FUSE Blog

Here is a quick take on the proposed changes to 12b-1 fees by consitituency:

• Fund Companies – Fund share class types span the alphabet to cater to investor and distribution channel preferences. Should the proposed ruling take effect in its current form, the fate of a handful of share classes which cater to the retirement channel will be put in question. These costs won’t disappear but will instead be re-routed and re-labeled in an attempt to transform embedded costs to explicit ones. Charging for services at the client/plan sponsor level will require new plumbing but will introduce even more pricing variability and free asset managers from the share-class pricing burden that impairs competition and the “free movement” of prices. However, it remains to be seen whether distributors will take on the responsibility of charging the client or simply demand the same level of support from asset managers without taking on pricing responsibilities.

• Advisors – A small segment of the advisor population does a majority of its business in C-shares. Some advisors use C-shares to transition their book of business to a fee-based model, others use C-shares to “hide” the costs of their services on monthly client statements. The rule will help alleviate the latter use of C-shares and will drive this business towards advisory platforms which often use load-waived shares and clearly disclose the cost of advice.

• Broker-Dealers - As assets migrate from C-shares to converted A-shares or advisory platforms, we should expect more price competition at the broker-dealer level. Competition will increase as BDs market competitive commission rates and advisory pricing schedules. However, clients will be hard pressed to compare and contrast pricing options as the data will be largely unavailable or difficult to obtain.

• Operational Concerns – We assume that if other individual investor data such as redemption activity and Patriot Act related data can be tracked, than 12b-1 fees can also be accounted for at the shareholder level. That said, we expect the majority of the burden and accompanying costs of tracking this data will likely be subsidized by asset managers.

The unprecedented asset shift to fixed-income is potentially at risk given the odds of interest rate and inflation increases. This fact will challenge fund companies to proactively arm their distribution teams with the right messaging and advice to their advisor constituents. We believe the following broad themes would be beneficial to most fixed-income marketing campaigns going forward:

• Inflation risks aren’t geography neutral – Emphasize global and international fixed-income strategies that monitor inflation trends globally. The evaluation of country-specific credit and fiscal risks on a global basis will help investors avoid emerging pockets of inflation and take advantage of the low correlation of bond performance that can occur across countries. That said, expectations of inflation continue to be pushed out into the future.
• Multi-strategy, dynamic approach – If everyone knew the answer to fighting inflation, it would no longer be the question. Taking a multi-asset class/strategy approach (high yield, convertibles, securitized, commodities, FX, global TIPS) to inflation fighting makes the most sense for fund companies playing the percentages. A strategy of this type will naturally limit the number of fund companies that can credibly offer such an approach to those larger in scale and those tapping sub-advisors or affiliates.
• Emphasis on credit-specific research ­– All the macro talk can prompt advisors to forget the importance of security selection and that certain credits will outperform others regardless of the interest rate or inflation scenario (i.e. specific risk). Of course, demonstrating actual evidence of alpha-producing credit research would be helpful.
• Yield is on your side – Relative to treasuries, higher yielding corporate credits can better offset interest rate increases as the greater yield compensates for capital losses resulting from interest rate increases. The emphasis here is on total return and highly dependent on our third bullet point.

ETF sector assets have grown on a compounded basis at 37% over the past five years while mutual fund sector assets have posted negative growth of 4% over the same time period. Over time ETF sector fund launches have been negatively correlated with fund sector launches due to a number of reasons including: 

• Fee sensitivity among all classes of fund buyers has increased 
• The presence of institutional and hedge fund buyers that were not traditionally mutual fund buyers has brought a new source of assets and demands for more specialized/niche ETF offerings 
• Growth of ETF managed account programs that rely on sector ETFs as building blocks 
• Troubles in the closed-end market (ARPs, persistent discounts) has caused product manufacturers to reroute new strategies into the ETF chassis.

Net sales totaled a modest $3.1 billion for the week ended June 16, as Fixed Income inflows were offset by net redemptions from Equity products. Taxable Bond continues to dominate the net flow charts, as the category produced $4.2 billion for the week. The other fixed income broad category, Municipal Bond funds, were largely flat for the week ($242M in). Conversely, Domestic Equity funds sustained net redemptions of $1.8 billion, while Foreign Equity were flat and Hybrid funds produced modest inflows.

Overall, economic uncertainty continues to impact the equity markets and mutual fund investors are looking for safety.

Source: Investment Company Institute

Long-term mutual funds captured net inflows of $2.1 billion for the week ended June 9, as $4.3 billion in net inflows into Taxable Bond funds were largely offset by net outflows of $3.7 billion from Domestic Equity products. The three remaining broad categories were largely flat, as Foreign Equity, Hybrid, and Municipal Bond funds captured net inflows of $1.4 billion. Market uncertainly continues to drive dollars away from Domestic Equity, while the tiny yield of cash products has shifted money into short- and intermediate-term fixed income products.

Source: Investment Company Institute

In general, quant funds are poorly understood among many retail buyers. The fact that some well known quant shops have experienced recent bouts of underperformance has not helped the industry to frame positive conversations around quantitative investment processes. That said, we believe managers should be proactively clearing common misconceptions and biases which exist in certain segments of the retail market:

• Misconception #1 - Quant funds underperform fundamental strategies 
  • Quantitative and fundamental strategies have tended to produce alpha in cyclical patterns and one could make an effective case for blending the two for added diversification purposes. 
  • Many quant models are based on fundamental factors, which are based on rational economic theory. A simplistic example based on mean reversion theory - low p/e stocks tend to outperform high p/e stocks over time.
• Misconception #2 - Quantitative funds invest via a “set and forget it” black box engine 
  • Quantitative models are not static – quantitative researchers are constantly adding and deleting factors in an ever evolving process. Often times, quants are refining their models based on the latest in investment theory and academic research. 
  • Managers should emphasize the discipline inherent in quant models. For example, consider a fundamental and a quant strategy that underperform over a quarter. The quant manager can point to specific factors that either contributed or detracted from performance while the fundamental managers must rely on “softer” reasons for underperformance that is often linked to stock-specific events.
• Misconception #3- Quant funds are all the same 
  • Quant funds come in all shapes and sizes. While some funds may exhibit some commonality of factors, the weightings of factors within models can vary dramatically. 
  • Increasingly, more firms are combining quantitative and fundamental processes. Today, T.Rowe, MFS, INVESCO, Vangaurd, and Goldman all offer some variant of a “quantemental” strategy.

According to data from MassMutual, retirement plan participants are gradually shifting assets back into equity products. During the second quarter the allocation to equities increased from 35.1% to 38.7%, while the stable value allocation dropped from 36.3% to 31.7%. It is a reasonably subtle shift, but still an important trend, as both the tax status of the plan and the typical long-term investment horizon of a retirement plan participant both favor substantial allocations to equities.

Our analysis of weekly flows has not shown much of a shift in mutual fund sales from fixed income to equity products with the exception of last week. We'll be curious to see if flows into equity products continue to pick up or if fixed income remains dominant.

Check back later this afternoon or tomorrow morning for our weekly net flows analysis.

Claymore announced a change to its Great Companies Large-Cap Growth Index ETF. Was it a shift to Large Cap Core strategy? No. How about All-Cap Growth? No. Instead Claymore has reengineered its Great Companies Large Cap Growth Index ETF into the Claymore/BNY Mellon International Small Cap Select LDR ETF. Claymore indicated the new strategy "expands our offering into an opportune space for long-term growth oriented investors: international small cap companies."

It is highly unusual for a firm to reengineer a fund into a completely different strategy, shifting both the market cap (Large Cap to Small Cap), as well as the regional focus (predominantly Domestic Equity to International Equity) of the product. So, while there are extenuating circumstances for this product shift, which include a very small asset base (~$3.8 million) and a willingness by Claymore to drop the management fee by 20 bps, we are more than a bit surprised the move received board approval.

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