taxing," Spence said. Among the 26 channel definitions supplied to FRC, there were only four that were used by more than half the respondents.

The survey was based on information provided by 15 fund manufacturers looking to win business by engaging third-party distributors, representing roughly 28% of the third-party fund business in Europe.

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