NEW YORK -- While corporate governance in the financial services industry has improved markedly over the past year, unsettled problems such as high executive compensation and continued conflicts of interest must be rectified, a top Ernst & Young executive said last Tuesday. The resulting tightened regulation combined with heightened competition from separately managed accounts and alternative investments for high-net-worth investors, is going to mean an especially competitive landscape in the year ahead, he said.

"As of yet, we don't see a great deal of evidence that executive compensation is changing," said Robert W. Stein, the company's chairman of global financial services, at Ernst & Young's annual "State of the Financial Services Industry" press briefing.

But one aspect of governance that companies have fixed with remarkable rapidity has been the independence of not just board directors, but board proceedings in general. Stein said that 90% of board meetings are held absent of a company's chief executive officer, up from 40% in 2002.

"By most any measure, boards are operating more effectively than they were 18 months ago," Stein said. Eighty-five percent of boards are performing checks and balances on their respective chief executive officers, and 40% of boards will have either independent directors or lead independent directors by the end of 2004, he said.

Besides strengthening the oversight of CEOs through the board, companies would be better off in separating the roles of chairman and chief executive officer, he said. "These two roles just don't seem compatible when they're merged into a single individual," he said. Slowly, his advice has been followed, and even the companies that haven't followed it have done the next best thing, which is name a lead independent director.

"We recognize that a lot has been done but we would say a lot more must happen," Stein said. In the fund industry, the Securities and Exchange Commission has mandated that all boards must have independent chairmen by 2006. No other sector of the financial services industry has received such orders, or is any expected to in the near future, he said.

Greater Competition Ahead

Steven Buller, Ernst & Young's director for the Americas and global co-director of asset management, said investment management firms have shifted toward catering to the high-net-worth client, as well as outsourcing key back-office and even some front-office work to other countries. Small firms may be in jeopardy, he warned. Much of the industry's changes were brought about by what he called the investment management industry's "midlife crisis," peppered by instances of late trading and market timing.

"The past year has really been the year of regulation for the asset management industry," said Buller, noting that 42% of fund groups posted outflows. Firms that have done well and continue to do well, such as Fidelity Investments and Vanguard, are what he called the "Wal-Marts" of the industry.

But in spite of funds' avid pursuit of high-net worth clients, these investors have steadily gotten out of mutual funds, opting for the more personally tailored separately managed accounts, an industry which has seen its assets jump to $535 billion as of the third quarter of 2004, 7.2% greater than the year before. "You can see the concern that SMAs are causing for mutual fund outfits," Buller said.

Hedge funds are also cutting into mutual funds' high-net-worth clients. That industry will grow by more than 20% this year and could have assets of $700 billion before 2006, he said. "I think you'll see more of a migration to alternative products [like hedge funds]," he said.

The high-net-worth client is not the only investor conventional mutual funds have to worry about. Exchange-traded funds, with their tax-friendly style and near immunity to late trading and market timing, have seen their assets grow steadily over the past few years. "While it's not meteoric growth, it's sustained growth," Buller said. ETF assets jumped 20% in the past 12 months through September to $180.8 billion.

Finding profits will continue to be hard for many fund firms amid the scandal fallout, he continued. Complying with the new directed-brokerage rule and tighter restrictions on soft-dollar usage has already cost firms, particularly the smaller ones, money. The soft-dollar curb has resulted in significant outsourcing, mostly by huge firms like Fidelity, which recently transferred its technology services to India. "I don't necessarily see a major issue in soft-dollar policy for the near term," Buller said. "I think the issue is whether there is enough flow to make the small firms survive long term."

After this tumultuous past year, what would a financial services conference be without a mention of New York Attorney General Eliot Spitzer, whose cleanup of the industry as a whole continues? Buller was quick to point out that some mutual fund firms are still anticipating subpoenas and charges, but the companies under the greatest scrutiny right now are those that sell insurance. On the same day that Marsh & McLennan announced it would be cutting 3,000 jobs, Ernst & Young Global Director of Insurance Services Peter R. Porrino tried to put the latest scandal in perspective with prior ones.

Porrino said that while investigations into investment research and mutual funds found transgressions that led to fines and strict regulatory actions, the insurance bid-rigging scandal is more of a case of firms going into a "gray area" and may lead only to better disclosure of incentives. He explained that steering business toward the companies that offer better incentives was "human nature" and contended that the main question was "whether or not they meant to do it."

When asked whether he thought Marsh & McLennan would survive the insurance scandal, Porrino resoundingly responded, "Yes." He called the scandal, "Eliot and the troop of insurance commissioners," all of whom he said were playing a game of "one-up-manship."

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