Money Management Executive
The Securities and Exchange Commission’s new rule requiring greater transparency in the costs of funds of funds could mean more headaches for active managers of smaller funds.
The rule requires funds of funds to include not only their own operational costs, but also those costs associated with their underlying funds in their expense ratios, thereby bringing data already buried in the prospectus to the forefront.
As expense ratios — though not necessarily overall costs — jump categorywide, smaller funds will have to work even harder to distinguish themselves from industry giants, better articulate the value they bring, and perhaps re-examine the composition of their funds.
It was the breakneck growth of these funds that incited the SEC to pass the rule, which took effect at the start of the year, in the first place. In the past five years the number of funds of funds has increased from 200 to nearly 2,000. Meanwhile, assets in these funds more than doubled — from $123 billion in 2003 to $306 billion by the end of 2005, according to the Investment Company Institute.
Easy to explain, and, therefore, easy to sell, life-cycle and lifestyle funds account for the majority of new funds of funds. The automatic enrollment and allocation provisions allowed by the Pension Protection Act of 2006 may help their popularity continue to surge.
As these products’ popularity has increased, so has regulators’ scrutiny. They noticed that in an effort to attract investors, some larger companies that bundle together proprietary funds reported expense ratios as low as 15 basis points. Those fees essentially cover the price or advertising and distribution, but regulators worried they omitted the costs associated with the underlying assets.
The old expense ratios gave investors no easy way to compare costs between competing products, according to Susan Wyderko, executive director of the Mutual Fund Directors Forum in Washington.
Giving investors a complete picture of a fund of funds’ cost “heightens the awareness and focus on expenses,” said Jeffrey Kiel, principal of Keil Fiduciary Strategies in Denver.
For those who had invested in products offered by companies like Vanguard and Fidelity, the new expense ratios could be quite a revelation. Some no-load funds that previously reported extremely low or no expense ratios on proprietary funds of funds might suddenly show expenses between 60 and 100 basis points. Meanwhile, investors in funds of funds with different share classes could suddenly see that the true cost is not 80 basis points, but 1.8%, said Marc Fowler, vice president of The Online 401(k) of San Francisco.
But managers whose funds include no proprietary funds and target the retail market rather than the retirement market say that including these costs puts them at a competitive disadvantage.
Of the 507 actively managed funds of funds that Lipper lists in the marketplace, only a few dozen are run by independent managers with no proprietary funds to draw from or institutional channels to sell through.
Another strategy is to focus on marketing, said Geoffrey Bobroff, the president of Bobroff Consulting in East Greenwich, R.I.
“Traditional brokers are not as inclined to buy funds of funds,” Mr. Bobroff said. “They are more likely to build their own.” Traditionally, these products take the form of a separately managed account, in which the broker picks the components, packages them, and adds his own fee.
But building these products, and getting necessary approvals, requires time and staff. Savvy fund-of-fund managers can package their products as less expensive, ready-to-sell wraps, Mr. Bobroff said.
