Future margins in third party fund distribution

Distributors currently enjoy the advantage in third party distribution relationships. But the balance of power is about to shift. Charles River Associates (CRA) looks at the strategies distributors must implement to maintain their advantage.

Sales of third party funds in the US have been outstripping those of proprietary products since 1994. Indications are that European third party fund distribution is heading the same way. On this basis, it is widely believed that the US trend towards open architecture will translate verbatim to Europe. Not so. Such predictions ignore the differences in the economic background against which fund distribution has transformed. In the US, equity markets were booming at the end of the 1990s, and it was relatively easy for third party funds to take their place alongside proprietary offerings. Distributors and manufacturers both benefited from burgeoning customer wallets, and their profits increased. The pie was getting bigger, so there was more for both parties. But since 2000, markets have continued to falter, wallet sizes have shrunk and it won’t be long before amicable “distributor/manufacturer” marriages slide into conflict. Fights for larger slices of the pie are likely to arise sooner and the European industry will change more rapidly than in the US. Balance of power Economics predicts that the highest rewards in a market will go to those with the scarcest commodity to sell. This applies to fund distribution every bit as much as it does to Hollywood actors, top footballers or prime retail locations on the Champs Elysée. This simple fact is often overlooked when predicting the outcome of negotiations between distributors and manufacturers. Historically the scarce commodity in fund distribution has been the customer relationships that the distributors have held. Manufacturers – both in-house and third party – have thus had to work through distributors to reach final customers. For their part distributors have not been slow to recognise their own worth – seeing themselves as the most valuable link in the value chain. The end result has been a proliferation of manufacturer/distributor agreements that have often left the fund buyer in a position of power. Our evidence suggests that some distributors have asked for as much as 75 per cent of the management fee. Survey data from London research firm Sector Analysis has found that distributors of third party funds sign agreements with significantly more manufacturers than they actually use in practice. French distributors appear to benefit the most from this: the average French buyer has agreements in place with 44 different manufacturers, but in practice uses only seven. The other 37 manufacturers gain little or nothing from the agreement – their products languish on the distributors’ shelf. Forces for change Providers may feel helpless to alter this situation, being compelled by competition to continue to negotiate such agreements in the hope that their products will be put in front of the final consumer. But economics has a further prediction to make, namely that profitable commodities rarely remain scarce for long. Already in Europe’s immature market we are catching glimpses which suggest the industry will not remain so easy for distributors. The market is developing in three new directions that alter the balance of power. First, new entrants are making headway into distribution. Second, manufacturers are developing “must have” funds. Third, manufacturers are developing ways to bypass distributors altogether. New entrants The size and profitability of fund distribution has attracted more firms into the business. Not all of these new entrants come from traditional financial services backgrounds so there may be much more scope to increase the number of competitors in distribution than was previously thought. The flurry of “lateral” entrants includes firms as diverse as Carrefour in France, BMW in Germany and Marks & Spencer in the UK. These businesses already have close relationships with clients, and are often branded at the high end of the market or are places where shoppers go frequently. As such, they hold customer relationships that are attractive to fund manufacturers. At this stage, few of these firms offer advice with their products, but this is not to say that they will not in the future. An advised offering would further close the gap with rivals from a traditional financial services mould. ‘Must-have’ funds Increasing numbers of industry players is not the only reason why the value of distributing funds through mediated channels may be falling. Subtle changes in the nature of competition are also encouraging greater emphasis on the funds themselves, and hence on fund manufacturers. Distributors have increasingly similar selection criteria for third party manufactured funds. All the fund buyers that were interviewed in a recent survey rated fund performance as the most important selection criterion, followed by brand strength and quality of management. Concentrating on a small number of selection criteria in this way creates so-called “focal points” of competition in the minds of final customers. This in turn makes it possible for manufacturers to develop a few “must-have” funds – funds that distributors need to include in their panels in order to attract consumers. Already some 8 per cent of buyers choose funds because they say their consumers demand them, according to the European Investor Focus Survey 2002. US managers appear to have gone furthest in creating strong brands. Ten of the top 20 managers selling funds across Europe are US-owned and their growing brand strength has been revealed in a number of consumer surveys. As brand strength, quality of management and investment performance become identified with a small number of funds, it will be difficult for distributors to leave these funds off their panels. And this is how power will shift to manufacturers. The situation can be likened to the UK beer market, where there are also must-have brands. Pubs can choose which of a range of lagers to offer their customers, but woe betide them if they don’t serve Guinness on St Patrick’s Day. Just as consumers won’t patronise a pub that doesn’t provide Guinness in March, they may avoid panels that fail to include the Fidelity American Fund, for example. Manufacturers who have developed must-have funds hold a degree of market power over fund distributors. In such cases, future negotiations will proceed on a more equal footing and a larger share of the profits will go to the manufacturer. Online distribution Some manufacturers have developed ways to bypass distributors altogether, and to access consumers directly online. In principle this cuts the power of conventional distributors, but we doubt that this market development will have much impact on advice-based distributor margins, at least in the next few years. European consumer attitudes and choices consistently show that they are as yet unwilling to buy funds without some form of advice. Far from buying on the Internet – as was expected in the height of the dot.com boom – European consumers have preferred to use it solely as an additional research tool. They stick to traditional channels to actually make their purchase. Nonetheless, there is evidence of change. Consumer education is increasing and the average age of those who buy direct is relatively young (see Figure 1). As these cohorts move through their life course, the online channel will surely grow. The only question is whether this growth will occur through mediated sites such as Ample.com or directly through manufacturer-owned sites such as JPMorgan’s FundsHub or Fidelity’s Funds Network. Wealth and power All of these reasons – new entry into distribution, must-have funds and online distribution – are likely to shift some market power to fund providers in the medium term. But this is unlikely to be the end of the story, and it is worth considering what may happen in the long-term even if, as economists are fond of saying, “we are all dead”. Predictions in this time-frame are not particularly favourable to distributors either. One prediction is that as the market matures the consumer will capture ever-larger slices of the value, and the industry will become commoditised. Whilst we are still a long way from this situation, there are some hints that we are moving in this direction. For example, as funds move into the direct channel their prices fall. Buyers in the offline world on average rate the fees of funds as only the fourth most important selection criterion, and 50 per cent of them argue that the price of the fund is entirely unimportant to their choice. By contrast, online fund supermarkets almost unanimously rate the price of the fund as the second most important selection criterion. Price is important online because supermarkets attract sophisticated individual investors who know what they want and just want to buy it at a cost-effective outlet. As more consumers develop this degree of sophistication, they will put ever-greater pressure on fund prices. This pressure is likely to spill over into the offline world. Increasingly we see high net worth individuals taking the initiative and looking for distributors who give unbiased advice, privacy, security, reliable data updates and ease of execution. This “shopping around” approach to obtaining financial services gives them much more power in the market than the consumer who has to be coaxed into buying a financial product. As wealth and education increase, one can anticipate that this trend will spread to other customer segments leading ever more consumers to shop around. Developing agreements It seems evident that change is coming for third party fund distributors. Their currently valuable customer relationships will be contested by new entrants to the market, the development of must-have funds and the expansion of direct channels. In the longer run consumers themselves will seek lower charges and become generally more demanding. So, how should distributors prepare themselves for these changes to the industry? There are two key challenges for distributors. The first is to understand their own competitive advantage and its implications. The second will be to develop innovative strategies to differentiate themselves from competitors and build a distinctive market position. What are these likely to mean in practice, and what sort of analytical work should distributors be doing now? Matching capabilities By and large there are three areas in which distributors can have a competitive advantage: cost-effective administration, brand strength and existing customer relationships. As we will see, each of these is conducive to a particular type of business strategy. The first step, therefore, has to be for distributors to evaluate their competitive strengths in these three areas, to understand where their unique capabilities lie. In many cases the answer will not be clear cut. Independent Financial Advisers (IFAs) for example, have proven expertise in administration, hold the customer relationships and – if they are part of a network – may also wield brand power. But for other distributors the choice will be easier. Lateral entrants to the market, for example, rely solely on their brand strength. Equally, many fund supermarkets are currently exploiting their administrative capabilities. And vertically integrated firms are often relying on the customer relationships they hold. These strengths not only suggest particular strategies, but also dovetail neatly with differing customer segments, as shown in Figure 2. In research for Zurich Financial Services, CRA identified three basic consumer segments:

• sophisticated active consumers – who are able to understand and search out the financial information that they need for themselves
• sophisticated inactive consumers – who can process financial information but who find gathering it time consuming and costly
• unsophisticated consumers – who cannot easily process financial information and depend heavily on advice in making financial decisions. Each of these consumer segments has unique demands for advice and product mix, and the distinctions between them have been accentuated by the Internet. As we have seen, sophisticated active consumers are now able (and likely) to go online to research suitable products and to execute their fund purchase. They are an appealing target for distributors whose competitive advantage lies in administration. Distributors that are efficient in handling large numbers of funds are likely to find it profitable to negotiate agreements with numerous fund manufacturers. In this way they will ensure that they are offering their sophisticated, active consumer base a wide variety of choice at low prices. Sophisticated but inactive consumers have little time to spend on financial decisions, and for them the distributor’s brand strength is likely to be its most important attribute. These consumers value the decisions made by those they trust – as is evident in the recent decision by BMW to offer a selection of five Frank Russell multi manager funds to their consumers. Building on its distinctive brand reputation, BMW has chosen a selection of funds that it believes best meets the needs of its customer base. Although choice is important to these consumers, the time and effort required to evaluate different financial offerings can often make it more efficient to outsource much of this function. Sophisticated inactive customers trust a brand like BMW to make sure that the necessary research is undertaken to create a short list of funds from which they can choose. It is essential to advise unsophisticated consumers if they are to purchase a financial product, and the distributor’s relationship with this type of customer is key. With little financial information, unsophisticated consumers are likely to be the most loyal segment, and hence provide the greatest opportunity for the sale of proprietary funds. For vertically integrated manufacturer/distributor firms in this segment there seems little incentive to move away from proprietary products at this stage. Nevertheless, this situation will not be sustainable in the long run: there is growing evidence that even unsophisticated consumers value at least some choice. One way of providing choice to unsophisticated consumers is through a fund of funds offering. Fund of funds products allow distributors to choose optimal portfolio allocations within the product itself and so give the unsophisticated consumer a degree of choice, whilst ensuring that the distributor remains the prime point of contact. What of distributors with a cross-section of sophisticated active, sophisticated inactive and unsophisticated consumers? Is it possible to devise a differentiated offering that meets each type of customer segment? Or are different third party arrangements through distinct distributors required? Inevitably the answers to these questions are likely to depend on the individual characteristics of the distributors themselves, although it is clear that business models that go across more than one type of customer segment have flourished elsewhere. In grocery retailing for example, the UK supermarket Tesco offers Tesco Value food products to its low-end consumers, and Tesco Finest products to those at the top-end. Neither brand appears to negatively influence the other. Whether this sort of example can be replicated in the world of fund distribution is less clear – the product is intangible and it may be more difficult to sustain two different types of quality reputation under one roof. An innovative position Thus, based on a robust assessment of the distributor’s distinctive capabilities and target segment, it is possible to determine the optimal structure of a third party distribution agreement for today’s market. However, as noted earlier the industry is maturing rapidly and a static business model – even one matched to customer segments and distinctive capabilities – may not be enough. Rather, distributors will have to develop new distinctive capabilities to stay ahead of the pack in the longer run. Recent research suggests three areas where distributors could develop an innovative position, allowing them to sustain their competitive advantage:
• a house view on performance consistency
• cutting edge models of asset allocation
• a reputation for independence. 1 House view The investment performance of a fund is a foremost concern for distributors and consumers alike, particularly in a deepening bear market. Having a well-reasoned house view on the existence and determinants of fund performance can bring tangible benefits for distributors. There are divergent schools of thought in the industry as to whether consumers can usefully exploit past performance information. This divergence of opinion provides an opportunity for distributors to take a distinctive position and add value to their customers. For example, if fund performance is random over time, then distributors should have as wide a range of product providers and funds as possible, to ensure that the “hot fund” of the day is included in their panel. But other research suggests that past performance does provide an indication of future performance, in a way that depends on many qualitative factors. A distribution strategy based on this approach would base fund selection on a sophisticated analysis of criteria including the size of the fund, the fund house, individual managers, and also around particular measures of past performance. Distributors using this approach could provide information on the likely future performance of a fund, and can tailor the performance statistics they produce to the needs of differing consumers. For example, in a fund supermarket with low switching costs, customers are often willing to undertake active management. For them, information on short-term persistency may be sufficient. Conversely, a consumer looking for a long-term investment will mainly want measures of performance that show persistence over the longer-term. While there has been a good deal of analysis of performance persistence in the US, there has been relatively little in Europe. Our research for the UK’s Investment Management Association has assembled the most comprehensive dataset of the past performance of UK funds to date. Models constructed using such data can help distributors and manufacturers to determine whether performance persists for particular providers and funds. 2 Cutting edge models The allocation of investors’ assets amongst asset classes has a dramatic impact on the returns that they are likely to receive and the risks that they are exposed to. The accepted wisdom is to balance low and high-risk investments to arrive at an optimal risk reward trade-off. The high-risk component of the portfolio is then diversified across a number of investment products or held in a single fund that is itself invested in diversified assets. In the past a tracker fund has been thought to be a near optimal vehicle for the higher -risk investments. However the theory underlying this traditional view – the Capital Asset Pricing Model or CAPM – is too restrictive for distributors targeting distinct customer segments because it suggests that optimal diversification is the same for all investors. It takes no account of the fact that investors carry very different risks, besides those inherent in their investment portfolios. Thus a homeowner on a variable rate mortgage is exposed to interest rate risks and may wish to take this into account when making investments. Similarly, a worker in an industry such as construction, which is highly exposed to recession, might be better off investing in assets that are relatively recession- proof; and someone who works in a new technology company may be advised to invest in old technology stocks. Although much of this appears obvious, investment practice still largely ignores it and assumes that a combination of a fully diversified tracker with a low risk asset is optimal for everyone. Our research suggests that more complex multi-factor models can capture these types of difference in risk preference. These models can help distributors to tailor the allocation of their assets – through a fund of funds for example – in light of their customer’s preferences. 3 A reputation for independence The distribution of third party funds leads inevitably to the question of the distributor’s independence from the fund manufacturers. This arises when distributors select a limited range of products or keep their own product in the portfolio on offer to consumers. In such instances consumers are quick to pick up on distributors’ conflicts of interest. It is clear that consumers value independence and impartiality. This is most evident in the high value that consumers place on independent advice (as shown in Figure 3). Yet it is not only in explicit advice that such independence is prized. Consumers also seek fund panels that they perceive are constructed with their best interests in mind rather those of the distributor. In this respect a reputation for independence is a vital asset for a distributor. Such a reputation can be developed in a number of ways. For some providers, brand strength will be sufficient – as their sophisticated but inactive consumers believe that the company will not do anything to damage the value of the brand and hence will choose funds objectively. Sophisticated active consumers meanwhile may require a total separation of the distributor from the manufacturer through a fee-based service, although as yet middle- and lower-income consumers appear unwilling to pay fees for advice. Between these two extremes there are many ways for the distributor to signal to consumers that it is even-handed and is working in the consumer’s best interest. In particular, the structure of remuneration, the openness of the fund selection criteria and the flow of business can be important signals to the ultimate consumer that the distributor is impartial. The structure of commission payments from manufacturers to third party distributors is a significant concern for investors. Our recent research for the UK’s Financial Services Authority showed that whilst there may be relatively little conclusive evidence of commission bias, consumers perceive such bias to be a widespread problem. Distributors can reduce consumer concerns without moving to fee-based advice. For example, they could agree to take the same level of commission from each provider, or the adviser could receive the same level of remuneration regardless of the commission his company accepts. The transparency and flexibility of the selection criteria are crucial to customers. There is clear survey evidence that third party deals are valued most highly when there has been some pre-selection of the fund manufacturers by the distributor. However, where this deal looks permanent the value of using third party distribution is greatly diminished. For this reason distributors should have a clear and transparent policy on when third party fund providers are selected and the terms under which they might change. One of the clearest signals of distributor independence is information on the share of business between third party manufacturers. This is especially important when the distributor provides its own proprietary product, as it provides a credible way of showing that it doesn’t simply give the pretence of choice but promotes and sells products from third party manufacturers. Conclusion Over the coming year European third party distribution is likely to develop at an accelerating rate. Many commentators have likened this growth to that seen recently in the US fund industry. But the evolution of the European market is likely to differ from its US counterpart. Most significantly US third party fund distribution matured during the height of the bull market. But by comparison the transformation of the European industry must make its way against a backdrop of falling equity returns and increasing volatility. We anticipate that this will hasten the shift in the balance of power from fund distributors to other parts of the value chain and eventually to the final consumer. It is therefore imperative that distributors prepare rapidly for this change in the industry. To do so, fund distributors first need to understand their distinctive capabilities to determine the type of third party deals to construct today and who to contract them with. A distributor who is certain of competitive advantage is likely to make the most out of agreements on third party distribution as they arise. However, a static business model – even one built on matching capabilities and customers to provision – may not be enough. To stay ahead of the pack, distributors will need to create a distinctive market position through innovative strategies. We have identified three areas where, with appropriate analysis, distributors can develop new ways to lead the market, namely developing a house view on performance consistency, creating leading edge models of asset allocation and developing a credible reputation for independence. Developing a distinctive market position can create a reputation for innovation that will sustain a distributor and protect their profit margins even when the industry is fully matured. Tim Wilson, principal; Sharon Biggar, senior associate, Charles River Associates