As part of this month’s Expert Insight feature, Finance Monthly had the privilege to gather insights from Bob Dorsey, CEO & Managing Director at Ultimus Fund Solutions, one of the largest independent mutual fund service providers in the United States.
Ultimus recently celebrated its 18th anniversary and I recently celebrated my 33rd anniversary in the mutual fund industry. Those milestones gave me an opportunity to reflect on how much the fund industry has changed in the new millennium, while also highlighting the trends for success.
The distribution models, investor expectations, and regulatory landscape are all markedly different today – influenced by regulatory scandals, the largest financial crisis in history and dramatic evolution of technology that has changed the way information is shared and people interact. Given the recent anniversaries this seems like the perfect time to look back on the events that have shaped the evolution of the industry, dig into the impact they have had on the mutual fund business and share some insights about what it takes for fund managers to succeed in this new environment.
Rise of the Mutual Fund Supermarket
In the late 90s fund distribution was completely different than it is today. There were many investors who would fill out paper applications and send checks directly to the funds. The funds were selling themselves largely to do-it-yourself investors in a much more fragmented model. But much like any industry, those inefficiencies created opportunities for innovation and platforms like Schwab, Fidelity and Pershing took advantage.
The platforms saw an opening to consolidate distribution through financial intermediaries instead of the direct to investor model. They began offering more and more services to fee-based registered investment advisors (RIAs) with the promise of being their back offices while offering access to thousands of funds through a single channel. The more services the platforms offered, the more RIAs got on board, and the distribution model and the balance of power in the fund business inexorably shifted.
The platforms soon became fund supermarkets, offering access to a seemingly unlimited number of investment choices, seizing control of the distribution channel and simultaneously changing the pricing structure along the way. The platforms fundamentally changed the way mutual funds are distributed. Funds rarely sell directly to investors anymore; they sell through intermediaries. Instead of buying funds, investors now buy advice or asset allocations models from RIAs.
Surviving in the New Distribution Dynamic
The new distribution dynamic has significant implications for funds, not the least of which is increased costs. As these platforms have become the norm, funds and/or fund managers must pay to gain access to investors. That has caused many fund managers to get out of the fund business altogether because they can’t afford the costs, but at the same time others have jumped in because they see a much simpler way to gain broad distribution.
For fund managers, the emergence of fund supermarkets has transformed distribution from a relationship sale to a strategic exercise. When a firm launches a fund it now must think about all the spheres of influence and consider every step in the process; from product design, pricing and positioning, channel selection and relationship building. That’s why many of the best wholesalers today are CFAs or investment professionals versus traditional sales professionals. They are no longer selling to individuals. They’re talking to financial professionals who want to speak to someone who can understand and articulate the difference between funds and strategies so they can make more informed decisions for their clients.
The most successful fund managers have figured out the complexities of the new landscape or work with someone who can help them navigate the nuances of the platforms to gain the distribution they need without breaking the bank.
The Technology Transformation
Technology is often seen as the great equalizer and in some ways technology advancements in the fund business have helped level the playing field among fund managers. Technologies like Fund/Serv have made automation widely accessible, allowing new levels of information sharing, order processing speed and documentation. Automated transactions have fundamentally changed the way transfer agents operate and e-delivery has dramatically changed the way we do business in general.
Technology has changed how we share and from where we get our information. Funds used to scramble to get the NAVs calculated by 5:30 pm because if they didn’t have it done by then they wouldn’t be published in the Wall Street Journal the next morning. Integrated technology solutions have made the daily NAV process easier, but perhaps a better indication of the impact of technology is that few people rely on the WSJ for that type of information.
For fund managers, technologies have delivered economies of scale that never existed in the pre-automation world. Unfortunately most of those economic benefits have been offset by the skyrocketing distribution costs mentioned earlier. They must continually look for new systems, new processes and new partners that will help them balance increasing investor demands, regulatory requirements and distribution needs with the need to keep costs as low as possible.
The Increasing Importance of Operations
Fund managers trying to succeed in the mutual fund business today face increased competition from new managers entering the space, higher product complexity and confusion, and growing compliance requirements, all of which can lead to increased costs at a time when investors are demanding lower fees.
In this environment, operations have risen up the list of fund business priorities. Not that they weren’t important before, but now an institutional-quality infrastructure is a business imperative. It can mean the difference between the right distribution strategy and an inability to gain assets; it can deliver process efficiencies that drive down costs or reputational risk that can force a firm out of business.
The most successful fund firms understand the importance of operations but they also understand that they need to identify the right partner to help them succeed. Because a fund manager that is forced to be focused on fund operations most likely isn’t spending enough time minding their strategy or serving their shareholders – and that isn’t a recipe for success.
The Regulatory Revolution
To say the regulatory landscape has changed in the last 18 years would be an understatement. When we founded Ultimus there was no Patriot Act, Sarbanes-Oxley or Dodd-Frank, and no Department of Labor fiduciary rule guidance. These pieces of legislation and the DOL rules have changed the way funds do business and interact with clients in general.
The piece of legislation with perhaps the greatest impact on the fund manager’s business is the Dodd-Frank Wall Street Reform and Consumer Protection Act. Dodd-Frank forced many alternative managers to register with the SEC, which opened the door for these managers to launch liquid alternatives funds. The DOL fiduciary rules have led to massive changes in fund share classes and payments to intermediaries. These legislative and regulatory events have resulted in the fund industry being a very different business than it was 18 years ago.
Thriving in the New Regulatory Normal
Creating a culture of compliance is critical to the success of fund managers in the new regulatory landscape. It’s not something they need to do simply in order to avoid fines or violations; it’s a business imperative — investors expect fund managers to have functioning compliance programs in place. The challenge is achieving a culture of compliance without having compliance costs go through the roof. That’s even more important as increased demands for transparency among investors drives fee pressure.
Essentially fund managers must find a way to be as efficient as possible because they’re getting squeezed between downward fee pressure and rising distribution costs. That puts a whole new level of pressure on the operational component of the fund business. More and more fund managers look to outside experts to support them in developing and executing key aspects of their compliance programs and broader operational functions. While there is a willingness to outsource compliance functions, smart managers know they can never fully offload responsibility. Working in partnership with outside experts creates the best balance and leads to better cost and compliance outcomes, ultimately driving greater business results for funds.
The last 18 years have definitely been transformational in the mutual fund industry. Looking ahead, the industry evolution is certain to continue based on dynamic investor demands, emerging technology, and cautious regulators, but will you be ready for these changes?