Mutual fund industry braces for shift in sales channels

Mutual fund groups groups must adjust to a new, potentially expensive distribution landscape, according to members of a round-table panel of fund executives, financial advisers and industry experts. With profits being pinched, changes in the brokerage industry will potentially alter the way that funds are sold, accelerating a move to fee-based platforms as firms look to retain clients, said Darlene DeRemer, a Boston-based partner and head of the advisory practice at Grail Partners LLC of New York, a merchant bank that specializes in the investment management industry. She participated in the InvestmentNews round-table discussion that was held at the newspaper's New York office April 6. Ms. DeRemer noted that Class B mutual fund shares are already on their way out, and Class C shares “won't be too far behind in going away.” That would be an added burden for asset managers whose profits are already being squeezed. Class A shares charge a one-time front-end load, B shares charge a back-end load, and C shares charge a level load applied annually as a fixed percentage of a fund's average net assets. The market will move to selling A shares at asset value, meaning the differences between no-load and load share classes “may simply go away,” Ms. DeRemer said. First Eagle sells Class A, C and I shares, said round-table participant Robert Bruno, president of First Eagle Funds Distributors, the -broker-dealer division of Arnhold & S. Bleichroeder Securities LLC of New York. The I shares are institutional shares that come without a 12(b)-1 fee. There has “definitely been a movement to I shares,” Mr. Bruno said. Total assets in mutual funds at the end of last year were $9.6 trillion, down from $11.99 trillion at the end of 2007.
Events that precipitated the asset losses include the September bankruptcy filing of Lehman Brothers Holdings Inc. of New York, followed by Charlotte, N.C.-based Bank of America Corp.'s acquisition of Merrill Lynch & Co. Inc. of New York, San Francisco-based Wells Fargo & Co.'s acquisition of Charlotte-based Wachovia Corp., and New York-based Citigroup Inc.'s announced spinoff of Smith Barney into a joint venture with Morgan Stanley of New York that is set to close this year. Furthermore, as a result of the market's collapse, “individuals' risk tolerances have changed dramatically,” Chris Cordaro, chief investment officer of RegentAtlantic Capital LLC, said during the round table. The Morristown, N.J., advisory firm has $1.8 billion under management. “It'll probably be decades before they're back to where they were, and you see that in the end portfolio,” Mr. Cordaro said. “They want to be very low-risk, and the focus is much more on absolute returns.”

CUTTING COSTS

In order to counteract the asset losses, “there are a lot of cost-cutting moves going on now across the industry,” said Roger Vincent, the New York-based independent chairman of the board that oversees the ING Funds, who also participated in the round table. The funds are advised by ING Investments LLC of Scottsdale, Ariz. Layoffs are one way the industry has tried to cut back. Waves of job cuts have been announced by such heavy hitters as Fidelity Investments; Putnam Investments; The Capital Group Cos. Inc., whose Capital Research and Management Co. unit advises the widely popular American Funds; and BlackRock Inc. “It's a balancing act, especially in the investment area, because we don't want to cut back too much and cut into the bone and meat of our research organization,” said round-table participant Curtis Jensen, co-chief investment officer and a portfolio manager with Third Avenue Management LLC of New York. But that may prove too challenging for smaller players in the mutual fund industry, Ms. DeRemer said. “It's not to say everyone has to have mega-billions under management,” she said. “But [asset managers] that really have mediocre performance and are subscale probably have to decide whether they stay in the business or exit.” Those firms that stay in business will have to meet exacting new demands from investors. The industry will likely respond with more products that stress absolute returns, Mr. Bruno said. “I do think absolute return is a philosophy that will be prevalent for the next few years at the very least,” he said. Mr. Bruno suggested that less emphasis will be put on fitting funds into style boxes popularized by Morningstar Inc. of Chicago. It is a difficult environment in which funds operate, but it is an environment that holds opportunity for fund groups willing to look forward. “I can't tell you what the product of the future is, but there will be a lot of product innovation,” Ms. DeRemer said. Third Avenue is looking at expanding its product line. “One of the things we've looked at is potentially launching a new credit-oriented product, where we think we have a competency internally and a history of investing in distressed debt,” Mr. Jensen said. First Eagle is also eyeing a new fund. “From our standpoint, we're looking at the dislocations that we see in the credit markets and saying maybe we should have strategic fixed-income [funds],”Mr. Bruno said. E-mail David Hoffman at -dhoffman@investmentnews.com. The following is an edited transcript of the round-table discussion. It was moderated by InvestmentNews reporter David Hoffman. InvestmentNews: How has the recent market volatility changed the way fund performance is evaluated? Is there more of an emphasis on absolute, versus relative, returns? Mr. Jensen: There's a little paradox here in the sense that clients always seek relative returns in up markets and absolute returns in down markets. And you can't really have it both ways. So at Third Avenue [Management LLC of New York], we've always put the emphasis on absolute returns. It's what literally puts bread on the table, and we try to communicate that to our clients. Of course relative performance gets some weighting, but the majority of the weighting, in our minds, is around absolute performance, and the environment really hasn't changed that. InvestmentNews: How do you get good absolute returns in a market such as this? Mr. Jensen: The other piece of it is trying not to get too focused on short-term performance. We've built up a track record over decades, and when you look back at 2008, the bulk of the downturn in our performance happened between Labor Day and Halloween. We lost 25% or 30% in two months. And I just have to put an asterisk next to that. It's going to happen periodically. Hopefully, it doesn't happen too frequently. Within our mandate, we don't try to hedge against market risk. We try to protect ourselves via our investment approach, which focuses on buying things that are sensibly valued and well-financed, especially in this environment.
Mr. Bruno: First Eagle [Funds of New York] and Third Avenue are somewhat similar in their approach. We're both value managers, and we've always focused on absolute returns. We used to say we don't really need a lot of marketing material. We have this one calendar card that shows 27 out of 29 years with positive absolute returns, and the only two down years being less than 2% cumulatively. So that used to be all we had to talk about. Now we have last year, which was -21%. [First Eagle portfolio manager] Jean-Marie [Eveillard] has a nice quote, which is, “You can't eat relative returns,” and it goes to the point about putting bread on the table. Of course, now when we go out and talk to people, they say, “How come you don't have that little card that has all the positive absolute returns on it?” But most people are comfortable with the fact that -21% was still a very good year, given last year's tremendous declines. It is definitely a difficult environment. For us, it's been more about what we haven't done versus what we've done. We try to avoid companies that are in momentum periods. We've always avoided companies that use great leverage. So we've always avoided financial services companies, which held us out of maybe the first half of last year's declines, or even up until Labor Day. But after Labor Day, the virus within the financial services market turned into a full contagion across all equities markets, and one couldn't have been exposed to equities without actually feeling some of that severe decline. So for us, it's been more about what we haven't done. We try to avoid situations that carry great risk. The first question we ask when we look at companies is, “What can go wrong?” not,”How much are we going to be able to achieve in a positive way with this company?” So it's kept us out of the big bubble periods. It's winning by not losing and not having unforced errors. Ms. DeRemer: The point's been made that you can't really sell relative performance. Our view is that 2008 was a mulligan for the industry. The returns were so bad across the board that there was really no place to hide. It makes three-year performance returns, on a rolling basis, almost irrelevant in the marketplace. Clearly, it's challenging the industry in terms of the viability of all the money managers.
Mr. Vincent: The perspective I have is really from the standpoint of shareholders and investors. I'll pick up on Curtis' point that in up markets or the expectation of up markets, investors do have an interest in relative return, and in down markets and expectation of down markets, absolute return, of course, has tremendous appeal. Strategic Insight [Mutual Fund Research and Consulting LLC in New York], a consulting firm for the industry run by Avi Nachmany, that many of us know, recently did a mutual fund survey of best sellers, and curiously, what they found was that the best-selling category was the fund groups that have the highest relative return-to-risk profile. That really speaks to the expectation of markets. InvestmentNews: What does that mean for product development? Will there be more of a focus on products that are going to deliver in all markets? Ms. DeRemer: Clearly, we think it will be a movement back to basics, back to simplicity, more transparency. Clearly, there's going to be demand for absolute-return strategies, and perhaps more robust global tactical asset allocation that includes more asset classes, including commodities and other instruments. Typically, in a market like this, a lot of products with sizzle fall by the wayside. Mr. Bruno: I try to travel with our wholesalers often, just to get the feel of what the intermediaries are asking for, and what we might do from an international-product standpoint. What I've been hearing is an interest level, No. 1, from an equities standpoint, limiting the number of funds they have, and maybe not worrying about cap-specific funds as much. Jean-Marie would say you should have three or four good managers, and it doesn't really matter what they're investing in. What a lot of our clients are looking at on the equities side is having two or three good funds and then maybe using [exchange traded funds] as perhaps the sizzle around three core fund managers that they like. And they can use the ETFs more in a tactical way to provide some extra value for the fees that they're getting. We don't have a fixed-income fund, we're basically an equities shop. From our standpoint, we're looking at the dislocations that we see in the credit markets and saying, “Maybe we should have strategic fixed income.” And I don't mean just the next year or two; I'm thinking more broadly. Strategic fixed-in-come funds actually did very poorly last year. Even people like [bond fund manager] Dan Fuss [of Boston-based Loomis Sayles & Co. LP], who are what we would consider at the very top of the industry, had a very difficult year. But there seems to be more dislocations on the credit side that one can take advantage of. But we can't compete with a [Pacific Investment Management Co. of Newport Beach, Calif.], so why have just a plain-vanilla fund? Do something that might be more high-yield or strategic fixed income, where you can go anywhere. Absolute returns are a great objective, but over time, I think an investor has to be at a specific benchmark, or otherwise why not just own an index fund or an ETF? InvestmentNews: You bring up a good point — the whole issue of diversification. I am hearing from advisers that they are focusing less on the traditional style-box mentality. Mr. Jensen: I don't know that that's taken root too much. I know we just had a call with a client that has announced they will consider leaving the fund because we don't represent something that's close to the index. And none of the public funds we manage really match up to an index. Our real estate fund, for example, is not a [real estate investment trust] fund, but inevitably, it gets compared to the U.S. REIT Index, for example, and our flagship fund, the Third Avenue Value Fund, has a very broad mandate, a go-anywhere mandate. Historically, it's had periods where it's holding cash. Today, there's an element of distressed debt, as well as equities. Half the portfolio's in non-U.S. names, so how do you put that up against an index? But in-vestors do. So I think the adviser or the investor out there has to get comfortable with the manager's philosophy and approach to investing and put it in their hands as to protecting their capital and growing it over time. InvestmentNews: Has the market caused funds to change the way that they evaluate risk? Mr. Jensen: The environment is terrific from an investor's perspective or fund manager's perspective because it's opened up a lot more. The valuation gaps have gotten quite stark in some cases and created a lot of opportunities. Our fund was started by our chairman, Marty Whitman, whose history and name is very much tied to investing in distressed-debt and bankruptcy securities. So it's always been part of the fabric of Third Avenue. Within our research group, there is a group of folks who are dedicated to originating and executing and implementing ideas in that segment of the investment spectrum. So it's starting to populate into our public-fund investments. We are examining whether it would make sense to introduce a credit opportunities fund. There are risks there, but I'm not sure they're the ones that the outside-world investors think they are. In in-vestors' minds, they hear the word “bankruptcy” or “distressed,” and they automatically assume there's a higher level of risk. In some ways, the risks are different and potentially less than they are in equities. Just starting out, you are dealing in an instrument that has a contractual obligation, and so some of the things we own will be performing loans, and we'll get our yields to maturity over the next three, four, five years. At least in the United States, you can't take away the creditor's right to what's set out in their contract. Although potentially, some of that's changing with government intervention. But I think the risks really are whether you have the resources internally. Because once you get into the world of distressed and bankruptcy investing, it's a different kettle of fish than being a passive owner of equities. It tends to be more adversarial and labor-intensive. And then you have to really insert yourself into the process and potentially be a voice in a restructuring or reorganization of a whole company. Mr. Vincent: Certainly, boards are very concerned about risk control. But we don't want to have our portfolio managers change the investment discipline for which we hired them. That was thoroughly vetted at that time, and it's our intention that they continue to operate on that basis. So it's a matter of history. We all remember back in the late 1990s when anything that had anything to do with growth was just going up all the time, and value managers were really struggling. One of the things we were very concerned about at the time was style drift — that our classic value managers would not throw in the towel and become surreptitious growth managers, perhaps exactly at the wrong time. So it's a slightly different take on risk, and risk control is clearly very important, but not to the point of shifting the discipline for which the manager is known for, hired for, and what they're very good at.
Ms. DeRemer: Clearly, there were a number of funds and a number of fund families where risk controls were simply nonexistent or very weak. There were a number of intermediate-fixed-income funds that frankly blew up and a number of target maturity funds that im-ploded. So clearly, there is a need for a heightened role of risk management, much like the chief compliance officer being a direct-report to the chief executive, and not having a direct-reporting relationship to the investment management team. Mr. Cordaro: From the adviser's perspective, we're using mutual funds for specific asset classes, and the risk that we see there is dramatic underperformance of the asset class. Some fixed-income funds just blew up and dramatically underperformed. So the end investor may have a difficult time understanding why the justification didn't help. But from the adviser's perspective, we want to see you allocate to achieve a certain portion of your portfolio in that strategy. Individuals' risk tolerances have changed dramatically. It'll probably be de-cades before they're back to where they were, and you see that in the end portfolio. They want to be very low-risk, and the focus is much more on absolute returns, the return of your dollars at some point in time. InvestmentNews: What is your take on the issue of how to evaluate expenses? It seems in this volatile market, it is difficult for funds to measure themselves against their peers, because everything has changed. Mr. Vincent: The mutual fund boards are required no less frequently than annually to do what's called [an Investment Company Act Section] 15(c) review, and under the Gartenberg standards, one of those standards is to look at the fund expenses and performance relative to peers. The real problem with the expenses is that the expense data is going to be very stale. So fund groups that are doing those kind of analyses in the first and second quarters will be dealing with cutoff dates of, say, Sept. 30, depending on what fund groups are in their peer group. Well, that obviously is before the most critical quarter in a number of years; it really shifted that dynamic. It's complicated by the fact that asset levels now are perhaps on the order of magnitude a half of what they were planned to be at this time. So as a result, expense ratios are higher. So we have a lot of pressure on that. I think from a board standpoint, the people that are starting to think about this say that the basic framework of doing that 15(c) analysis should not change this year, but pull out the outliers and subject those to an analysis to really make sure. So yes, it is possible that the firms within that peer group may shift. But the more important thing is, you don't have current data on those peers with respect to their expense levels. You do with respect to performance, but not expense levels, and that's really the complication that fund boards will be working through this year. InvestmentNews: Do you agree that fund expenses will increase? Mr. Vincent: Absolutely. InvestmentNews: So how does the industry handle that? Is there any pressure to keep them down? Mr. Vincent: There are a lot of cost-cutting moves going on now across the industry, certainly within the fund groups with which I'm familiar and talk to. Expense caps are certainly also a factor that have to be weighed in terms of what is going on at that shareholder level. But definitely, the industry is trying to cope with the phenomenon of what had been an expense-level base with now an asset base that is dramatically reduced from what business plans had been projecting for 2009 when they were perhaps put to-gether last summer. Ms. DeRemer: Just looking at the preliminary data on the first quarter of 2009, there are a number of money funds that have put in ex-pense caps or complete fee waivers. Given where interest rates are, they didn't want to have negative returns on money flux. So just to get to zero, they've had significant concessions on the part of management. The industry really has become a game of scale. With the net redemption in the industry and the market depreciation, you're seeing funds that are significantly smaller than they were a year ago. And they simply can't cut expenses fast enough. If someone is in a unitary fee structure, as an example, they're under enormous pressure, and then there are other expenses that are fixed fees that have to be spread across a smaller asset base, which is quite challenging.
Mr. Jensen: It's a balancing act, especially in the investment area. We don't want to cut back too much and cut into the bone and meat of our research organization, which lies at the heart of what we do as investment managers. And so our board is highly sensitive to fees, and we have a fairly rigorous exercise that we go through, the 15(c) exercise. We'll be looking very hard at the peer groups and comparing their experience in terms of redemptions and performance versus ours. And so it gets a lot of attention from our board and senior management. On the other hand, we have to protect our business as well to the extent our investors care about us as a viable business. We have to look at our cost structure, and that's been one of the exercises we've been going through in the last six months. Mr. Bruno: On most of our fees, we've negotiated basis points, so there are economies of scale. There are some fixed costs, but the econ-omies of scale are not being so adversely affected. We're finding clients focus on absolute returns in down markets. When you're achieving 20%+ on an annual basis, they don't worry as much about [0.02% or 0.03%], but that be-comes the issue in the down market. We actually increased the size of our sales force and created another territory, because our view is that advisers are probably trying to reach out to us more now than ever before, in terms of getting information on what our managers are thinking. What can I say to my clients to make them comfortable in this environment? On the sales side, many of our competitors are actually cutting back dramatically. It seems to me that if your clients need more and you're cutting back, you've got a situation where you're not helping your business long-term. The key for us is the focus on not cutting — we haven't made any cuts when it comes to the investment side of our business. In fact, we hired another analyst on the sales side, and we haven't cut back in terms of compliance. We've kept that team the way it is. We're hoping it's more of a short-term situation — not in terms of our margins' being tightened, be-cause that's probably a long-term issue. We're probably going to have to get comfortable with less. But we're not doing anything to hurt our business. We want to keep it going strong. InvestmentNews: It sounds like you view what is going on as an opportunity for you to take more business. Mr. Bruno: Increase market share, absolutely. And that's how we look at companies we're investing in. Are they going to do well? They won't be doing well necessarily, but they may increase market share when their competitors fall by the wayside. InvestmentNews: After all this shakes out, would you expect there to be a change in the landscape of asset managers? Mr. Bruno: American Funds [advised by Capital Research and Management Co. of Los Angeles]] has, in our world, dominated the landscape. It has been a very core element of every adviser's book of business. They're still very high. They've just come down a lot. I think there's a feeling that they performed very poorly, and while they didn't do very well in 2008, I don't think they've done as poorly as advisers feel, just because they had such a high expectation level. I think there will be a lot of combination of funds. Maybe you won't have 150, maybe it will move down to 100. There's a lot of shake-up in the money market side of the business because that's just not a profitable business and has such tremendous risk associated with it right now; that is, breaking the buck or actually not making any money. In fact, many of the funds have actually slowed purchases. They don't want to receive more money. So it will definitely be a change in the landscape for us because we target the intermediaries. The biggest issue for us right now is just the movement that's taking place in intermediaries. You've got Merrill Lynch [& Co. Inc. of New York] going to Bank of America [Corp. of Charlotte, N.C.]. Merrill Lynch has maintained their largest financial advisers, but there's a large bulk of advisers that are moving because they haven't retained them. There are movements taking place between the big wirehouses. There are people who are moving from the wirehouses to the independent channels, and probably the larger wirehouse teams are looking to move to [registered investment advisers] or become RIAs and move to [The Charles Schwab Corp.] or the Fidelity [Investments] channels. For us as a team, we just have to keep track of it and make sure we don't lose someone who's a client of ours. My personal feeling is, the media's making a big issue of the movement to independent and RIAs right now. It will probably take place over time, but it seems to me right now that the wirehouse people are just bouncing around to whoever's going to give them the biggest retention package. Mr. Cordaro: We're an independent RIA, and we look at this as -survive-and-thrive mode. If we could be guaranteed that our revenues weren't going to decline much further — we actually had a planning meeting on this — we would have an enormous growth push going on, because I think there are smaller independent advisory firms where if they've just lost, let's say, 25% of their assets under management, they've gone from maybe having reasonably decent margins to maybe the principals' losing money or skipping paychecks in order just to survive and make it. So I think we'll see consolidation of some of the smaller RIAs. At least that's one avenue that we're looking at.
It's a very difficult time, because the end investor is demanding more and needs more. Yet at the same time, they want much lower costs. It's very unpalatable for people to lose a quarter of their portfolio and still be paying for it. It's going to take a bit of explaining that the management fees haven't gone up. It's the fixed costs over a smaller asset base that just drives the percentage higher. You can spin it the wrong way and maybe have some adverse feedback from the end consumer as far as expenses going up. There's going to be a lot of movement of clients between different advisers, just because they feel angry, and they have to take action, and they're going to move from one adviser to another. They're not really moving to someone who had better results, because I don't know that anybody really knocked the cover off the ball in 2008. But they're just moving because they have to move for their own psyche. InvestmentNews: Is there anything that the funds can do to help the advisers in that situation? Mr. Cordaro: The information on how the specific portfolios have done is really helpful, so that you have some talking points to take to clients. But also it's psychology. I really feel for some of the newer folks in our office. In the past couple of months, there have been very painful discussions with clients. They've got to alter their lifestyle in order to have some hopes at retirement of financial security. InvestmentNews: Do funds give you the information that you need? Mr. Cordaro: There's been a lot more communication from funds back to the adviser. Some information you find more helpful than others, but the positive here is just the sheer flow of information that's been made available to try and help understand what's gone on and how to communicate that to the end client. Mr. Jensen: We've always spent a lot of time trying to communicate with our shareholders and clients. I think we get some notoriety for our communication. We've always put out quarterly letters, even when it wasn't mandatory. In the third and fourth quarter of last year, we started having quarterly conference calls with the advisory channel. We put our portfolio managers, myself included, on the phone with whoever wants to listen. We open it up to clients. It's a chance for them to ask questions and dig a little deeper. We've put as much as allowed by compliance on our website, and we're trying to reach out as much as we can and make ourselves available. I think we've always been about being as transparent as we can be, and communicating as openly and as much as people want. Mr. Bruno: I would say that Third Avenue's shareholder letters are required reading in our shop. The only difference, because we're load and Third Avenue is no-load, is that we also have external wholesalers who make direct visits to intermediaries. We've never been about selling. We've been about being more consultative and being proxies for the portfolio managers. So we're not changing our communication. We only have six external wholesalers, so they have very large territories and internal partners. We're there to communicate what our portfolio managers are thinking. We have a lot of access to our portfolio managers. When they travel with us on the road, one of our team is required to take notes and send it around to the rest of the team. So we try to keep a lot of information flowing so that we can be good proxies to the portfolio managers. Our whole focus is on explaining what we're doing, how we've performed and what we have done to avoid certain things. We redid our website this last year and increased a lot of our functionality. We push out e-mails on a periodic basis. We don't want to be too annoying with e-mails, so we try to do them perhaps once a month. We put out reprints that have appeared, because we know that advisers like reprints to be able to show that there's a third-party validation on the product. We also do white papers and newsletters. For example, we have something on the case for gold. It's part of our philosophy and has been for many years. It's something the advisers can pass on to their clients. We had one regarding temporary versus permanent impairment of capital and how we view all of our positions as being temporary. That is, we didn't own [American International Group Inc. of New York] or [The Bear Stearns Cos. Inc. of New York] or Lehman Brothers [Holdings Inc. of New York]. That is a permanent loss. We've tried to create these informational pieces that we think that advisers would be able to hand off to their clients. We've tried to in-crease the level of communication while not being overly burdensome so that advisers don't say, “Not another e-mail. I'm not going to open it.” We now have a team of three portfolio managers. So we can have one out of the office while the other two are in the office. We want to make sure not to overload our portfolio managers with too much travel, so we have an 80/20 rule that they have to be in the office 80% of the time focusing on the investments. We try to do that to ensure that they've got enough time. But they are out and communicating to our top clients. InvestmentNews: In this period, is there more communication be-tween the adviser and the board than before? Mr. Vincent: Undoubtedly, yes. Take the fourth quarter as an example, where things seemed to be changing on a daily basis. It was not uncommon for fund groups to be having more than once-a-week telephone updates from the investment adviser, really hear from the leadership — the chief risk officer, chief compliance officer — about what's going on. There was clearly breaking news that everybody was following in the media. We had periods where we were on the phone several times a week on matters, and now that has dissipated. Ms. DeRemer: When you look at some of the issues with fair- valuation portfolios, oftentimes, these pricing committees were meeting several times a day, never mind once a day. Given the counterparty risks that we had in the marketplace, the issues with securities lending with a number of funds, it clearly elevated some of the issues for boards. I think going forward, the way funds are sold is going to be very different from how they've historically been sold. Clearly, it's all about client retention and asset retention today as opposed to at-tracting new gross sales. Ultimately, you're starting to see confidence come back into the marketplace. But it has moved to predominantly an intermediary-distributed business. Going forward, perhaps the B shares will go by the wayside. American Funds just announced that they're not going to continue to sell B shares. We think C shares won't be too far behind in going away. So increasingly, the market will move ultimately to probably A shares sold at the asset value so that the semantics between being a no-load direct and an intermediary load sold may simply go away. The professional gatekeeper, the fund selection unit, clearly has a heightened role in going forward. I think that role will continue to evolve and grow given the need for more risk control, more due diligence in the investment process and truly understanding that the portfolio managers are doing what they said they were doing, and not only living by the guidelines in the prospectus but actually implementing and executing on them. InvestmentNews: What's the future of some of these share classes? Mr. Bruno: We have A, C and I. I agree that there's heightened attention toward C shares, because de-pending upon the length of the client investment, it can be perceived as the highest expense share. But it really has a lot to do with the length of time the client's an investor. I definitely see a movement to I shares. They're institutional shares. They carry no 12(b)-1 [fees]. The I share is really the lowest fee class. So eventually, there's probably an A and an I that survive to a certain extent. There has been talk about the C share, for example, at a certain period of time, having an exchange option to A, so that if you have an investor who's in C for, say, five years or more, you automatically convert when it becomes the highest fee class. That's likely to take place over time. I was told that the 12(b)-1 issue is probably going to be shelved for a little while because the [Securities and Exchange Commission] is facing so many issues right now. Ms. DeRemer: Prior to this market correction, most of the distribution clout was with the distributors as opposed to the manufacturers, and the shelf space demands were rising in terms of revenue sharing. And now you have to wonder, with fewer but bigger firms, whether that revenue-sharing demand continues to go up or if we've ultimately hit a high-water mark. Mr. Bruno: We worry less right now about assets leaving to go to another fund complex than assets just leaving to go to cash. We hear from our intermediaries that their biggest issue is just holding on to the clients staying invested. Our view is, you don't want to go to cash after a crash. But we also understand that there's a certain level of capitulation. If somebody can't sleep at night, then they need to be able to sleep at night. InvestmentNews: What are everyone's thoughts on 12(b)-1 fees? Mr. Vincent: On some level, it was not a surprise. Everybody appreciates that there's a lot on the plate of the SEC right now. So they have to pick their priorities. I'd have to say on a personal basis, I was disappointed. I was looking forward to 12(b)-1 reform. I think it's something that's overdue. We truly are, and the SEC in particular, going through unprecedented times, and I respect the fact that they really do have to choose the priorities that are most important. Mr. Cordaro: Where it affects us is on the different custodial platforms where there are no-transaction-fee funds that the 12(b)-1 is going to. If you look at the amount of revenue going toward being listed on a platform, it's a lot. It's a pretty high cost to be listed at the Schwabs or the Fidelitys of the world. The part that concerns me is that there is less competition, so you're almost in a situation where you've got to be on these platforms in order to attract the [assets under management]. There's not a great deal of competition. I don't see that the end fund companies have the clout to pressure the custodial platforms. Mr. Bruno: American Funds might have clout, but the large majority just don't have the clout. And most advisers want to use the no-transaction-fee platform since they don't want to have to pay ticket charges. It might also be easier for them to reallocate their assets in the no-transaction-fee platform. Coming out of 2001, the SEC had seemed to rattle chains a bit, and revenue sharing — which had been an under-the-table arrangement — became contractual and public. I'd love to see the pendulum switch to the manufacturer and away from the distributor. If you look at the load world and the consolidation of some of the major wirehouses, it seems the strength is going to shift more to those distributors. And given the environment we're in, where profit margins at those major broker-dealers have shrunk, they're being much more aggressive about wanting more. So you've got an environment for asset management companies where assets under management have come down, so fees are down. Your distributors are asking more from you because they want to maintain their current margins. It's going to be interesting over the next four or five years to see who can survive and grow. The worst thing to happen would be fewer choices that are good choices. Mr. Cordaro: I think it's not just a competitive pricing model; they fixed the freight. At some point, the only way to get around it is for the end intermediary and the adviser and manufacturer to get together. Mr. Bruno: What I would really like is for the SEC to put some of that onus on the broker-dealer, and not direct the attention to the adviser to do something about it. It's very tough for the adviser to do something about it when it's the -broker-dealer that's essentially going to distribute it. The reason I pointed out the SEC becoming somewhat aggressive after 2001 is that I thought more attention would have been devoted to the broker-dealer. It seemed to me the attention was brought to the adviser to in-crease their level of compliance. And we've done that, but I thought we had a pretty good level of compliance as it was. So the costs get passed on to the shareholders, and I don't think you really want that. I'd like to see broker-dealers take more responsibility personally than distributors. Mr. Vincent: We have an end consumer shareholder paying the 12(b)-1 fee. It then is collected through the fund complex. It's then rebated out into the distribution channel. And I believe that most consumers don't really understanding that. Frankly, I think it would make more sense to put it out and let the distributor charge the investor and let the investor decide whether that's the place where they want to be doing their business. Mr. Jensen: Some of this does circle into our world as far as we are faced with that margin compression, and the distribution channels, be they Fidelity, Schwab, are knocking on the door asking for higher fees at a time when our revenue base is shrinking. There aren't a lot of choices as far as the distribution channel. Only a handful of the largest firms can get your product out there. As far as selling our funds, we aren't out there pushing them, but I always try to remind people of what I call three P's, which is not only performance but the portfolio and the people who created the track record. Obviously, the performance gets a lot of weighting, but I try to get people a little bit focused on the quality and value proposition of the portfolio and whether the people are still in place who have created the track record. Those sorts of questions I think are important for advisers and shareholders as well. InvestmentNews: What will the distribution landscape look like in a couple of years? Ms. DeRemer: It could look dramatically different. I think there will be far fewer fund groups, far fewer funds in terms of rationalizing product, as well as classes of shares. I think there'll be heightened competition from other package solutions, whether it's an ETF structure or collective-trust pool. Clearly, the future is about outcomes and solutions for the consumer. So I think you're going to see a lot of different product packaging coming forward. It's all about asset allocation, fund wrap or ETF wrap and really using funds as blending ingredients in some sort of an asset allocation setting. It could perhaps be a core satellite structure. Given the pressure on expense ratios, the investor is not willing to pay for beta. So fund sponsors that are not providing, over a long term, alpha generation are pretty vulnerable if they've got a mediocre product that's high-cost. Clearly, it's a sign of a maturing industry. Mr. Cordaro: I agree that beta is a commodity and could be had very inexpensively, and should be. For the part of your portfolio where you just want beta, you should not pay a lot for it. I don't know if the world needs any more ETFs, but within the ETF menu, you can really just get about any type of beta exposure you want, for relatively low cost, and bypass a lot of the distribution issues. If you think about retirement income for people, the only way to really address that is by pooling longevity risk so that the end retiree can spend more money. People need to pool that longevity risk, but doing it through an insurance product now becomes extremely dicey. You look at the health of insurance companies, and people's willingness to make an irrevocable decision on annuitization, is not there. The fund industry has an opportunity here if they can figure out a solution to it. InvestmentNews: How can the fund industry do that? Mr. Bruno: There's an opportunity, clearly. In addition to funds' being limited, you also have hedge funds that really have generated a lot of assets over the past five years. I think you'll see a lot of hedge funds close, and you might see that industry begin to get smaller. It's the same thing with private equity. The managed-account world, which was growing rapidly over the last five or six years, has performed quite poorly over the past few years, so there's real concern that assets might move out of there. So if you focus on how much money has moved to the sidelines from those different vehicles, there really is an opportunity now for fund families that will survive and thrive. In our shop, we're actually quite excited about the next five years. It's just the day-to-day environment that's tough to deal with in terms of clients' capitulating. If we retest the lows again, what we saw take place last November and earlier this year will be much worse. There'll be an even greater movement. We have this analysis called Coates Analytics [from Coates Analytics LP in Chadds Ford, Pa.] where we can see, within broker-dealers, where the assets are moving. Over the course of November 2008 to January 2009, in one major broker-dealer, the money market funds went from $9 billion to $30 billion in a four-month period. I personally believe in the core satellite approach. The traditional intermediary — I'm talking more about wirehouses — would say, “I'll invest in domestic equities and use a mutual fund for international because that's just too difficult for me to manage.” Now I think that movement is clearly toward, “I'm not going to invest in equities any longer; I'm going to have a core approach with regard to mutual funds, and my satellite's going to be the ETF.” I think that the core satellite approach is going to be a much more common approach within many of the intermediaries going forward. Mr. Vincent: The savings rate in the United States, which was perceived to be much too low for a very, very long period of time, has now really gone way up. And while that has some short-term problems in terms of contributing to illiquidity in the market, over the long term, I think it is very positive. There is a lot of money that's going to come back into the investment world in some form. Second, there have been discussions around the kitchen table in virtually every household in the United States with anything to invest, and on balance, that's good. It really has couples and families talking about how this is going to work. That will lead to consumers' making more informed decisions. The money is there, the retirement need is there, and people are talking about what to do. Those are all the ingredients to feed a -survival-of-the-fittest argument in the investment adviser business. The weaker players will be winnowed out. The scale will increase by reducing the number of funds. So all this comes together in a positive way down the road. InvestmentNews: Do you see ETFs as a threat to mutual funds? ETF net flows were positive, while mutual fund net flows were negative during the most volatile times. Ms. DeRemer: Our view is that ETFs will complement mutual funds. Certainly, with the advent of active ETFs, they could be a better solution in some ways for some investors, particularly from a tax perspective, if they come in at a lower cost with more-customized solutions. Mr. Jensen: We don't view ETFs as competition. But almost by definition they are, because they're out there and an investor or adviser can get exposure to any asset class by using an ETF. On the other hand, our portfolios are constructed very differently from most of the major indexes. History and data suggest that we're not all that correlated with the major indexes. People generally seek us out because a byproduct of our investment process is that we tend to zig when the market zags. So we've never held ourselves out as a core manager. But there's certainly a role for somebody like us to complement what an investor and adviser are doing in their core portfolio. That's how we've tended to be used, generally. Thinking about it a little bit differently, to the extent that ETFs allow for hotter money in the market, there's lots of liquidity, and it's attractive from a cost standpoint. There may be pressure against some of the names we own in our portfolios, and in that sense, it may work against us measured in a short period of time. Mr. Cordaro: I think ETFs are just a great tool. From an adviser perspective, it's not an either/or. I'd rather have a hammer and a saw. Each one of them has a unique purpose. But if you just look at how many ETFs are out there, it's an absurd proposition that all of them will stay around. We'll need to see some of them consolidate. InvestmentNews: Do you see any particular product coming out of the mutual fund world as a result of the current environment? Mr. Bruno: We've got a much more-educated environment than post-Depression. So while it might have taken investors from the early 1930s to perhaps after World War II to start investing in the markets again, I don't think that that's going to take place now. I'm actually quite surprised at how a rally all of a sudden changes the mood. Perhaps the media has a lot to do with that. CNBC has become a much more positive place than it was six weeks ago, and maybe that is moving a lot of investor behavior. But I do think absolute return is a philosophy that will be prevalent for the next few years, at the very least. And you might find some depression with regard to asset allocation. I'm not so sure you're going to want nine funds fitting into nine [Chicago-based] Morningstar [Inc.] style boxes. And ETFs will continue to be used. You might have the three major ETF houses having the most liquidity. Mr. Vincent: From the investor's standpoint, how many different investment styles are there? There are quality alternatives for every style that someone can imagine. So there is a need for new product. Money is likely to follow investment performance, with the obvious caveat that we all understand that past performance is not a predictor of the future. Nonetheless, dollar flows do tend to follow the performance. That said, marketing people are paid to market and develop products. I think there will be certainly new products coming out here. From the investor's standpoint, there are a full range of product alternatives to permit investors to participate in forward markets with whatever risk profile they choose to set for themselves. Ms. DeRemer: I think the fund industry has always been fairly resilient. Every time there's been a major crisis, there's been new product development, whether it was the evolution of money funds or the growth of fixed income in the 1970s. So I can't tell you what the product of the future is, but there will be a lot of product innovation. The real opportunity here is for someone to crack the code on designing the retirement income solution to deal with longevity risk and do it in a way that's cost-effective. Mr. Cordaro: The opportunity the fund industry has is that maybe you don't insure it. Because the explicit guarantee of having insurance is expensive. But funds have the op-portunity to pool individuals to-gether and take the longevity risk of the pool, so there's not an insurance company behind it. InvestmentNews: What new regulations might we see? What would you like to see? Mr. Vincent: I mentioned before that 12(b)-1 reform is overdue. That would probably top my list. Mr. Jensen: I think it's important for folks to realize they have a pretty good deal in the mutual fund world. There's a high level of transparency. There tends to be a fair amount of communication, a lack of fraudsters. It's been a pretty good deal for investors when you compare it with some of the alternatives. Ms. DeRemer: I think there's significant debate about re-regulating the money funds side of the business and whether they maintain a constant $1 [net asset value] or not. There are issues around the short-selling rules, the uptick rules. Securities lending could come under some review, and certainly, more attention could be paid to understanding the counterparty risks that are involved. Mr. Bruno: It seems to me that most individuals over the last 20 years have viewed money market funds as bank deposits because of the ability of the dollar to be constant. And if the U.S. government has to guarantee them, then I'm not sure I understand the difference. So maybe that should be an area. Fair valuations are an interesting area that we've heard a lot about over the past five or six years, and it would be nice if there were some very specific guidance. We're benchmark-agnostic, and price to model is not something I think our portfolio managers are wholly in agreement with. I agree that from a regulatory standpoint, the mutual fund industry is one of the best-regulated areas. They've strengthened the boards by encouraging independent chairpersons. Mr. Cordaro: Not being in the mutual fund industry, I would give yourself an A. If you look at how different parts of the market got stressed and where we saw different issues come out, I think the mutual fund industry, going through these past months, has probably come out much stronger than many other alternatives. And that's probably because of the amount of regulation that is already in place. Ms. DeRemer: I also think we could see some form of a superregulatory body going across banking, insurance and commodities. There were so many regulatory bodies involved, only looking narrowly at certain areas, we didn't see the unintended consequences of what happened in one market segment im-pacting another. InvestmentNews: What are the biggest challenges ahead for the fund industry? Mr. Vincent: The biggest challenges we're seeing are fund performance, number one, and number two, the cost to shareholders. Number one is always there. From a board perspective, that's the challenge that we're really paying the most attention to — successful fund performance. InvestmentNews: There's always been a bit of tension with regard to how involved fund boards should be in evaluating what is acceptable in terms of fund performance. Where do you see yourself in that argument? Mr. Vincent: Fund boards are in general more active than they were many years ago. My own perspective is that you hire a portfolio manager to manage the portfolio. The board should not get involved at the level of what the holdings are in the portfolio. They really need to address it at the level of whether they have the right portfolio manager. In some ways, the most complicated issue is how much underperformance a fund manager can live with. Anybody that studied this industry knows that you can take historically the most successful fund managers over a very [long] time and find periods in which they have significantly underperformed. So when we en-counter situations like that of underperformance, we will really go back to the basics, and many cases in-volve meeting with a portfolio manager to make sure that the investment style for which the portfolio manager was hired is still the way the portfolio is being managed, that nothing has changed. We do an extraordinary amount of analytics to follow that on a very current basis. These are very tough calls. We make them. We consider them regularly. We make decisions periodically. You really try to strike a balance be-tween not moving too soon and not failing to take action. I think that judgment continues to be one of the great values that boards of directors of mutual funds bring to the shareholders. Mr. Jensen: We talked a little bit about the challenge around maintaining the philosophy and integrity of the investment process at a time when there are challenges around revenue and expense control. So that's one piece of it for us. We're also re-examining our whole risk management process, asking people to go into every corner of their business, whether it's operations, marketing or the portfolio managers, to look for areas of risk in the organization. We're extending ourselves. That is not necessarily a challenge, but it is taking a little bit of extra energy and time. We think it's time well-spent, especially in this kind of environment. Last, in terms of opportunities, one of the things we've looked at is potentially launching a new credit-oriented product where we think we have a competency internally and a history of investing in distressed debt. Ms. DeRemer: Clearly, the industry is challenged by margin pressure. I'm not so sure that we need as many small fund families with mediocre product that we have. Certainly, we're believers in meritocracy. It's not to say everyone has to have mega-billions under management. But people that really have mediocre performance and are subscale probably have to decide whether they stay in the business or exit. Mr. Bruno: We view ourselves as an investment management firm, not as an asset gatherer. So first and foremost, we've got to focus on ensuring that we have the right people and the right resources within the investment team. And if there's one benefit of this time, it's the ability to attract very good people in the industry. When private equity and hedge funds were rising so dramatically, it was very tough to hold on to good people, because there were some amazing opportunities that presented themselves. So hopefully, we'll be able to continue to take advantage of that. Ensuring the strength of our investment team is first and foremost on the marketing and sales side. It's key to ensure our investors understand that they have to be invested in enterprise to achieve their financial goals and that keeping money in cash at a very low rate of interest is probably not going to allow you to achieve your financial goals. So you have to be somewhat exposed to enterprise. We do that by communicating as much as we can and hoping that they see a broader, longer-term future. I was with an adviser last week, and he said one of his largest clients told him he had to go to cash. They tried to hold off as much as they could. That person probably missed a 10% to 15% increase over the past month. And the client came back a week later after the market had rebounded a bit and said, “OK, look at me as a new client. What should I do now?” And he said, “Well, I think you should do exactly what we had you invested in before.” So market timing is not a process with a great level of success. I think the best thing we can do is to try to keep our investors recognizing that they need to be exposed to enterprise long-term. Mr. Cordaro: The biggest risk I see in the fund industry is losing a generation of clients — those people who just couldn't take the volatility any longer and had to go to cash. Especially if we retest the lows again, that risk of losing folks for a long term increases even more.