1	Forces Shaping the Worldwide Mutual Fund Industry 2-08 Avi Nachmany Director of Research, Strategic Insight
2	2008 Anxiety in Context of “Tectonic Plate” Investment Industry Shifts in Recent Years A challenging year: assumptions to make? Worldwide, from “home bias” preferences to int’l diversification; will it last through the stock markets price corrections? Asset allocation “religion” greater prominence, implications 2H ‘07 Value to Growth rotation – 2008 correction impact? Pricing, fees, distribution trends, and more.
3	$27 Trillion, and Growing: Internationally and in the U.S.
4	Beyond US: SI Recent Study - Asia Fund Management and Middle East Opportunities: Investing in the Future Opportunity: Over the next 5 years, mutual fund assets in Asia could expand from $1.7 trillion to $6-$8 trillion (assuming normalized economic growth) Future is Here: In 2007, net flows to stock and bond fund in Asia ~ $450 billion; annual flows might rise to $1 trillion in 2012 Insatiable Demand: To succeed, local distributors must partner with quality investment managers in Europe, America, and Australia SI Resources: new in-depth study augments the suite of research resources we already offer nearly 70 of the world’s most dynamic investment and distribution firms, helping them build their businesses in Asia and worldwide.
5	US Sales, Inflows: Open-End Stock and Bond Funds
6	Down Market Redemption Spikes Short Lived, and Equity Fund Overall Redemptions are Trending Down
7	Equity Fund Portfolio Managers Buffer Investors’ Fluctuating Flows
8	Just Before the Alarming Correction: Extraordinary Expansion 2006 –2007 Assets gains: ~$1.8 trillion ’07, $1.6 trillion ’06 Equity investors returns: 16.4% ’06; ~10% ’07 US growth style outperform value in ’07 by 12%, and flow rotation to growth was in place 2H07 Int’l Equity: ‘07 Int’l active fund flows ~ $180 B (US active fund negative); same pattern as 2006 (of course, many US funds grew, but other shrunk) 29% = int’l equity fund share of equity fund industry sales in 2007, 28% in 2006; will increase more… Fund-of-funds:’07 FoFs net inflows ~ $140 B Bond funds: ’07 bond fund flows ~ $140 billion; gains in FoFs, wraps, US Dollar play, specialized strategies; small impact of credit market turmoil Money market fund flows: ~ $600B YTD.
9	US: Strong Demand for Active Funds Persists Stock / Bond Fund Inflows $B
10	Majority of Managers Continue to Experience Organic Growth
11	Asset Management Industry Profitability High (Of Course, Not For Everybody…)
12	VA Fund Net Inflows: Sales and Switching Pace Up, Net Flows Still Modest
13	Accelerating Closed-End Fund IPO Cash Flows, Until 7/07; Rebound through Income-at-Retirement Focus?
14	SMAs – Steady Expansion; Complementary to Mutual funds
15	Pausing, as We Look Ahead By their actions, investors worldwide have shown more confidence in the mutual fund vehicle than some of us believe, but caution is evidenced also and many legacy managers failed to participate Fund Selection Units and other sales practice changes opened doors to smaller, alpha-generating investment firms (“centers of excellence”) at expense of larger managers.
16	II: Bull, Bear, Painful Timing Errors, and Risk Control Lessons
17	Converging Forces: Bear Market, New Regulations, Political Risks in Being “Guardian of Nation’s Retirement Savings”: “Always Protect Yourself” “Million Dollar Baby”, pre-assembled advice / asset allocation focus, greater use of “screened, selected” funds (Fund-Selection-Units), fee-based pricing, “need based” packaging - all eyes on pre-empting conflicts and keeping politics away…
18	“Investing as Consumers:” Understanding Our Biases Making choices in our lives based on “past experiences” is common, if not innate Buying another Lexus, Godiva, or Jimmy Choo makes sense Buying the “hottest” (stock, fund, style) generally does not The US financial industry is transitioning towards offering more selections featuring “asset allocation by default”.
19	Solution: Asset Allocation by Default “Investing as Consumers” dilemma, the Herculean task of investor education, and other drivers of the explosive growth of “Assembled Advice” and asset allocation processes Because of fiduciary concerns, “Assembled Advice” will increasingly dominate financial advisors’ / DC plan recommendations For example, a prudent higher allocation to int’l equity funds (currently 29% of equity fund overall assets); more to come (a move away from “home-bias” in Europe, Canada, Japan …) Or, adding to bond fund exposure during flat yield-curve periods.
20	From Exuberance of “One-at-a-Time” to “Package Deals”: Inflows, Lessons Funds-of-funds: 2007 flows ~$140B; ’06 $110B; ’05 $80B Fund wrap inflows rising: $85-90B in ’07 flows, up from ~$60B in ’06 Asset allocation programs’ net inflows > 2/3 of all open-end stock/bond fund net inflows How can you participate in the restructuring of the wealth management process towards asset allocation, evidenced everywhere?
21	Asset Allocation, “The Paradox of Choice”, The Future of Advice Huge sales gains by FoFs, “Wraps”, and the like; more to come due to U.S.’s 2006 Pension Protection Act; marketplace forces a transition to “asset allocation by default” “Choice within constraints, freedom within limits, is what enables the little fish to imagine a host of marvelous possibilities” (Barry Schwartz, The Paradox of Choice: Why More is Less, Page 236 and the closing sentence) Using a “total wealth” frame of thinking, instead of zeroing in on individual investments (for which perceived risks are amplified) lead to better long-term decisions (as suggested by Daniel Kahneman, recent Nobel Prize winner); funds-of-funds or “wrapped” investments help to keep investors more in “total wealth” frame of mind…
22	Pre-Assembled Advice via Funds-of-Funds: Away from “One-Great-Fund-At-a-Time”
23	A Unifying Solution: Mutual Fund Wraps
24	Comfort Zone Investing: Balanced Funds’ Share of Equity Fund Sales (Some Substitution by Funds-of-Funds)
25	International Equity Fund Extraordinary Flows: Rational + Opportunistic
26	International Equity Funds: Recent Explosive Gains, Anticipation of More ’07 flows ~ $240 B; foreign equity allocations to further rise from still-too-low ~29% of assets; is a 50:50 allocation hyperbole? Will it settle instead at 65:35? Int’l style-box mindset (+ Emerging Markets) + innovative strategies + FoFs trigger additional sales due to refined asset allocation Away from “home-bias” (worldwide); trailing returns, US Dollar long-term trend favorable International fund inflows stay high; trend strong enough to overcome temporary stock market volatility or Dollar (temporary?) rebound.
27	Away from “Home-Bias” in US, Italy, Spain, Germany, Canada… to Continue A “Flat World” for wealth opportunities (and risks) dictates a greater exposure to intellectual capital outside your home country, especially for long-term oriented retirement portfolios Beyond (cyclical) nature of investors chasing yesterday’s winners (lately, int’l equity funds…); the desire for global diversification is here to stay Such secular demand could serve as a counterweight during periodic reversals in return-chasing investor flows.
28	Diversified Int’l Equity Funds Summary (Exc. VAs)
29	Emerging Markets, Regional, and Sector Int’l Equity Funds (Exc. VAs)
30	Global / Int’l Bond Funds (Exc. VAs)
31	III. US Growth vs. Value Performance Differential
32	US Growth Fund Flows: Rebound, Pause, 2H07 Gains, 2008?
33	US Value Fund Inflows: Slowdown after 5-Year Leadership
34	IV. From Equity Focus to Income: Finally, Using Our Cash in the Bank: For What?
35	Bond Funds: 1H07 Flat Yield Curve to Recessions Expectations 1H08
36	Bond Fund Rising Sales Despite Flat Yield Curve 1H07: ’07 Bond Fund Flows ~$140B!
37	Historically, but Not in 2007: Bond Fund Sales Accelerated When Yield Curve Steepened, Collapsed When Short Rates Rose
38	Bond Fund Sales, Flow Trends Asset allocation requires (core) bond fund exposure even in today’s yield curve; also for wealth protection, economic and US Dollar anxiety Bond fund NAV risk (from rising interest rates) lower than generally assumed, since average duration of bond funds very short – 4 years for taxable, 6 years for Munis Plus, $5+ trillion in cash looking for a solution; as cash income less than inflation Bond fund ’07 flows ~$140B, ’08 demand persists.
39	For Your Income Solutions Income, dividend fund sales, a story to tell every day; helping brokers engage MMF / Banks $5 trillion+ in cash Strategic Income, Total Return Bond fund, Core-Plus (for asset allocation), Int’l bonds, other innovative strategies: unrealized sales promise.
40	Bond Funds’ Vulnerability to Rising Rates: Less Than Believed (Average Duration 4.9 Years)
41	V. Newly Introduced Funds: Less than Before, Against the Tide Equity funds: funds-of-funds with diverse strategies, international, clone funds to manage capacity, quant, global real estate, commodity real return, other non-correlated strategies, institutional stand-alone funds, many sector / innovative ETFs, etc. Bond: international bond, floating rate, TIPS, multi-sector, short duration, cash+, and other strategies; some expansion in bond ETFs.
42	VI. Investors Worldwide Continue to Focus on Managed Assets Increasing demand for funds; accelerating shifts from stocks to “managed assets” (funds, SMAs, ETFs, FoFs, etc.) Fund expansion globally, inflows accelerating in Asia (~ $450B in 2007!) Institutionalization of fund selection (FSUs) Further transition toward “fee-based” SMAs help fund managers cross-pollinate Hedge fund boom, but for individuals, mutual fund investments “not-fully correlated to market” only slow gain (~$5B in ’07 flows, same as ’06; in market neutral, 130:30); recent slowdown as a result of a reality-check.
43	Questions on our Collective Minds: US Mutual Fund Investments Beyond just selling 1-fund-at-a-time: how to participate (distinctively) in assembled advice, asset allocation programs and industry transition 2008: What’s next for value funds? Growth-style sales recovery for real this time, despite January? Will high demand for international equity last in 2008? Bond fund opportunities in steepening yield curve ETF: stock/sector bets vs. mutual fund substitution? VAs: attracting new customers, retirement income reality Closed-end fund IPOs: ~28B ‘07, but window now closed My Company investment process: understanding institutional analytics, building internal consensus (CIO, portfolio managers, sales, marketing, etc.), and articulating externally to clients.
44	VII. ETFs: Rapid Expansion, but Slower Growth as an Active Equity Fund Substitute My view: for now, 80% of ETF use by individuals represents substitution of stocks / SMAs, and not of actively-managed mutual funds; but retail use of ETFs and ETF “wraps” materializing slowly Inst’l and retail: ETFs aggregate 2007 net flows ~$150 billion more than twice the $69 B in ’06 vs. $54B in both ’04 and ’05 Bond/Currency ETFs hold only $38 B in assets, but growing; $15 billion 2007 inflows When will active ETFs become reality? Does this matter? Funds-of-ETFs use?
45	ETFs: Common Themes Retail: mostly stock / SMA substitution, asset allocation building block; completion strategy (when no small cap SMA or in-house product); core-satellite (passive Large Cap core and non-ETF active “satellites”); new or small account implementation; strategic sector bets; commodities Institutional: cash equitization (liquid ETF holdings instead of cash) / futures substitute; risk management (add / remove duration risk to portfolio); portfolio “building blocks”; portfolio hedging/shorts; manager transition Emerging themes, and future: commodity/currency, leveraged/inverse ETFs, US sub-sector, “fundamental” index-based, additional bond ETFs; value/growth of regional int’l funds; int’l sector; lifecycle; funds-of-ETFs; ETF of ETFs, the retirement market, replicating active funds using attribution analysis? Using ETFs to wash away capital gains? Will truly active ETFs be allowed? Will they be cheaper than today’s active funds?
46	VIII. A Reality Check on Fees: Some Observations, Frequent Questions Advisory fee breakpoints, economies of scale; (fee waiving at times, but less than 7% of funds changed contractual advisory fees in ’04, ’05, ’06, ‘07) Consistency (harmonization) of breakpoints: funds vs. VAs and throughout one’s fund line Performance-based fee asymmetries TA fee benchmarking, small accounts’ impact Retained advisory fees in sub-advised funds Fund closing and 12b-1 fees Advisory contract renewal other themes.
47	XYZ Fund vs. Mid-Cap Growth Peer Group Hypothetical Advisory Fee %
48	XYZ Fund vs. Mid Cap Growth Peer Group Sub-Advised Funds Only Hypothetical Sub-Advisory Fee %
49	Why 22c-2? Abusive Arbitrage Trading in Int’l Funds Largely Gone
50	IX. What Will Investors Buy in Coming Years? Stock market lingering concerns; equity funds for the “long-term”; relative return winners; higher dividends; growth style rebound delayed?; will tax management re-surface? Bond funds: sustained demand, despite flat yield curve 1H07, ~$140B in ’07 flows! “Pre-assembled advice” investing continuing International fund sales gains persist Tactical asset allocation, long-short, 130:30, and other clear-eyed strategies?
51	Lessons from Bear: Losses, Yet Equity Funds Remained a Leading Theme Past bear market did not change long-term investment optimism in US ; perception of most – risks are only in the short term, rewards are certain in the long term Equity funds purchased for strategic asset allocation; unless and until there’s a long period of reduced personal confidence (not just NAVs!) or the US becomes a nation of pessimists But, re-dedication to asset allocation.
52	Because of Retirement Funding, Even During Bear, Sales Majority to Equity Promises (Automatic Investments Help)
53	Buying or Redeeming Individual Funds: Look Back Style-Based Excellence A compelling reason to buy, and a compelling reason to redeem; funds are not commodities…. Style-adherent risk-adjusted past return excellence – a magnet for inflows; winners grow, losers shrink Take your pick: Morningstar Stars, Lipper Leaders, S&P Stars, or just 3-year simple look back – any such measure correlates well to flows.
54	Buying / Redeeming on Past Performance: Flows vs. Relative Risk-Return Excellence – (Trailing 3-Years; Mid Cap Blend)
55	Risk/Return Excellence Over Time, and Resultant Flows: Look-Back, Rolling 3-Year Periods
56	Key Investment Selection Question Unanswered “Seattle” (top left) vs. “Miami” (bottom right) positioning on risk-return grid: which to buy for “win probability” for next 3-5-10 years? Not just looking back, and “investing as consumers” “Stars”: predictability, or lack thereof Dynamic rebalancing away from “hot” style; toward an investment process, not just look-back ranking excellence (within a “fuzzy-border” style box).
57	X: Fund Distribution and Pricing Evolution Financial advisors control present and future fund distribution Accumulation for retirement key; how soon (or if) “distribution” phase? Will “outcome-based” dialogue becomes a common reality? A continuing transition toward fee-based relationships The newer standards of due diligence Institutionalized selection and B/D Investment Analysts’ expanding powers.
58	Financial Advisors Increasingly Dominate Mutual Fund Distribution
59	Financial Advice: Market Forces, Best Practices in Transition From “1 idea at-a-time” to “assembled advice” Many financial advisors are moving away from previous primary focus on investment “discovery”; more often, attractive funds are now identified by Investment Specialists (Fund Selection Units), not the advisor; and allocation / rebalancing done by Investment Committee, freeing advisors to do other things… Instead, advisors concentrate on needs of their wealthier clients, and offer specialized advice (real estate, trust, education, insurance, etc.); focusing on “total financial life”; replication (understanding their best clients, searching for similar prospects), aggregation (capture more of best clients’ household wealth), validation (investment choices, beliefs, concerns); FAs need help building a business. A new dialogue: income-at-retirement vs. product-focus?
60	Questions on our Collective Minds: Distribution, Retention 2008-2010 Institutionalization of fund selection: evaluation process, information flow, wholesaling structure implication; tomorrows’ wholesalers trained today Retirement income; will such “need based” discussion become industry “new language?”; fluctuating personal risk horizons; and what “financial freedom” means Overcoming brokers’ fatigue (away from “exciting” ideas and to “asset allocation” makes story “boring”) Fast gains in fund “wraps” to persist Rollovers: large and growing; FoFs and rollovers Keeping fund directors within their comfort zones via active engagement, education; trustees’ rising interest in understanding changing distribution and fund pricing landscape and its long-term implications Expansion opportunities in Asia, Europe.
61	Income-at-Retirement: New Dialogue with Clients Income-at-retirement (pre-mature) reality; but benefits of “outcome-based” dialogue Fluctuating Personal-Risk-Time-Horizons Financial freedom for some = opportunities Financial freedom for others = no financial fears Income-at-retirement is a very different concept for these two groups.
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63	Almost All 401(k) Investors Use No-Load Shares Classes or “A” Shares Purchased at NAV
64	Expense Ratios Paid by Investors Using Mutual Funds for their 401(k) Plans are Significantly Lower than All Fund Investors, and Are Falling
65	XI. Fund Pricing: Asset-Based Fees, with Some Exceptions… Commissionable “A” down to possibly 15% of B/D sales (some exceptions); and “perfecting breakpoints” is not an exact science Star Blind: time for Morningstar to stop panelizing “A” shares due to their (rarely charged) loads “C” shares 13-15% overall B/D sales (higher among some B/Ds’ retail lines); automatic conversions (SEC’s buzz?) “B” shares falling to 3% of sales, down from 25% a few years back; “Bs” rapidly liquidating
66	Fee-Based Pricing: Transition Largely Accomplished at Nat’l B/Ds, vs. Legacy Pricing Still Common Elsewhere Pricing dichotomy national BDs vs. others e.g., Merrill Lynch: Retail A/B/C (60% level-load), Retirement Platforms (mostly NAV), and Fee-Based (NAV) But among some fin’l planners, regional BDs, some front-load business sustainable since this is most attractive to ‘buy-and-hold’ (AG Edwards, ED Jones evolution too?) Overall, transition to fee-based, externalized (non-fund) fees for advice.
67	Developments in Share Class Pricing: Change Ahead in 2008 Past: no major pricing modifications by fund managers considered leaders / trend setters for equity or longer duration bond funds (except some fine-tuning…) ’08 Watch for: will UMA activity at Smith Barney, Merrill, ED Jones may unleash a wave of new inst’l share classes (no 12b-1, 10 bp Sub-TA only); but lower fund fees does not mean lower expenses to investors as overlay fees high (and in after-tax $) SEC Rule 12b-1 actions?
68	Retirement Share Classes: Summary Most retirement business comes at 25 bp / no 12b-1 fee share classes American Funds control the great majority of this segment; note that its effective total expense ratio (before 12b-1) is just 0.41% of fund assets 12b-1 fee 0.50% R-share demand is evidenced but growing only slowly; little activity at 0.75% and 1.00% 12b-1 R share classes (exc. Am. Funds) Exc. Am. Funds: Only 7 managers with R-shares whose 12b-1 fees are ~0.50% garnered $200 million or more in ‘07 net inflows within such funds; only 10 such funds gained > $100 MM in ’07 flows.
69	SI Helps You Monitor Pricing, Fee, and Other SEC Filed Changes Set up a customizable e-mail Daily Alert of all Fund / VA SEC filing changes you care about via www.SimfundFiling.com Instant link to Latest Prospectus and its Key Data Weekly synopsis: all new SEC filings Fund and VA detailed fee data; subadvisory fees (Simfund) Research library on-call (Annuity Insight.com, Sionline.com).
70	XII: The Path Toward Institutionalization of Fund Selection Most B/D sales at NAV within a platform, esp. among national B/Ds, large planner firms In Key Accounts – from one-third to 100% of sales within the screened list Selling by mixing science and art: transition from legacy, relationship wholesaling, to a new institutional process and culture Yet range and diversity of FAs; wholesaling coverage continues to be very important See FSU Checklist in 2-07 issue of SI’s Windows report.
71	Fund Selection Units (FSUs), Investment Analysts’ Expanding Roles Same review process throughout product lines due to merging of investment analyst units: mutual funds, VAs, SMAs, retirement, 529, closed-end, and in Unified Accounts… Fee-based pricing puts more power in hands of investment analysts within distributors Analysts’ interest in unknown managers Responding to this trend, fund managers intensify review of FSU engagement process and people, and expand their teams In the long-term, this also has investment strategy implications.
72	To Optimize Engagement with Investment Analysts, Selection Units A small number of FSU teams control a high % of your sales opportunities – must invest time in getting to know them; Articulate investment process, internally and externally, and expand role of competitive analysts (w/in sales unit) to cover FSU needs Product development, investment risk control, CIO and management considerations What data to share with B/D investment analysts? How and how often? Proactively? Critical for company to provide funding, build internal team skills, resources.
73	Understanding the FSU Process, and Greater Engagement Within your key accounts, how well do you understand Fund Selection Unit (FSU) methodology, matrix (anticipate, reach out) Peer group confusion: Morningstar, Lipper, or customized peer group Helping FSUs beyond just articulating your investment process Support: the importance of FSU to the investment analysts’ own organization (which may still just focus on legacy-type sales…)
74	Relationship Gatekeeper Viewpoint: Asset Allocation Consciousness, Implications Transition to asset allocation vs. “story” sales; how to overcome my brokers’ fatigue Identifying quality, capacity in int’l equity funds; what if their sales rise to 40-50% of total equity fund sales? Unique bond funds to add value to FA advice? Identify interesting asset allocation funds, processes; role of flexible funds, global funds, funds-of-funds; long-only funds as building blocks vs. long-short vs. non-correlated funds...
75	Relationship Gatekeepers: Increase Sales by Monitoring Changes -- What’s Selling, PMs, Capacity, Fee, Benchmarks, Strategies Business: Do I offer the funds investors buy elsewhere? Timely news about MyList of such funds, managers; limited capacity funds, partial closing; new unique funds, and where they fit Investments: PM changes, investment policies, portfolio data updates (what, how, and how often)? fees (absolute, relative, peer group, and timely updates) How high is The Wall, Business vs. Investments? Quality, timeliness of investment managers’ response, when needed; helping you (build, strengthen, protect) beyond just articulating investment process.
76	FSU Investment Analysts: Screen, Select, Monitor Luck vs. Skills Past-performance (which) methodology: return, risk, time horizon Peer group confusion: Morningstar, Lipper, customized peer group, stated index, other? What is short-term measurement period? Long-term? How much tolerance of under-performance? Forward looking: buy-sell decision, culture, compensation, training Monitors pricing; “C” vs. “A” vs. “R” vs. “I”; 12b-1?; fee benchmarking; emerging solution for National BDs: no-12b-1 fee, low sub-TA, and no other revenue sharing.
77	XIII: VA Fund Net Inflows: Sales and Switching Pace Up, Net Flows Still Modest
78	The VA Business: Highlights VA Guaranteed Minimum Withdrawal Benefits (GMWBs) main sales driver; more lifetime and spousal versions available ’06-07 sales above those in prior years; but net flows flat and modest Inflows of note: funds-of-funds; int’l equity and bond funds with diverse strategies, selected Multi-Cap Growth, small/mid-cap, natural resources, intermediate bond, TIPS Equity Indexed Annuities’ (EIAs) rising compliance demands hurt their sales ’06-07.
79	Variable Annuity Annual Sales Trends
80	VA 2006-2007 Developments: Funds and Investment Strategies Overall sales rising but data shows no corresponding gains in net flows Asset allocation funds-of-funds’ growth accelerated, and interest emerged in target maturity FOFs; ~$39B of FOF annual flows implies over $45 billion in sales (possibly 30% of total sales, and higher in some sectors) Master feeder formats adding VIT portfolios Consolidations of sub-advised platforms continue.
81	VA Assets and Net Flows by Fund Segment
82	Factors Fueling Growth in Sub-Advised Segment Attractive profit retention even after outsourcing investment management Multi-manager diversification Flexibility in replacing under-performing managers, and pricing power Allows adding of brand name investment managers Ability to add a unique investment approach Superior performance (return / risk) Other (e.g., access to distribution).
83	Considerations for Managers on VA Platforms Performance, based on strong Morningstar Ratings, Lipper Scores… attractive 3-year return / risk record a prerequisite… Style discipline important for hedging, asset allocation management… insurers, investment analysts count on style-purity, well articulated investment process within the style box… Fewer opportunities in large cap funds; capacity-driven need for small cap, int’l funds, alternative strategies.
84	XIV. A Closing Thought US mutual funds will continue to grow unless bottom falls out; ~$13 trillion now, $30 trillion next decade; similar asset trends, and even faster growth in Asia; yet ’08 a challenge Expansion opportunities for alpha-generating funds with open capacity To grow and defend what you have built, you need to increase learning consciousness of others in firm, since you have no time to teach, or learn yourself. Strategic Insight and its 65+ associates can help, as we have already done for over 21 years.
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86	SI Research Services Already Used by Managers of 90% of U.S. Fund Industry Assets, and Globally, nearly 70 Leading Managers, Distributors Simfund Databases: Funds, VAs, and Soon Asia and Europe SI On Line.com SimFund Filing.com Strategic Insight Global.com Annuity Insight.com Strategic Insight 212.944.4455 Avi@sionline.com