Customers want a bank mutual fund to deliver what they thought they were buying. So do regulators.

Developing reliable products requires a well-informed, accurate sales practice and portfolio management adhering to the investment process and objectives disclosed in the marketing and prospectus materials.

But laws and regulations are qualitative, while investment management is quantitative. For instance, an inverse floater that is seen qualitatively as a prudent government security might quantitatively involve embedded futures that prove disastrous.

The key link between quantitative and qualitative approaches is performance benchmarking. Let's take an example of a new aggressive growth fund, and consider how product reliability can be built from the time the fund is developed.

The portfolio manager identifies the benchmarks against which the fund is to be measured, such as beating the Russell 2000 in up markets and taking a defensive position in down markets. Management now considers this benchmarked measurement as a performance standard. Accordingly:

*Benchmarks are shared up front with legal and marketing staffs, which use them in shaping prospectus language and marketing literature.

*Accounting creates a monthly checklist that tracks investment restrictions and measures fund performance against the stated benchmarks.

*Information technology determines whether relevant investment restrictions can be measured and tracked systematically.

*Marketing, with input from the portfolio manager, tracks how industry sources such as Lipper and Morningstar create peer groups for this asset class and compare the fund's performance against its peers.

*Information technology supplies ongoing performance measurement tools that help identify causes for underperformance or overperformance .

*Management sets performance parameters, which trigger exception reports if they are exceeded.

*Management establishes a formal process for periodic portfolio review, including whether the stated objectives of the fund remain appropriate and achievable.

Defining and measuring product reliability properly can make portfolio compliance more effective than in the traditional model and can provide useful tools for monitoring investment performance. Most compliance problems have arisen when portfolio managers, striving for unusual performance, have adopted a trading strategy that pushes the envelope successfully for a while. If hot performance is pulling in assets, will greed overcome prudence?

Proper use of benchmarking tools requires good internal communications, across functional lines. Many portfolio managers may see that as clipping their wings. Therefore, product reliability is a matter not only of tools but of management orientation.

A mutual fund can decline in value and still be reliable so long as:

*The customer understood what he or she was buying in the first place.

*The benchmark declines proportionately.

*The customer understands the link between the product and its market benchmark.

*The bank or sales executive is proactive during the down cycle and when the fund is an outlier vis-a-vis its benchmark or peer group.

Customers' understanding of what they are buying is a cornerstone of bank sales compliance. To date, the real level of customer understanding has been hard to determine and subject to considerable debate, typically centered on suitability.

As broker-dealers registered with the National Association of Securities Dealers, bank brokerages are supposed to determine suitability of a product to a consumer's investment needs.

Normally, suitability is satisfied with some sort of profile that the broker produces with the client, matching risk tolerance and demographics with assets. Suitability screening can be expanded to provide statistical monitoring of variables that correlate customer factors with investment criteria such as net worth, investable funds, and demographic data.

Most of the focus on suitability has been on the customer side - creating profiles of life cycles, and projecting customer liabilities with the objective of limiting investment risk.

These efforts, though valid, miss some important points. Is the customer taking enough investment risk to achieve goals? Are the funds the bank offers "best in class" for reward versus risk in each relevant asset class? Have the asset classes under consideration been evaluated for their impact on the client's portfolio diversification?

This broader sense of suitability borrows methods used by pension funds in evaluating their investment options. It will result in a better match between customer needs and end results than a simple assessment of a fund's investment risk.

Most bankers and brokers think compliance ends at the point of sale. Technically, they may be right. But post-sales tracking is vital. Customer needs and suitability requirements change over time. Profiles should be updated every year or two.

A unified approach to reliability in products, in sales, and in post- sale reporting can yield many benefits. Customers are satisfied with the investment process and results; the bank gains a higher share of wallets, has fewer regulatory problems, establishes a dialogue with clients, and is able sell to more.

This formula has not been lost on the mutual fund industry. Merrill Lynch and Smith Barney have launched no-load fund wrap-fee programs designed precisely to achieve these objectives. Fee-based financial planners, using services like Charles Schwab's OneSource, are striving for similar ends. And the Fidelity walk-in investment center can deliver a similar service.

Fortunately for the banking industry, none of these competitors have yet perfected their approaches.

In most banks today, mutual fund risk management is seen as an unpleasant chore - one that has nothing in common with competing with Merrill Lynch, Schwab, or Fidelity for customer loyalty. Sadly, this view leaves the bank fund industry open to the greatest risk of all - the risk of misunderstanding and misapplying the management of investment risk and reward.

Bank mutual funds have not lived up to their promise. Consequently, most banks assume their fund lines cannot afford the investment needed to achieve reliability. As a result, nonbank fund companies continue to take market share from banks - and banks continue to underinvest in risk management.

This cycle can be broken; the necessary investment may be less than is normally assumed. But creating a culture and process of reliability will require repeated intervention from senior management.

The real challenge is to give more attention to mutual funds than the current P&L would seem to justify.

Part I of this comment appeared Wednesday.

Ms. Binstock is national director of the investment management regulatory consulting practice and Mr. Marshall is national director of the bank mutual fund practice at Ernst & Young in New York.

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