According to a survey released by Deutsche Bank in September 2014, ‘From Alternatives to Mainstream Part Two’, total assets managed by ’40 Act mutual funds reached a record high of USD257 billion by end-2013, representing over 60 per cent growth for the year. Through May 2014, that figure had grown a further 18 per cent to over USD300 billion.
There is no doubt that interest is building among European managers – traditional and alternative alike – to tap in to the massive USD17 trillion US regulated investment company market, but there are a number of considerations that need to be taken into account before taking the plunge. While the potential is vast, this is not a market that suits everybody, and this is definitely not a market where you build it and they will come.
“Over the last 12 months, we’ve spent a lot of time educating our hedge fund clients and others on the liquid alternatives opportunity set. Managers need a clear, well-defined strategy and a long-term commitment before making the decision to go that route. In our view, there has to be a minimum of three years of performance to have a reasonable shot at success,” says Philip Masterson (pictured), Senior Vice President and Managing Director, Investment Manager Services at SEI in London.
“Even though there are several very successful London-based managers, our discussing with them about some of the key considerations and key success factors effectively led the majority to decide, ‘I like the opportunity but this isn’t the right strategic move for us,’” continues Masterson.
There are a number of factors to consider, some of which this article will go into greater detail on. They include:
- Branding – putting the right systematic marketing and social media strategy in place to succeed over the long term
- Fund strategy – does it fit well within a regulated construct? Will liquidity and diversification constraints etc. negatively affect the strategy’s performance?
- Investor profile – what type of investor base is the fund aiming to attract? Is it purely retail money or institutional?
- Distribution – managers have to have a solid distribution strategy in place. Do they intend going direct or through an intermediary?
Establish your brand
There are two schools of thought on this. One is that branding has to be taken extremely seriously given the number of heavyweight brands that are already in the ’40 Act fund arena. Traditional fund houses like Blackrock, Fidelity, Vanguard, and Oppenheimer have a long, rich heritage and as such have a 40-year plus head start on almost all alternative fund managers.
“We want the managers we work with to think about their media, PR, and brand strategy even more so than their sales strategy. Because hedge and PE managers are generally unknown in the liquid funds space, we think they should focus on their brand first and foremost,” says Jonathan Dale, Head of ’40 Act Distribution at SEI’s Investment Manager Services division. “From a recognition standpoint, they are at a distinct disadvantage.”
The second school of thought is that well-established, successful managers already think they have a good brand that can translate across the pond. The question is perhaps whether they overestimate it with respect to the US market.
“They think they are already well known in the spaces they are looking to sell a regulated product but soon get surprised when they find out that a lot of the registered investment advisers (RIAs) don’t really care too much about who they are.
“That, to me, is critically important. It comes down to reaching key distribution milestones: performance, track record, and commitment to the market are all important considerations before an RIA will commit their client’s money to a manager,” says Dale.
Those who have a good brand that resonates with the market in which they are looking to enter are going to be in a stronger position when it comes to an RIA taking their call or setting up a meeting.
“That’s where, for certain larger managers with global brands, they might be well known more institutionally but not necessarily downmarket in the retail investment advisory space.
“What we have found is that the managers who are successful in the US, regardless of where they are headquartered, whether they are European or US managers, establish a thought leadership brand strategy early on in their product development. Most platforms or research groups require a three- to five-year track record. That then gives you the opportunity to better meet allocator criteria as well as receive a good Morningstar rating. If you look at net flows into five-star rated funds over the past year, it’s close to USD200 billion,” explains Dale, “while those with one- and two-star ratings had net outflows.”
The point being, any manager making their first foray into the US – no matter how prestigious their name – can’t get that high Morningstar rating or meet advisors’ research criteria overnight. Allocators and/or gatekeepers look at a variety of metrics that they believe identifies best-of-breed or high quality managers, and whether it be a Morningstar or Lipper Leader rating, meeting minimum risk/return figures or manager/fund AUM, it is putting the cart ahead of the horse by building a large sales team before the market is primed and there is anything legitimate to sell.
The best thing for a manager to do, says Dale, is to control their message and their brand and try to establish themself as a leader in their particular discipline over the first couple of years.
“Even if you don’t get a five-star rating but you’ve established yourself as a leader, you will be in a better position to raise assets. A lot of the managers that we work with think they should immediately hire highly successful wholesalers. However, these salespeople’s success often comes from fund families with an established brand presence and track record. From our experience with new fund families, it’s better to time that a bit later, once you’ve identified that your brand is resonating in the US,” stresses Dale. Indeed, boots on the ground here relates more to content marketing and education than product-specific sales.
From Masterson’s perspective, there seems to be a roughly 50:50 split in terms of those managers experiencing demand pull – whereby investment consultants and distributors are approaching them directly to create products – and those managing billions of dollars who think their strategy would work well in a long-only product.
“They see liquid alternatives as the next generation of the firm’s growth and, importantly, they see themselves as truly global managers. The US mutual fund market is around USD15 trillion; it’s an enormous market with immense opportunity.
“Fundamentally, if I were to break it down simply, it’s about commitment. The firms we’ve seen go down this path that we think will be successful, have entered into the US market with a clear long-term strategy with reasonable goals. We can often tell from the first meeting with a manager whether they are just interested to get an education on liquid alternatives but aren’t ready to go forward, or that they are seriously interested and ready for the long haul necessarily to properly build out a strategic plan.
“I would estimate that approximately 10 per cent of managers we speak actually decide to go down the ’40 Act path,” confirms Masterson.
Given the daily liquidity constraints of running an alternative mutual fund, the strategy has to be a good fit and not simply shoe-horned into a ’40 Act wrapper. This is very similar to the European UCITS market. There are strict limits on position concentrations and diversification, so in many ways running a regulated strategy is a completely different ballgame.
Equity-based strategies will typically be the best suited, although there are plenty of CTAs and fixed income managers now offering ’40 Act versions of their offshore strategies. In terms of what might appeal to US investors right now, Dale thinks small-cap European equity strategies are an attractive option. US investors like to invest with managers who are embedded within the very markets they are trading.
“There are plenty of US managers running international equity strategies but they aren’t necessarily embedded in the European market so that’s a space that is in short supply. Any European managers who specialise in the small-cap space are interesting to US investors,” says Dale.
A structure that may be an interesting option is the interval fund which sits within the unlisted closed-ended fund space. These are referred to as ’33 Act funds. Whilst they still fall under the auspices of a ’40 Act fund, they are not true open-ended mutual funds and as such allow the manager to run more illiquid strategies. This is particularly appealing to credit hedge funds and private equity managers. They can set up a separate account-type structure which uses monthly subscriptions and quarterly redemptions.
“The liquidity provisions are less stringent and allow managers to do something a little more different from a strategy perspective. It’s a smaller market but the large wirehouses such as Merrill Lynch and Morgan Stanley are expressing interest in these types of offerings. A lot of European managers are asking about this at the moment,” confirms Dale.
The US retirement space
“I think the perhaps the biggest opportunity for both private equity and hedge fund managers is in the customised target date fund arena within the USD4 trillion-plus DC market in the US. Target date funds dominate the DC space with upwards of 80 per cent of flows now going to these funds,” says Masterson. “At SEI, we have agreements in place with 15 of the top DC record keepers, which in itself represents USD3 trillion, giving clients a leg up on meeting their distribution challenges.”
Additionally, Dale recommends that every manager should have a consultant relationship strategy.
“Go after the large institutional consultants, as they are the ones that are going to recognise a lot of the European managers, to determine if you can crack the 401(k) market.
“Many of the large consultants consult on the same corporate DC plans as they do defined benefit (DB) plans. So over time, there’s a very good chance that once you’ve established your brand and track record within the defined benefit market, that same consultant will want to use you in their 401(k) plan as well,” explains Dale.
Some of the guidance consultants can provide managers relates to the most appropriate fund vehicle for the target channel and investor type. The benefit of having a ’40 Act mutual fund is that it’s generally the most flexible vehicle in terms of distribution. But given the fee and expense pressure of funds within the DC space, an alternative comingled fund, called a collective investment trust (CIT), may be a viable option.
Simplistically a CIT is an unregistered mutual fund targeted to the DC market, yet because they are subject to ERISA rules that aim to protect US retirement assets, they have less flexibility in terms of portfolio management strategies and diversification. Because of this, there is less scope to attract broad-based assets, but nonetheless, CITs are expected to control upwards of 20-25% of the DC market, and at 2020 estimates, that could still be a very significant USD1.5 trillion.
While ’40 Act mutual funds can be used in a 401(k) – the US defined contribution pension scheme – just as much as in a traditional brokerage account, with a CIT, the manager is limited to ERISA-qualified defined benefit and defined contribution plans.
As such, any European manager who chooses to launch a mutual fund targeting retirement assets must again focus on brand identity. Given the intense competition for assets, a newcomer will have a very difficult task conquering, or even breaching, the 401(k) market in the short-term.
The ’40 Act mutual fund is still more appropriate for the traditional financial advisor and RIA channels. With respect to the wirehouse channels, managers are considering separate accounts. European managers who have good relations with the likes of Merrill Lynch and Morgan Stanley are choosing to start off with a separate account as a way of testing the waters.
It should come as no surprise that distribution in the US is a tough exercise so European managers have to be patient.
There are key minimum milestones that need to be met in order to just “get in the game”, and tie in with what Dale mentions above when discussing branding. An important milestone, without doubt, is reaching a three-year track record, ideally with decile, or at least upper quartile fund performance.
Three years typically is often the minimum period to give advisors enough information to assess how well the fund has performed. Dale, however, has seen advisors also use five or even 10 years as key criteria.
“Align your resources accordingly to achieve those milestones. Think about how you are spending money on distribution in the US. In my view, managers should focus on consistent messaging, points of differentiation and their brand first, and then add the sales field team later on as the brand message starts to resonate. We also advise managers to hire a national account manager who acts as the key decision maker on how to optimally distribute the product in the US.
“Brand is the number one priority to break in to the US market. Establish yourself as an expert in your particular discipline as early as possible. That will then allow you to align your distribution strategy accordingly.
“The best part about the brand strategy is that if you develop a strong web presence, and a great social media strategy, you can gather invaluable data on who is clicking on your website, spending time reading your material, checking out your LinkedIn page, whatever it might be. Then you can make more insightful decisions on how to build your sales team to go out and connect directly with these people. That to me is a smart approach and a great way of managing resources,” outlines Dale.
As Masterson points out in conclusion: “The opportunity is ostensibly huge but it takes significant support from sales and marketing to successfully promote a ’40 Act fund product. There has to be a serious commitment to staffing, resources, and a reasonable timeline.”
SEI has a series of white papers that go into the above areas in greater detail, which you can click on here: