- Money Moves Out
Net investment flow from mutual funds managed by banks, first three quarters, 2000, by type of fund
- Winners and Losers
Bank-related mutual fund managers ranked by flow of investment dollars, first three quarters, 2000
Setting up a mutual fund, or a family of mutual funds. Only a few years ago, it seemed like such a perfect match: Banks, with their cozy--and coveted--retail relationships, and mutual funds, the hottest product to hit the retail investment market in history.That was then. But times have changed, or at least experience has taught a growing number of banks that running a mutual fund company is not as easy as they had thought.
And now the business is getting worse as bank-run funds as a whole are witnessing net outflows. In the first nine months of 2000, banks experienced a $2.5 billion outflow, despite an increase of $155.4 billion by all mutual funds, according to Boston-based Financial Research Corp.
Fixed-income funds paced the bank outflows (see table), but bank-run equity funds had nothing to brag about either. Their net gain was a measly $209 million.
Lack of asset growth in mutual funds means no increase in revenues. At the same time, expenses remain the same, or rise, with lower earnings as the upshot.
Experts say that, as a result, many banks are considering exiting the business, or are trying to figure out how they might. No bank contacted by U.S. Banker acknowledged that it was considering getting out of the mutual fund manufacturing business, but Jim Folwell, a consultant with Cerulli Associates Inc., a financial services consulting group based in Boston, says that "a lot of banks are reevaluating" the issue.
"They are trying to decide whether they should stay in the business, and if they do, how they should position their funds and how to market them," he says.
Running a fund is not cheap. "A fund complex of less than $1 billion probably doesn't make a great deal of sense," says Bob Christian, chief investment officer at Delaware's Wilmington Trust Co.
Wilmington Trust had problems of its own in squeezing a decent profit from its funds, and now is trying to take advantage of the problems other banks are facing by functioning as an outsourcer.
While selling mutual funds manufactured by others still can be lucrative, the business of setting up funds, managing, advising and marketing them is becoming less attractive, the experts say.
Legal fees per fund run anywhere between $100,000 and $300,000 a year. Board fees are $25,000 to $50,000 per person for outside members, and each fund has its own board. And the Securities and Exchange Commission recently called for more outside directors, which would increase costs.
In addition, processing fees run about 10 basis points, not including investment advisory fees. "That's at least half a million bucks before you've collected the first dollar," says Christian. "And that's where the investment adviser earns his money."
The Investment Company Institute, the trade association for mutual funds, estimates that the average operating expense ratio for funds with less than $250 million in assets is 250 basis points, compared with 70 basis points for funds with assets of $5 billion or more.
A. Michael Lipper, founder and chairman of the mutual fund research company (now owned by Reuters Group) that bears his name, indicated in an interview that a fund needs about $50 million in assets to break even before marketing expenses.
And marketing is the biggest cost, especially in a highly competitive market when cash inflows are declining.
In the current market scenario, smaller operations are quickly discovering that without the power of national branding or hot performance numbers, self-run mutual funds are becoming a drag on earnings.
Generally, the more funds a group makes available, the better. That's because when a company offers dozens of funds, the chances are much better that one or several of them will turn out to be top performers. These winners are flaunted by their operators, giving the entire group a marketing boost. Banks that don't have a large number of funds lose that advantage.
Yet by creating more funds, a bank increases its costs and must decide whether the money spent will get the returns it seeks, or whether the money would be better spent elsewhere. A growing number of banks are deciding that pouring more money into manufacturing mutual funds won't pay off, the consultants say.
In contrast, with the runaway stock market of the 1990s, banks spent aggressively to capture investors' assets, converting their trust operations into mutual funds and buying up established money managers at sky-high prices.
Mutual fund assets under bank management surged. Banks' share of the mutual fund market nearly doubled during the past decade, accounting for nearly 10% of all mutual fund assets under management by 1999, according to FRC.
But by the late 1990s, bank-owned mutual funds hit a wall. There were often conflicts between a bank's traditional bankers and its new-found brokers, especially about how each should be compensated if deposits moved into funds accounts.
Compounding those problems was banks' innate preference for highly conservative investments--notably blue chip stocks and triple-A bonds--when all the action was in high-flying tech stocks.
The results have been painfully obvious. Until this year's sell-off in the technology sector, bank-owned funds had consistently trailed the rest of the industry in overall performance, according to Morningstar Inc. in Chicago, missing as much as a third of 1999's run-up. Bank-advised equity funds returned an average of only 22.81% in 1999, compared to 32.84% for all equity funds.
"Unless you can get the investment results, you are going to have a hard time selling these funds," says Geoffrey Bobroff, a mutual fund industry consultant in East Greenwich, RI.
But that costs money that few banks seem willing to spend, he adds. "The investment business in most banks has been less than 10% of revenue, so if you are a banker and are focused on earnings, this is not necessarily a significant contribution, and you don't invest resources there."
Performance is only part of the solution, says Charles Wendel, president of Financial Institutions Consulting in New York. Bank funds, like the rest of the second- and third-tier players in the industry, are finding it increasingly difficult to compete with the name recognition of Janus, Fidelity, Federated or Putnam. Customers want the comfort of familiar names, particularly in treacherous markets.
Through October 2000, the top 10 largest mutual fund families attracted 60% of all new cash flowing into mutual funds that year, up from 40% in 1997, according to FRC.
That's why Citigroup is pushing its mutual fund offerings behind the Salomon Smith Barney name and First Union Corp. is promoting its Evergreen brand so heavily, Wendel says. "The customers want to know the name and reputations of these guys. When you talk about a bank fund, it's more difficult to sell."
Only a handful of banks have made it into the new century with the critical mass and name recognition they need to remain viable players in the increasingly competitive and consolidated mutual fund industry. At the top of the list is Mellon Financial Corp. With its Dreyfus Corp. subsidiary, Mellon manages more than $110 billion in mutual fund assets, placing the company within the top 20 of the mutual fund industry's largest players.
Mellon provides a great case study in both everything that can go wrong in building a retail business and how to get it back on track. The company's first mistake was hiring people who wanted to work in a bank, conceded Christopher M. "Kip" Condron, chairman and chief executive officer of Dreyfus and president and chief operating officer of Mellon, in an address to a national conference of financial services executives in Chicago.
"We needed smart energized money people who weren't afraid to think in new ways on behalf of the customers," he told the group.
Mellon also needed to figure out how to compensate those employees. The scale was so out of whack that Mellon's own "personal investment consultants," or PICs, got paid more to sell Federated funds than to sell its own products.
And the products Mellon was selling were out of step with what clients wanted, says Stephen E. Canter, president, chief operating officer and chief investment officer of Dreyfus. When Mellon bought Dreyfus in 1994, only 10% of its assets were in equities. Today that is up to 40%.
Mellon beefed up its sales force and went on a shopping spree, buying up other asset managers to complement its Dreyfus offerings. Then it broadened its distribution channels, adding third-party intermediaries such as financial advisers and brokerage firms to its existing direct sales efforts.
"Few competitors can match the breadth of our offerings, combined with our nationwide, multi-channel distribution network," Canter says.
The results so far have been impressive. From 1999 to 2000, sales of total mutual funds and variable annuity sales by Mellon's PICs jumped 47%, while internal sales of Dreyfus products increased 113%. Dreyfus products accounted for 69% of total sales in 2000, compared with just 48% the year before.
Chase Manhattan Corp. is hoping to make the same inroads with its acquisition of J.P. Morgan & Co., which was scheduled to close by the end of 2000. Morgan's institutional prowess, combined with Chase's lineup of Vista funds, could propel the bank into the top ranks of the mutual fund industry, Wendel says, but it is still a risky proposition. Mergers like this tend to generate a lot of turnover.
Bank One Corp. figured that out eight years ago when it started focusing on the retail money management business, says Mark Beeson, president of the One Group family of mutual funds. The first thing the bank did was to consolidate all of its investment adviser functions. Then the bank started heavily recruiting portfolio managers, not from the traditional bank sources but from the mutual fund industry, and structuring their compensation along mutual fund industry standards.
"We have always viewed the mutual fund company as a mutual fund company, not as part of our trust operations or as part of our captive distribution system," Beeson says.
That early separation helped the One Group avoid several of the traps most bank fund operations fall into. First, its portfolio managers were willing to invest in technology stocks, so the group's growth funds have managed to hold their own against the competition. And with 51 funds under its belt, getting a few winners wasn't that difficult.
While it was building its portfolio management expertise, One Group was also building its distribution network--again, following the traditional mutual fund model. The company has 11 external wholesalers knocking on brokerage doors and expects to double that by the first quarter of 2001.
"We have dealer agreements with all of the major wire houses and most of the regional firms," Beeson says. "We've gone from 90% of our new sales coming through internal channels to the mid-70% now."
It's a very different story for banks with mutual funds assets of less than $5 billion. It is getting harder and harder for any smaller fund company to compete, and harder for bank mutual companies to compete within their own corporations for the dollars necessary to stay in the running. "As public companies, current earnings per share are a critical issue for banks," Bobroff says. "That kind of investment, millions of dollars usually, is a cost most banks don't want to incur."
Recognizing the problems, about three years ago, Wilmington Trust started restructuring its mutual fund business. It spent about three years making acquisitions and restructuring its portfolios, and it now markets its asset management business to smaller mutual fund producers.
In order to provide a full range of products to its customers, Wilmington Trust bought big stakes in two private money managers: Cramer, Rosenthal, McGlynn, a value manager in New York, and Roxbury Capital Management, a growth shop in California. Then it began the messy process of consolidation, merging portfolios and shifting investment responsibilities to the appropriate asset managers. By the end of 1999, the process was complete, and through 2000 almost all of Wilmington Trust's funds are in the top quartile of their peer groups.
But Wilmington Trust found that even that was not enough. So it decided to steer clear of competing directly for retail investors, and, instead, has developed a distribution system targeted to current mutual fund producers that would like to get out of the business. "A number of funds out there are not growing very quickly, and there are a number of CEOs out there who probably wish right now that they weren't in the mutual fund business," says Christian.
Wilmington Trust plans to consolidate those funds into its existing portfolios, creating a "clone fund." The company could take over all legal and day-to-day responsibilities, with the original fund keeping its name but assuming the historical performance of the fund it is now tracking.
Wilmington Trust has ready done this with the Kiewit Fund, formerly managed by a construction company in Omaha. "We can do it for anybody," Christian says. "There are unlimited possibilities."
And the company is selling its branded products through third-party brokerage firms and its internal sales force. "We're aiming for each (distribution system) to generate about $500 million a year in assets over the next four years," he says.
Private labeling may be the last line of defense for smaller bank-advised funds determined to keep their names in front of their clients. Most are simply getting priced out of the business, Wendel says.
"It is expensive to run these things, and unless you have significant dollars under management, they are just too expensive to operate," he says. "In the next year there will be more of a focus on cost reductions, so there is going to be more focus on whether they are making enough to justify staying in the business."