Funds to Embrace More Elaborate Investments

While one of the big trends in the mutual fund industry has been its embracement of sophisticated alternative investments, mutual funds and hedge funds alike are about to become even more complex in the next year, the Financial Times reports.

In Europe, Asia, Africa and Latin America, funds are taking advantage of the European Union's 2006 Ucits III legislation, which permitted regulated funds to increase their exposure to derivatives and other asset classes.

"This is going to completely change the investment industry as we know it," said Michael Ward, chairman of the Ucits III steering committee at Merrill Lynch. He said that long/short 130/30 funds are only the beginning.

"We are being approached by a number of hedge fund managers asking us if it is technically possible to do convertible arbitrage in a Ucits environment," Ward said. "I'm certain that there is going to be a broader range of strategies to choose from."

Guy Monson, chief investment officer at Sarasin Chiswell, which recently launched a suite of mutual funds that employ hedge fund strategies and attracted $625 million, said, "It's a Big Bang, and we have only just scratched the surface of what we are going to see in the next two or three years. It's hard to underestimate what a revolution this is. You ain't seen nothing yet."

In the U.S., Merrill Lynch estimates that $75 billion is currently invested in mutual funds that use alternative strategies, with two-thirds of that money in 130/30 funds and the rest in market-neutral funds. Steve Deutsch, an analyst with Morningstar, said three of the drivers of the interest in funds that employ alternative strategies are investors' increasing familiarity with hedge funds, lower returns in long-only funds and mutual fund companies' interest in going head-to-head against hedge funds.

China Asset Industry Seen Growing 24% a Year

Assets under management in China have grown an incredible 60% over the past three years, and while growth won't continue at this rate, it will still increase at a clip of 24% a year over the next 10 years.

That's according to a recent report from McKinsey, which says that the investment management industry will be the fastest-growing segment of China's financial services industry, China Daily reports. While the brokerage and mutual fund industry has expanded at a tremendous rate in the past two years, there's room for even more growth, since the Chinese have 79% of their assets socked away in low-yielding bank accounts and only 3% of household assets are currently invested in mutual funds.

Demand will come not only from retail investors but also from the Chinese government, which runs the $40 billion National Social Security Fund and is prompting individual companies to provide pension plans for their workers.

"In 10 years, the assets under management of these enterprise annuities are expected to reach $150 billion, up from today's $15 billion, partly as a result of their increasingly favorable tax treatment," according to the McKinsey report.

Since China expanded the Qualified Domestic Institutional Investor program, which allows the Chinese to invest in foreign investments through domestic firms, from fixed-income to also include equities in May, this will also boost the industry. Evidence of this came already with the offerings of QDII funds by four leading companies, China Asset Management, China Southern Fund Management, Harvest Fund Management and China International Asset Management-each raising $4 billion in a single day.

What could hold the market back, however, McKinsey said, is the lack of diversified offerings. "So far, the vast majority of mutual funds in China have offered strikingly similar compositions [due to] a limited number of attractive companies listed on the Shanghai and Shenzen stock exchanges," the report said. "This makes it difficult for fund managers to differentiate themselves, let alone hedge against the market through other asset classes."

It will also be hard for U.S. and other global asset managers to crack the market since there are already 27 foreign asset managers competing in China. "Multinational financial services companies can't ignore this market, but capturing a large share of it won't be easy," McKinsey said.

Further, China's securities regulator has been very slow and methodical about allowing new funds on the market, for fear of a market crash, and Chinese investors typically cash out of mutual funds within six months, so companies must constantly offer new funds to win investors' loyalty.

China Admonishes Fund Firms to Tamper Growth

The China Securities Regulatory Commission has warned the mutual fund industry to be responsible about its growth, marketing and advertising, and risk controls, and to be sure to hire adequate experts and cut back on short-term trading, which is fueling market speculation.

It is the second notice the CSRC issued for the mutual fund industry, which currently has 341 funds with $444.21 billion in assets under management handled by 59 companies.

Many of China's fund companies operate with loose management controls and fail to advise investors about the inherent risks in mutual fund investments.

SEC Partners With FINRA To Assist Brokerage CCOs

The Securities and Exchange Commission and the Financial Industry Regulatory Authority will hold seminars to help chief compliance officers at broker/dealers, much as the SEC helps CCOs at investment companies through its CCOutreach. The program will be called CCOutreach BD, with the first national meeting tentatively scheduled for March, followed by regional meetings throughout the country.

"This is an opportunity for broker/dealers and their regulators to learn from one another about how best to ensure compliance with the securities laws," said SEC Chairman Christopher Cox.

The SEC's office of compliance inspections and examinations and its division of market regulation will sponsor CCOutreach BD in conjunction with FINRA.

The SEC and FINRA are currently soliciting input from CCOs on topics of interest for the first national meeting, with a list of potential agenda items available at the SEC's website. They include: sales practices, trading issues, debt securities issues, conflicts of interest, new products, protecting customer data and non-public information, annual compliance reports, the CCO's role in businesses that are constantly changing, regulatory compliance examinations, business continuity/pandemic planning and Regulation National Market System.

Lipper to Rank Target-Date Retirement Funds by Peers

Lipper announced Tuesday that it has devised a method of rating target-date funds, which are hard to assess as a group since their asset allocations and glidepaths vary so widely and they themselves are structured as funds-of-funds, Reuters reports.

To address this challenge, Lipper has created peer groups of target-date funds with similar performance to compare on a quarterly basis. Lipper likens this to the Bradley-Terry model of comparing tennis players.

"Deciding which firm's target-date funds to buy has been hard," wrote Lipper's head of research for the Americas, Andrew Clark, in a report. "Buying one of these products is certainly more complex than buying a single mutual fund."

Among 30 target-date funds with a finale of 2030, Lipper ranked a fund from T. Rowe Price first, one from Principal Investors second and one from Fidelity Investments third.

In August, 401(k) Advisors launched a similar scorecard for target-date funds, with 80% of the scoring based on such quantitative measures as performance and holdings, and 20% qualitative, based on such things as expenses and service. To tackle the issue of future shifting allocations inherent in these funds, the scorecard uses a standard deviation calculation meant to measure performance risk, rather than compare performance to industry sectors.

Funds with scores over seven are considered "favorable," while those that earn a four or lower are tagged "poor." Funds that earn a five or six, would be put on a watch list, and fiduciaries would be encouraged to monitor their performance and future scores.

Morningstar to Uncover Funds' Derivative Holdings

Morningstar has been working with mutual fund companies for the past year to develop a tool to permit investors to determine a fund's exposure to derivatives, Dow Jones reports.

Morningstar Chairman and Chief Executive Officer Joe Mansueto spoke of the efforts at Baron Funds' recent annual investment conference. "Fund companies have been very cooperative in working with us to get that information, [which] is not always apparent," Mansueto said.

The use of derivatives has expanded, even among mutual fund companies, and many derivatives have been linked to the subprime mortgages that blew up over the summer.

Mansueto added that Morningstar intends to offer data on funds-of-funds, hedge funds and retirement income instruments. Currently, Morningstar covers stocks, mutual funds, closed-end funds, exchange-traded funds, annuities and pension funds.

"Morningstar today is much more than mutual funds," Mansueto said.

Furthermore, Morningstar intends to more than double its overseas revenue from 22% to 50%, the chief executive officer said.

Fidelity Switches to LLC, With Tax Benefit Possible

Fidelity Investments has changed its organizational structure to a limited liability company, or LLC, in an apparent move to reduce its tax burden, Bloomberg reports.

FMR, Fidelity's parent, decided on the change earlier this year. An October filing with the Securities and Exchange Commission made the move public. It could bring tax advantages for the family of Chairman Edward Johnson III and other FMR shareholders.

An FMR spokesperson said the change isn't a prelude to a sale or float of the company. It is in line with other cost-cutting efforts such as staff reductions, 200 of which began earlier this month.

By changing into an LLC, the group may escape federal taxes because LLCs pass on all earnings to their owners, who themselves usually have to pay a tax of up to 35%.

One downside of the conversion is that it could lead to a large, one-time capital gains levy. That would turn on whether the Internal Revenue Service considers the change to be a sale of the company.

BRIC Markets to Continue To Offer Incredible Gains

Analyzing the total valuation of the stock markets in Brazil, Russia, India and China, or BRIC markets, as compared to their combined gross domestic product, Morgan Stanley and Bloomberg conclude that there is still room for exponential growth in these emerging markets.

BRIC markets are valued at $1.71 trillion, which is only 25% of their GDP, whereas stocks in industrialized nations account for 81% of GDP.

BRICs are still "in the early stages of the rally," Jeffrey Kleintop, chief market strategist at LPL Financial Services, told Bloomberg News.

Recently, Klientop said, he sold shares in industrialized nations to buy up stocks in developing ones, and he is now "overweight" emerging markets.

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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