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Navigating Marketplace Changes to an Adviser’s Advantage

Oct 2, 2018 10:00:00 AM  |  Industry , '40 Act

Posted by Adam Kornegay

An Update on Product Trends in the Mutual Fund Industry

Navigating Marketplace Changes to an Adviser's AdvantageInvestment advisers with longstanding mutual funds, as well as advisers looking to make their first foray into the ’40 Act Fund world, usually have distinct opportunities when it comes to growing their assets under management (AUM).  In both cases, innovation is always a key component of the manager’s strategy.  The U.S. mutual fund industry is a crowded space, with 54% of the AUM captured by the 10 largest fund families.  Innovative strategies make a new fund stand out and can drive asset capture; however, investment advisers have to temper their penchants for innovation with the reality of operating in a highly regulated industry, known for frequently changing regulatory regimes. 

In light of these factors, we find ourselves in a market often characterized by varying product trends.  To help advisers understand the changes and take advantage of current industry dynamics, we will explore in more detail what trends Ultimus is currently seeing, what we believe is driving them, and where we think they will take investment advisers in the registered fund space.

Lower Cost Structures
The DOL (Department of Labor) Rule may have been dead on arrival, but after 2+ years of discussion and debate, it left its impact on the industry.  Even without consideration of the Rule, the mutual fundLower Costs expense ratios have been steadily sliding down the scale for quite some time, driven by perceived lower cost alternatives, such as Exchange Traded Funds (ETFs); a trend towards passive strategies, buoyed by a vibrant market; and large fund houses that use scale to keep costs at a minimum.  Some could argue that the once impending rule only hastened the need for expensive fund families to address their issues.

Probably one of the most alluring pools of investment dollars to money managers in the United States is the $28 trillion in retirement assets.  While mutual funds have long been the most popular option for these assets, recently we have seen a shift toward lower cost products, primarily collective investment trusts (CITs).  These trusts operate very similarly to mutual funds, with the ability to invest in nearly all of the same asset classes, but with inherently lower expenses.  It’s a classic case of what’s old is new again, and it is easy to see why – the structures are simple, with the trustee handling most of the operating and regulatory burden of the product.  At a manager level, the CIT looks like just another separate account, but it’s a vehicle that can be used to pacify plan sponsors and consultants that are always wary of costs.  The downsides?  These funds are only open to qualified investors, i.e. ERISA (Employee Retirement Income Security Act) assets, so the ability to gather broad spectrum AUM en masse does not really exist, and they are not portable for investors leaving a plan.  Additionally, managers are typically, though not always, compensated at lower rates than they would be from a separately managed account (SMA) or mutual fund structure.

Alternative Strategies for the Masses
This trend has been gaining steam for quite some time.  The opportunity to offer mass retail investors the sophisticated investments and commensurate returns usually reserved for the wealthiest one percenters is undoubtedly alluring.  The proliferation of closed-end fund structures, such as interval and tender offer funds, present somewhat viable options for these strategies, but like any good thing, there is always a catch.  These innovative yet complex structures do not come without their own sets of rules and limitations, many of which can make executing on a manager’s vision of bringing 2 & 20 (2% management fee and 20% performance incentive, usually reserved for alternative fund managers) returns to retail investors difficult to attain.

Both tender offer and interval funds can hold far less liquid investments than mutual funds; however, there are still certain specific liquidity requirements that interval funds have to adhere to.  Relatedly, these funds need to have the ability to value their underlying investments around the stated intervals for subscription and redemption.  The type of illiquid private equity and hard asset investments often sought by managers can make adhering to these valuation requirements often quite difficult.  Furthermore, these are still registered products; meaning, Securities and Exchange Commission (SEC) registration is still required – the regulatory review period and comments can be extensive, increasing the cost of setup due to runaway legal expenses.  Intermediaries have also been reluctant to add these types of vehicles due to the lack of efficient trading and risk they may incur, as these structures do not offer daily liquidity.

Figuring out and establishing the right structure for the intended portfolio strategy can be time consuming and expensive, but these funds can open the gates to many different asset classes that otherwise would not work in a fund.  The managers who have been successful enjoy a corner of the market that is less crowded with competitors and allows for higher fees; however, mass distribution and automation have been slow to follow suit and finding success for a start-up in this space is an uphill battle.

Be Different, but Not Too Different…
There are over 1,000 different U.S. mutual funds in the Morningstar U.S. Large Cap Growth category.  This is not to say that a manager cannot successfully differentiate and distribute their Large Cap strategy; however, it is difficult to compete when you are up against four and five-star funds, with multiple billions in AUM, single-digit basis point expense ratios, and long track records of good performance.  Certain niche categories are often more intriguing to investors, and intermediaries in particular, as they can provide exposure to segments of the market that are underrepresented in portfolios or lack interesting ideas. 

StoryWe continue to see good small cap managers grow their assets.  Small cap funds with a great story and/or possess unique characteristics specific to the manager’s strategy are consistently interesting to distribution counterparties, particularly when capacity is a constant issue for successful managers.  There are lots of ways for managers to differentiate with various international strategies, but these funds can be expensive and operationally difficult to run.  A long-running bull market has beaten back a once vibrant liquid alternatives segment; however, we continue to see more esoteric strategies, such as call option-writing funds, gaining traction due to their very specific purpose for certain types of portfolios.

On the other hand, managers that are too focused on being different –or overly innovative – can often encounter regulatory hurdles or challenges creating their product under the ’40 Act framework.  Not that the mutual fund industry is not prone to innovation or new ideas but finding success as the first manager to create a new strategy in a mutual fund can often be a long and difficult road.  There are times when we have to counsel managers that while an idea might be unique and exciting, the prospects for establishing it in a fund are onerous, and the pace of adoption in the industry might not warrant the time, effort, and expense that the manager will undertake.

Share Classes – Cheaper is Better (see Lower Cost Structures)
From what we have observed, the days of new funds opening an Institutional, Investor, A-class, C-class, etc. are over.  Some distribution channels will not even accept a fund that has load associated with another class.  At Ultimus, approximately 80% of the flows we see into our funds are through clean fee structure share classes, such as Institutional or R6. 

We are also seeing the creation of no transaction fee (NTF) platforms that are specifically built to trade institutionally priced funds.  On a regular basis we are working with our clients to revisit legacy share classes and embedded fees to adapt them to both the demand for lower overall expense ratios and the increasingly complicated fee schedules from the intermediaries.

Conclusion
Staying on top of trends and understanding their impact on an adviser’s firm are not only important for ensuring survival but could even be a necessary component to growing AUM, if acted upon with strategic forethought.  We operate in a dynamic marketplace, with numerous factors contributing to shifting demands and desires – often increasing both complexity and opportunity simultaneously.  Understanding the driving forces behind such factors can give an adviser a key competitive advantage in managing and distributing their fund.  Since we at Ultimus take a consultative approach to doing business with our clients, we are uniquely positioned to support advisers as they navigate these prevailing trends and sometimes challenging shifts in the marketplace.  Are you in the best place to take advantage of the current trends?

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