The mutual fund industry has weathered its midlife crisis, a two-year period marked by the trading scandal, and is now on the way to becoming a mature industry, Ernst & Young reports in its annual "State of the Financial Services Industry Report."

While the regulatory storm is far from over, the mutual fund industry is clearly gravitating toward the use of a common distribution platform to sell both high-end and discount products, especially at the largest groups.

"This has already occurred in the banking industry, where the first wave of change had banks trying to provide insurance, banking and trust products under one umbrella," writes Steven Buller, Americas director and global co-director of Asset Management Services at Ernst & Young.

Funds that sell through a proprietary sales force or broker/dealer, or their own distribution network, are now evolving into that model, he contends. Within the next two years, retail mutual fund groups that sell directly or through an outside sales force will also begin leveraging a lower-cost common infrastructure.

Expect aggressive pricing on those common products, too, Buller maintains.

"This means that index funds, exchange-traded funds and even some core products, such as core equity funds, money market funds and fixed income funds, will be viewed more as commodities and be subjected to that same competitive pressure," he said.

Broader Customer Range

The goal of the common distribution platform, where discount brands and premium brands occupy the same shelf space, is to reach a broader range of customers, which has become critical for fund companies, Buller said, as "high-net-worth customers increasingly are going elsewhere to buy alternative products, separately managed accounts and exchange-traded funds. At the same time, they want to continue to serve the lower-margin but higher-volume retail customers."

A common platform also enables them to cross-sell financing, accessory products, service plans and other products to the same customer. Think of a large building with two entrances - one labeled Wal-Mart and the other labeled Neiman Marcus - and within that infrastructure trying to approach two different targets, Buller offers.

The Wal-Mart door, he continues, is characteristic of the direct marketplace and includes high quality, low prices, high volume and elimination of the middleman. Take Fidelity Investments, for example, which now sells 10-basis-point index products to retail customers.

At the Neiman Marcus door, meanwhile, is the personal service investors are willing to pay for through high-performance and tailored products, including alternative products, separately managed accounts, wrap accounts and trust products that provide a higher profit margin to the fund group.

"The one thing to keep in mind, though," he warns, "is that the box in the center has to have Wal-Mart characteristics. These include a moral conservatism to protect the reputation of the enterprise, quality products and low costs, to remain competitive."

Challenges for 2005

Generally speaking, however, the asset management industry faces three broad challenges in the coming year. According to Buller, the industry is mired by unusually slow growth, faces stiff competition from low-margin and fast-growing products (including separately managed accounts and exchange-traded funds), and is wrestling with substantial increases in distribution costs because of the number of classes fund groups are now sponsoring. In the past two years alone, for example, the number of fund classes has increased by 16%, from 16,600 to 19,300, while assets per class have been generally declining, according to Ernst & Young figures.

Shelf space and finance distribution costs for those back-loaded products where funds have to pay a commission to distributors up front but don't receive the revenue stream until a later date are also posing cost challenges, Buller reports.

Expect new challenges on the regulatory front, too, he adds.

In arguably the busiest period in its 70-year history, the Securities and Exchange Commission passed 14 new rules governing mutual fund groups between September 2003 and April 2004. A total of nine new guidelines were passed last year and three more rules are pending, including the controversial, hard 4 p.m. trading close for mutual funds. According to Buller, other regulatory changes that could prove costly in 2005 include:

* The additional fees funds must pay because they no longer can direct commissions to distributors to reimburse them for distribution costs.

* The reduction in funds' ability to use soft dollars to fund research as more boards scrutinize the use of soft dollars.

* Breakpoints and product suitability as more fund groups change their breakpoints to make sure the products are suitable to customers.

* Competitive challenges presented by high expense ratios and inconsistent fees.

* The costs of an expanded compliance infrastructure.

Among those cost points, though, it's compliance that could impose some of the greatest expenses upon fund groups. In 2002, Buller recalls, the compliance team at a fund typically comprised two-and-a-half people conducting routine testing activities and two part-time attorneys performing routine document maintenance. Looking forward to 2005, however, funds must maintain a more comprehensive and continuous compliance assessment process, Buller asserts.

"This means the compliance team no longer is involved in just routine matters, but in implementing new firm initiatives and regulations, and interfacing with the entire organization," he reports. "As a result, the core compliance infrastructure has grown to about six people and three attorneys, all of whom are addressing issues that didn't even exist two or three years ago."

Fee Harmonization'

As a result of regulators' continuing obsession with fees, Buller expects fund companies to begin the process of "fee harmonization." In other words, fund complexes will closely examine expense ratios and loads across the organization and attempt to harmonize them. If successful, they'll likely adopt the lowest expense ratio and the lowest load structure.

"They likely will adopt something akin to a standard rate card, which many industries use now to identify the lowest fees for preferred customers," Buller predicts.

And this will cause revenues to decline.

"That makes it even more important for funds to have a low-cost infrastructure, in order to support the loss in revenue," he advises.

The recent scandal will also pressure retail fund complexes to invest further in protecting their reputations as 2005 unfolds. For example, fund companies may leverage nonproprietary relationships to grow their institutional hedge fund business. Perhaps, Buller offers, they'll sell third-party hedge funds instead of starting their own products, an approach that provides protection if a particular product doesn't perform as well as expected.

"Traditional retail fund complexes likely will align with institutionally sponsored hedge funds because they want partners that have a strong control infrastructure to manage risk. So it's less likely that their partners will be stand-alone hedge funds," he reports.

Hedge funds, which numbered nearly 7,000 in 2004 with $800 billion in assets, will enjoy continued and sustained growth in 2005, Buller notes. While not nearly as dramatic, exchange-traded funds, which last year numbered about 150 funds with about $180 billion in assets, will also witness sustained growth in 2005 and put further pressure on mutual funds.

The $7.5 trillion mutual fund industry, which enjoyed a modest $140 billion expansion in assets in 2004, should also realize quality growth through strategic mergers and acquisitions in 2005. No longer driven by the sole desire of growing assets, fund groups will seek specific products that complement their portfolio or provide new distribution channels. What Buller calls "marriages of convenience" or "live-together" arrangements, where fund complexes and distribution platforms join temporarily with sponsors of alternative products or commodity funds until each party is able to build the missing link or develop a more beneficial and lasting arrangement, will also emerge during the New Year.

Finally, as fund companies continue to perform cost-cutting measures in 2005, Buller said the trend towards outsourcing, particularly in people intensive areas, will accelerate.

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