Transparency and Objectivity: New Mantra to Mutual Fund Investing

This article looks at the world of mutual funds, and the dramatic changes it has undergone in recent years.

The road to Damascus is sometimes a crowded stretch of highway. In the footsteps of Saint Paul, have followed for example, the Catholic Church (the earth is the centre of the universe: it does not orbit the sun). In corporate matters too, we sometimes see changes of strategy that remind us of the power of revelation — blinding or gradual.

Many companies go through significant changes of strategy on an on-going basis — something between revolution and evolution. Such a change has been taking place in the world of financial services, and, as is usual, much of the drive for this change has been coming from developments in the United States.

The Quiet Revolution

Let us consider the world of mutual funds. For many years the industry was managed on some widely accepted assumptions. The provision of controlled exposure to the capital markets (bonds, equities, currencies) could be provided to retail clients (or individuals with larger amounts available) at relatively attractive rates to both parties. The mutual fund company could charge an up front fee (up to 5% was not unusual), and an annual management fee. The individual could invest with a trustworthy counterparty that had intimate knowledge of markets, for relatively modest amounts.

As people in Western countries grew more affluent, and access to market moving information became more widespread, so the industry developed. More and more mutual fund companies were formed, providing funds that invested in everything from traditional markets, to different style orientations (value versus growth) to emerging markets, sector funds, index funds and so on. Not only this, but other competitors began to enter the marketplace. In short, the marketplace became very crowded. This had several effects. The sheer number of funds and investment options became very difficult to monitor and properly assess. Financial advisers (independent or otherwise) began to provide a service of distinguishing between the many products available, and, inevitably, price was becoming a competitive issue.

A Crowded Marketplace

One of the first decisions confronting the advisers in this marketplace was what strategy to adopt. Some banks, for example, had long traditions of only offering clients access to their own funds. They did not have the history, or the infrastructure, to filter a universe of 40,000 funds, to decide which were appropriate to recommend to their clients. It should also be borne in mind that this ‘in-house only’ approach is not simply a self-serving way of gaining more fees from clients. There are fairly weighty arguments that can be used to justify the ‘in-house’ approach. The most important is due diligence. As a financial adviser, you assume a responsibility for the advice you dispense. If, therefore, you recommend third party funds, you have to be sure that the fund you recommend will be managed consistent with certain base requirements in terms of style, tracking error, investable universe, investment process, risk management — and all this before we even begin to talk about performance. With the ‘in-house’ option, you know that the due diligence standards that are applied to the managed funds are consistent with the corporate standard.

Secondly, much of the due diligence process within a fiduciary relationship comes from having a good knowledge of the client, and their risk profile and investment objectives, and matching this to the appropriate investment solution. This can be easier when you are thoroughly familiar with your ‘in-house’ option, than if you recommend a few mutual funds that performed well over the previous 12 months. For example, third party providers may be more susceptible to changes in style or risk appetite, that render them inappropriate to clients for whom they were once suitable.

The Counsellor Speaks

Despite the points raised above, however, it is intuitively easier for clients to accept the bank/intermediary in the role of a ‘trusted counsellor’ if the interests of the two parties are aligned. In other words, there can be no ulterior motive for the advice given apart from the strict criteria of ‘client’s best interest’. This is certainly the case in the US, where the grandly termed concept of ‘Open Architecture’ is increasingly the norm. What implications does this concept have for the average client, and the institution that services them?

Most obviously, the fiduciary responsibility of the institution must be fulfilled. This has significant implications when one considers that there are over 40,000 funds in this crowded marketplace. In order to be able to responsibly recommend a third party (competitor) product, you must be able to satisfy yourself and your ultimate client on the creditworthiness of the counterparty, on the robustness of their investment process and their fund manager, on the repeatability of their (above average) performance, on their risk adjusted return and so on. In addition, you have to ensure that when you compare funds, you are comparing like with like (not all US equity market large capitalisation funds would necessarily have the same universe, benchmark, policies on hedging etc). This means that a meaningful investment must be made by the institution in ensuring that they have a search and assessment process that is powerful and robust. This, in turn, precludes intermediaries of a certain size and below being able to compete in terms of cost or headcount.

Size Matters

Smaller institutions and intermediaries also suffer another disadvantage. Not only are the costs associated with setting up and maintaining such a rigorous screening and selection process high, one must also consider the position of the third party provider (competitor). In many cases, particularly when one considers funds that have sustained strong performance over a longer period of time and through various market cycles, the investment houses and the managers would regard their process as proprietorial, and secret. It would not, therefore, be in their interest to make available their valuation models, for example, to anyone who asked. As a consequence, the investment house is driven by the economies of the industry, to be more motivated to disclose its processes to an outside institution that is in a position to direct the largest asset flow. In plain terms, the bigger the institution conducting third party manager selection, the bigger its leverage.

In the above, of course, the end client is the beneficiary. There is also another advantage: historically the mutual fund market was not that transparent, either in terms of comparative performance, or in terms of pricing. Just as the emergence of financial powerhouses providing their clients with an open architecture environment has increased the transparency of the performance issues in the mutual fund industry, so there is an impact on pricing. In the past, most mutual fund managers marketed directly to potential clients via the mass media or financial journals. In this relationship, pricing was relatively inelastic. Now, however, if you have another institution offering your funds, some price erosion would be normal. Even more so, if a given large institution, in assessing a wide range of fund providers, and with significant potential client assets to advise on, has clear visibility across the industry, can apply pricing pressure in the interests of its clients performance, and its own margins.

Client Benefits

Ultimately, the move away from an exclusive, or partial, reliance on in-house funds will be in the interest of clients. Additionally, what is to prevent banks, for example, from offering discretionary portfolio management, say, on an open architecture platform? In this way, we could envisage a client talking to his advisor at a German bank, and being recommended to choose this large American brokerage firm to manage the US equity portion, this British fund manager being responsible for the European equities, and a Japanese bank managing the global bond portion. All based on the systematic analysis of their respective performances as assessed by the bank’s third party selection process.

In the end, therefore, we may just see the emergence of a brave new world where in terms of due diligence, transparent assessment and selection and pricing, it is the client who wins. Further, given that we are talking about peoples’ savings, this is the way it should be.

Jeremy McAteer
UBS Private Banking