As mutual fund assets continue to decline and investors migrate to low-cost products, fund companies are struggling to make their management fees stretch even farther.
In addition to cutting staff, already lean firms will need to consider automating or outsourcing various functions, merging small funds and eliminating some funds altogether, according to observers.
"All fund groups have suffered substantial losses of assets under management, which has been reflected quickly in earnings," said Burton Greenwald, the president of the Philadelphia consulting firm B.J. Greenwald Associates. "Funds will obviously look at expenses as one area where they can exercise control. This is particularly true in publicly owned companies."
Paul Ellenbogen, director of board consulting services at Morningstar Associates LLC, said that in the recent past "funds were launched with high initial fixed costs under the belief that market gains would continue to push forward." Now those costs "have become a ball and chain, and expense caps have become a liability for advisers."
New funds put expense caps in place with the expectation that the fund would be small for only a short period of time, after which the caps would go away, Ellenbogen said. Instead, those caps are staying put while assets flounder.
The problem is that firms cannot raise fees to cover rising costs, and even though investors have become keener on low-cost funds, the fees are not getting any lower, he said. "No one is really happy."
Keith Brown, the president of Beacon Consulting Group in Boston, said the majority of fees are asset-based. Fixed costs are steady even when assets are declining, so operating costs are rising, he said.
Ellenbogen said: "As the market takes away assets, or as investors withdraw assets, funds are going back up that staircase, up to higher breakpoints."
Performance fees can also have a bizarre effect in down markets, he said; when a fund outperforms its benchmark, its fees typically go up, but investors get irritated when a fund loses 35% and their fees go up anyway because it still beat the Standard & Poor's 500 by 200 basis points.
Assets under management have dropped anywhere from 20% to 40%, Ellenbogen said, and one-year returns are down 50%. Some funds once worth $200 million are now worth $100 million.
"It's pretty bad when almost half of funds aren't at the critical point for profitability," which is $100 million, he said. "This is a big problem for at least half of all mutual funds."
Many firms will need to merge small, underperforming funds and declare some obsolete, he said.
Brown said a lot of fund firms "feel they need to have every imaginable strategy," but only two or three of their funds hold the majority of the assets. "There are really significant, immediate savings in product rationalization."
Ellenbogen said even the largest, most cost-effective funds are being forced to cut people. He noted that American Funds Distributors Inc. has announced it is cutting an additional 500 employees.
"There have been an awful lot of layoffs," he said. "People are such a big cost."
Greenwald said the industry's staffing cutbacks last fall were followed by two to three more waves, along with hiring and salary freezes.
Until there is evidence of a real turnaround, there is very little companies can do to influence inflows or the appreciation of markets, he said.
Brown said there are "layoffs and staff cutbacks across the board," but they have not translated into savings for the shareholders. "There is not a direct correlation between head count and lower fees."
Ellenbogen agreed with that assessment. "You won't hear firms saying, 'Now that we've laid off 25% of our staff, we're going to start lowering our advisory fees,' " he said. "Fund fees tend to be very sticky on the way down."
Edward O'Brien, senior vice president of institutional wealth services at Fidelity Investments, said that even though assets have declined, "advisers' primary expenses — people and technology — remain largely fixed" and are likely cutting into profit margins. "As a result, enhancing profitability through greater efficiencies has become critical. In times like these, with margins under substantial pressure, advisers need all the time they can get to spend on profitably growing their practices."
Besides slashing staff, firms can consider other cost-cutting alternatives, such as automating manual processes, putting more information on the Internet and outsourcing work to third-party administrators.
"In the current economic environment, mutual and collective fund companies face a greater need to reduce fund expenses while retaining customer business and satisfaction," said Pat Centanni, executive vice president and head of global product management at State Street Corp.
Funds can replace manual or partially automated processes and outsource paperwork-intensive, administration processes to provide broader functionality, scalability and accuracy, Centanni said.
Kirk Botula, chief operating officer at Confluence Technologies Inc., said, "There is tremendous upside potential for fund administrators to consolidate data and automate processes that will not only abolish the risks associated with manual processes, but also transform fund administration, so that it is ready to meet future challenges and the next wave of growth and prosperity."
Brown said software vendors are doing a much better job in terms of investment product coverage, but he still sees "a gaping hole in the ability of software vendors and service providers to address risk management needs."
Fund companies will go back to their vendors and service providers for concessions, he said. "Whether they will get it is a whole other issue."
According to Greenwald, one ongoing challenge with technology is that it requires up-front spending. "These expenditures will be returned in terms of long-term savings, but most fund companies are not prepared to make those up-front expenditures at this time."
Michael Ma, a principal at the New York industry consulting firm kasina LLC, said the Web "clearly needs to an integral part of the discussion" about costs. "Those who aren't thinking about it are likely to be leaving money on the table."
Given the current economic and distribution challenges, Ma said, firms should take time to consider how they can integrate online and offline sales efforts to increase efficiencies.
