EVENTS

Date:	Wednesday, March 15, 2006
Time:	2:00 PM -- 4:00 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

March 2006

The Economics of the Mutual Fund Industry

Recently, two large players in the mutual fund business, Citigroup and Merrill Lynch, sold off control of their fund businesses to smaller, more specialized organizations. In addition, many smaller investment advisory organizations have been leaving the field, although there has been little change in the overall concentration of the industry. What economic or regulatory forces are driving the acquisitions, dispositions, entries, and exits that characterize the mutual fund industry today? At a March 15 AEI conference, the sixth event in the series, "Is There a Better Way to Regulate Mutual Funds," experts gathered to discuss this and other questions.

Peter J. Wallison
AEI

The aim of this conference is to explore the regulatory and economic forces behind recent developments in the mutual fund industry. For instance, in recent months, two of the largest financial services providers in the country--Merrill Lynch and Citigroup--gave up control of the huge mutual fund families they had developed over many years. In addition, the concentration in the industry has changed little, even though the top ten providers have changed.

Among the possible regulatory factors behind these trends, compliance costs are perhaps the most significant. These costs stem from the application of Sarbanes-Oxley to mutual funds, as well as rules requiring chief compliance officers, greater percentages of independent directors on fund boards, and independent chairs. Further, evidence suggests that the SEC has not taken seriously the mandate in the '40 Act to consider "efficiency, competition, and capital formation" when it promulgates new regulation. These regulatory costs are felt especially by smaller investment companies.

Along with regulatory factors, economic forces, particularly competition, could be driving developments in the industry. It is possible that competition from other collective investment vehicles such as exchange traded funds, hedge funds, and separately managed accounts are drawing away from mutual funds both the high-value customers and the necessary management talent.

Also, distributional arrangements could be responsible for recent changes in the industry. The particular arrangements that could prevent competition at the sales level include: section 22(d) of the '40 Act, which requires the price of a mutual fund share to be sold only at the price stated in the prospectus; and the unusual requirement that sales personnel actually be objective in recommending the mutual fund products of their employer.

Robert C. Pozen
Massachusetts Financial Services

Between 1992 and 2002, the number of fund acquisitions increased, particularly among banks, trusts, and insurance companies. The rationale behind these particular acquisitions was to have more products to sell existing customers, add streams of stable income to offset sales cycles, and obtain higher growth rates than their current operations were yielding. In addition, but to a lesser degree, domestic fund sponsors were acquiring other U.S. fund sponsors, primarily in an effort to fill out their product lines, expand servicing of high net worth accounts, and have a greater aggregation of asset managers. Along with acquiring domestic funds, U.S. fund sponsors and U.S. banks and insurance companies were also acquiring a few foreign asset managers. Concomitantly, many European insurers and banks were purchasing American funds. However, there were no Asian acquirers due to the weakness of the Japanese banks and the Asian Financial Crisis of 1997-98.

In more recent years, U.S. mutual fund sponsors have faced greater pressures, and the rationale for acquisition has changed. Prior to the year 2000, it was typical for investment clients--both retail investors and sponsors of company retirement plans--to entrust all their monies and investment needs to one sponsor. Today, however, under the new open architecture of the industry, investors prefer to spread their money around different investment sponsors in order to achieve the best performance. Now, affiliated salesmen can offer the products of other companies with ease. In the retail market, high net worth customers want customized investment solutions that involve using different firms for different needs, which include banking, insurance, and collective investments. Concerning company retirement plans, the plan sponsors want the record keeping and operations administered by a single firm, but they also want the best in class funds for each subcategory of assets, which translates into monies' being divided amongst different fund sponsors.

Along with the new open architecture, regulatory reforms from the SEC have created greater pressures for fund sponsors. Today, salesmen receive no special compensation for selling proprietary funds, and brokerage commissions may not be used to reward fund sales. The disclosure requirements have become more onerous and confusing, and higher compliance costs and price wars on index funds between large sponsors like Vanguard and Fidelity have put pressure on management fees. Furthermore, mutual funds have had to compete with the rise in other collective investment vehicles, such as separately managed accounts, hedge funds, and exchange traded funds, all of which have seen substantial growth over the past five years. These factors have made it harder for the sponsors to sell affiliated funds. Thus, many large brokers have begun to experience negative asset flows in their affiliated funds and have considered--and in some cases even have gone through with--releasing ownership of their affiliated fund business.

In this regard, there are two opposite trends. Merrill Lynch and Citigroup divested their asset management arms to become pure distributors because these brokers had trouble selling their proprietary funds through third parties  On the other hand, Lehman brothers acquired Neuberger Berman, which kept selling its branded funds through third parties--as did the Van Kampen funds, though they were acquired by Morgan Stanley.

Moreover, in recent years, the fringe players in the industry like banks and insurance companies who acquired funds in the 1990s have realized that the industry is very competitive, and that their involvement might not be as profitable as they had first assumed. Smaller companies, in particular, have exited the industry due to competition and due to the regulatory costs. When Mr. Wallison asked Mr. Pozen to estimate the effect of greater compliance costs, he replied that the costs probably amount to anywhere between two and five basis points, given that one must take into account economies of scale. Board meetings now take two to three times longer than before, funds must employ chief compliance officers and more staff, and mutual funds now face heavier regulatory requirements as a result of Sarbanes-Oxley, which was not even intended for mutual funds.

Paul Stevens
Investment Company Institute

Mutual funds throughout their modern history have exhibited the hallmarks of an intensely competitive market--demonstrated in fees, services and innovation--to the benefit of consumers.

First of all, the mutual fund industry has a large number of firms, none of which dominate. Investors can select from over 8,000 funds offered by more than 500 different firms. According to the Herfindahl-Hirschman Indexes that measure industry concentration, the mutual fund industry is considered unconcentrated, with the top five firms controlling less than 40 percent of assets. Not only do mutual funds compete amongst themselves, but they also face competition from other investment services, such as insurance products, separate accounts, hedge funds, and bank trusts.

Second, the mutual fund industry is characterized by low barriers to entry and exit. Every year, hundreds of new funds are created, and hundreds of pre-existing funds are merged or liquidated. Of the top ten firms from 1985, only five of those remain in the top ten in 2005.

Third, the industry has a vast number of people--over 90 million individuals in over 50 million households--investing in mutual funds and choosing between a wide range of options. The Internet and fund supermarkets make it easier for investors to switch between competing fund firms, and data shows that investors do vote with their feet. Each year from 1990 and 2005, between a quarter and a half of all mutual fund complexes experience net cash outflows.

Fourth, investors have access to a vast amount of information about mutual funds, especially thanks to the Internet. In addition, it is evident that investors and financial advisers incorporate what they learn into their decisions. Over three-fourths of stock and bond fund assets are held in funds with above-average ten-year performance. Also, approximately 90 percent of the assets of stocks and bond funds are invested in low-cost funds. This market pressure has been a driving force in the reduction of the costs of owning mutual funds, with fees having fallen by nearly 50 percent since 1980.  More evidence of competition is the fact that funds have undertaken substantial innovations in investor services.

The success of mutual funds has been in large measure due to the competitiveness of the industry. However, there is the potential that recent and proposed regulations could undermine that competitiveness. Compliance costs, for example, can be particularly onerous for small fund sponsors, which do not benefit from economies of scale as much as large fund sponsors do. Recent trends indicate that smaller firms are withdrawing from the mutual fund industry, and it is probable that others will be deterred from entering. This is particularly important given that 59 percent of fund sponsors manage less than $1 billion in assets. Also, increased regulation could encourage wealthier investors to shift their money into alternative products, such as collective investment trusts, hedge funds, and separate accounts.

Also in response to a question from Mr. Wallison about the apparent contradiction between investors' use of the Internet to do their own research and their use of advisers, Mr. Stevens noted that the disclosure regime overseen by the SEC must be designed to meet the needs of investors with quite different preferences, as well as analysts, advisers, and the media. He pointed out that fully 80 percent of fund shares sold involve some professional financial intermediary providing help and advice to the underlying customer.

Robert G. Dorsey
Ultimus Funds Solutions, LLC

Over the past three years, there has been a net reduction in the total number of funds, but an increase in the total number of share classes. Share classes have increased because fewer products are being distributed through multiple channels. The number of money markets funds and bond funds has been leveling off. Both products are similar to commodities, and regarding money market funds, it is difficult for small firms to profit off of them. Also, as banks have merged, they have consolidated redundant products. Equity funds, on the other hand, will likely see growth. Further, this is the area that smaller firms are out to service.

Even though the top twenty-five fund complexes control 71 percent of the industry, this leaves a sizeable market of $2.5 trillion in which the smaller firms can compete. Many of these small firms are private, entrepreneurial, offer unique funds, and are oriented towards growth and value. In order for many small firms to be competitive, they cap their expense ratios, and the advisers absorb any additional costs. In general, as total fund assets increase above $100 million, the fund begins to benefit from economies of scale. However, while entry into the industry is fairly inexpensive, success in the industry has become more costly. Higher operating costs end up negating the benefits of economies of scale, and thus the expense ratios see little decline.

One of the factors behind the cost increases are the compliance costs. Not only do funds end up paying the salaries of a new chief compliance officer and staff, the company must also pay to send them to educational seminars, as well as cover travel costs to investigate fund vendors. Further, now that boards are more engaged, the boards themselves are traveling to monitor the offices of service providers.

Legal fees have also increased. Because the board and committee meetings are more time consuming and the documents like the prospectus take longer to read, the counsel bills more hours. Also, due to PCAOB requirements and greater scrupulosity by the board, auditors now have more work. Further, insurance premiums have increased.

Michael Sharp
Citigroup

Citigroup's decision to sell off control of its fund business in 2005 was ultimately the result of the open architecture that the firm had begun to develop in the 1990s. By distributing other companies' funds, the percentage of Citigroup funds distributed by Citigroup naturally began to decline. As Citigroup was changing its architecture during the 1990s, the firm sought to remove conflict of interest from the point of sale by amending the pricing structure and changing the way salesmen were paid. This also had an effect in decreasing the distribution of proprietary funds. In 2002 and 2003, when firms fell under even stronger regulatory scrutiny, that trend was exacerbated as Citigroup redoubled its efforts to eliminate conflicts of interest and as bad publicity about conflict of interest going on in the media had the effect of getting our clients and our Fas more interested in nonproprietary products. By 2005, 88 percent of mutual funds distributed by Citigroup were non-proprietary funds.

In the end, Citigroup found that proprietary sales were not important and instead wanted to focus on distribution, which earned higher revenues. In fact, Citigroup had already sold off its insurance business in 2003 and its variable annuity business in 2005. Now that Citigroup no longer has control over its own funds, it can focus on providing investors with exactly what they need.

AEI staff assistant Dan Geary prepared this summary.