How Regulation is Changing Marketing, Sales and Distribution ...

© 2007 SEI Investments Developments, Inc.

How Regulation is Changing Marketing, Sales and Distribution of Investment Products

Web Seminar PresentationNovember 11, 2004

2November 11, 2004How Regulation is Changing Marketing, Sales

and Distribution of Investment Products

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What is the SEI Knowledge Partnership?

The SEI Knowledge Partnership is an ongoing source of actionable business intelligence and advice for SEI’s investment management clients.

It engages clients and industry experts in analyzing the trends and issues that will reshape business conditions in the years to come.

The Partnership is designed to help SEI clients:• identify the issues they need to be addressing actively. • keep abreast of changing best practices.• develop more competitive business strategies.

Its agenda currently centers on issues concerning:• legal and regulatory change• business operations • marketing, sales, distribution, and client service• business strategy



Agenda

1. Regulatory Update

2. Rules Affecting Marketing, Sales and Distribution of Investment Products

3. Business Impacts:

– Mutual Funds

– SMAs (institutional and retail)

– Hedge Funds

4. Spotlight: Implications for Mutual Funds

5. Participant Questions



Today’s Presenters

Geoff BobroffPresident, Bobroff ConsultingGeoff Bobroff has worked in the investment management industry since 1969 in various capacities. Mr. Bobroff today provides consulting services to investment managers and boards of mutual funds. The work involves strategy, product design, pricing, compliance reviews and contract renewal assistance for many of the leading organizations in the asset management business.

Bobroff Consulting, Inc.401-886-1194 phone

401-886-1194 [email protected]

Thomas LemkePartner, Morgan, Lewis & Bockius, LLPThomas P. Lemke is in the Business and Finance Investment Management Practice resident in the Washington, D.C. office. He concentrates his practice on the full spectrum of investment management matters, including advising mutual funds, investment advisers and broker-dealers. Mr. Lemke is a frequent speaker on and has written extensively about investment management matters and has co-authored a number of books in the area.



Today’s Presenters (Cont.)Jim VolkChief Accounting Officer & Chief Compliance Officer, Investment Manager Services, SEI InvestmentsJim Volk is the Chief Accounting Officer & Chief Compliance Officer for SEI’s Investment Manager Services unit. He is responsible for formulating and communicating SEI’s position on all proposed new accounting rules and regulatory changes that impact the services SEI provides to its clients. He is also the designated liaison for Chief Compliance Officers of SEI’s Investment Manager clients that have registered investment products.



Regulatory Update

• Adoption of Hedge Fund Advisor Registration Rules (pg. 8)

• Deferred Effective Date of Code of Ethics Rule (pg. 5)

• "Hard Close" Alternatives (pg. 5)

• Fund Transaction Costs/Soft Dollars- NASD Task Force Report (pg. 6)

• Mandatory Redemption Fees/Fair Valuation Issues (pg.6)

• Investment Company Governance (pg. 10)

• Breaking developments

www.seiglobalfundservices.com/knowledge.asp



• Amendments to Investment Company Advertising Rules(already went into effect as of 3/31/04)

• Disclosure of Breakpoint Discounts by Mutual Funds

• Prohibition on the Use of Brokerage Commissions to Finance Distribution

Adopted Rules



Disclosure of Breakpoint Discounts by Mutual Funds (9/1/04) • Must ensure that breakpoints are strictly applied• Disclosure must match “reality,” explain aggregation rules and should be concise• Method used to value accounts must be determined and disclosed

– Historical cost– Net amount invested (net asset value)– Offering price (public offering price)

• Must capture all necessary shareholder information for purposes of aggregation• Disclose whether shareholders must provide certain information to assist funds

with properly applying breakpoints (account statements)• Must verify processes and procedures used by T/As and sub-T/As (i.e., financial

intermediaries) to ensure they are making the proper determinations• Funds should have T/As and sub-T/As review draft disclosure before finalizing• Will your website make breakpoint information available (if not, SEC requires

funds to explain why not)



Prohibition on the Use of Brokerage Commissions to Finance Distribution (12/13/04)

• New rule prohibits compensating broker-dealers either by directing transactions or by participation in “step out” arrangements (broad interpretation)

• The ban extends to any arrangement or understanding, whether binding or not

• Proving “best execution” alone is not sufficient (policies & procedures must ensure selection of a selling broker is not influenced by fund sale considerations)

• Policies & procedures require board approval and are covered by new rule 38a-1

• New rule requires written procedures if fund executes portfolio trades through any broker-dealer who also sells fund shares

• Adopting release instructs CCOs to monitor and periodically test policies & procedures

• Challenge of new rule is that a fund must be able to “prove that it is innocent”

• SEC did not provide significant guidance on monitoring. At a minimum, CCO should look for a significant correlation between sales and the direction of brokerage that might suggest existence of informal arrangements



Proposed Rules

• Compensation for the Sale of Investment Company Securities(By requiring disclosure of revenue sharing arrangements and differential cash compensation arrangements to customers, NASD is attempting to identify and eliminate potential conflicts of interest)

• Confirmation Requirements and Point of Sale Disclosure Requirements (SEC is attempting to eliminate potential conflicts of interest)

• Disclosure of Mutual Fund Expense Ratios in Performance Advertising(Controversial “text box” will further focus shareholders on fund expenses)

• Request for Comments on Measures to Improve Disclosure of Mutual Fund Transaction Costs (Could put additional pressure on funds to prohibit using fund brokerage for soft dollar for purposes benefiting the advisor)



Where Might Mutual Fund Distribution End Up In 2005-06?

Implications for Mutual Funds



Flows Are Increasingly Concentrated Among Top Complexes, but AUM Concentration Remains Constant

Concentration of AUM & Net Flows by Manager

0%

20%

40%

60%

80%

100%

2004*200320022001200019991998199719961995

AU

M ($

bil)

0%

20%

40%

60%

80%

100%

120%

140%

160%

% o

f Tot

al A

nnua

l Net

Flo

ws

Top 10 AUM Top 25 AUM Top 50 AUM Remaining Funds

Top 10 % Net Flows Top 25 % Net Flows Top 50 % Net Flows

Source: SEI Investments, Strategic Insight* 2004 Net Flows are EstimatedNote: L/T Open-Ended Funds Only



Indexing Represents More Than 30% of Total Flows…ETFs Now Account for Half

Index vs Active Management

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2004*200320022001200019991998199719961995

Net

Flo

ws

($ b

il)

-

100

200

300

400

500

600

# of

Fun

dsETF Net Flows Index (ex ETF) Net Flows

Active Net Flows # ETFs

# Index Funds (ex ETF)

Source: SEI Investments, Strategic Insight* 2004 Net Flows are EstimatedNote: L/T Open-Ended Funds Only



No-Load Funds Gained Ground Over the Past 5 Years as Front-Loaded Funds Held Steady

Source: SEI Investments, Strategic InsightNote: L/T Open-Ended, Non-Index, Non-ETF Funds Only

AUM by Sales Load Type(excluding index funds)

-

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

YTD200320022001200019991998199719961995

AU

M ($

bil)

0%

10%

20%

30%

40%

50%

60%

% o

f Tot

al A

UM

No Load AUM Front Load AUM Level Load AUM Back Load AUM

No Load % Front Load % Level Load % Back Load %



Even When Excluding Indexing, No-Load Funds Gained Ground Over the Past 5 Years as Front-Loaded Funds Held Steady

Source: SEI Investments, Strategic InsightNote: L/T Open-Ended, Non-Index, Non-ETF Funds Only

AUM by Sales Load Type(excluding index funds)

-

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

YTD200320022001200019991998199719961995

AU

M ($

bil)

0%

10%

20%

30%

40%

50%

60%

% o

f Tot

al A

UM

No Load AUM Front Load AUM Level Load AUM Back Load AUM

No Load % Front Load % Level Load % Back Load %



Fund Rollouts Have Leveled Off, But New Money Is Going Into All Types Except Back Loaded Funds

Source: SEI Investments, Strategic Insight* 2004 Net Flows are EstimatedNote: L/T Open-Ended, Non-Index, Non-ETF Funds Only

Net Flows & Number of Funds by Sales Load Type(excluding index funds)

(50)

-

50

100

150

200

250

300

350

2004*200320022001200019991998199719961995

Net

Flo

ws

($ b

il)

(1,000)

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

# of

Fun

ds

No Load Flows Front Load Flows Level Load Flows Back Load Flows

No Load # Front Load # Level Load # Back Load #



12b-1 Fees Become the Norm…But Higher Fees Mean Net Outflows

12b-1 Fees: Net Flows & Number of Portfolios by Avg 12b-1 Fee

-50

0

50

100

150

200

250

2004*20032002200120001999

Net

Flo

ws

($ b

il)

1,000

1,500

2,000

2,500

3,000

3,500

4,000

# of

Fun

d Po

rtfo

lios

None 75 bps + 50 - 74 bps 25 - 49 bps < 25 bps

# with 12b-1 # w/o 12b-1

Source: SEI Investments, Strategic Insight* 2004 Net Flows are EstimatedNote: L/T Open-Ended, Non-ETF Funds Only



Flows into No-Load Funds with 12b-1 Fees are Substantially Off Last Year’s Pace

Source: SEI Investments, Strategic Insight* 2004 Net Flows are EstimatedNote: L/T Open-Ended, No-Load, Non-Index, Non-ETF Funds Only

12b-1 Fees: AUM & Net Flows for No-Load, Non-Index Funds

0

500

1,000

1,500

2,000

2,500

1999 2000 2001 2002 2003 2004*

AU

M ($

Bil)

0

20

40

60

80

100

120

Net

Flo

ws

($B

il)

With 12b-1 AUM No 12b-1 AUM

With 12b-1 Net Flows No 12b-1 Net Flows

# of Funds with 12b-1 fees 471 556 633 656 701 701

# of Funds w/o 12b-1 fees 3,679 3,831 3,798 3,729 3,690 3,763



Distribution Trends● Landscape:

• Shift to fee-based pricing and the selection of the best of breed by the financial intermediary

– Mergers/liquidations of funds to reduce numbers

• Importance of scaleable advice• Retirement plan sales very important but what about the Bush Administration’s push

for life-time savings? Social Security Reform–boom or bust? Will it be like 529—small accounts with high activity?

• Proprietary firms fall on hard times and a review of the non-proprietary world● Still more regulatory overhang—the whole sales process being picked apart, ”redemptions

fees,” “hard 4:00 PM close” and “point of sale disclosure”● Changing economics—no more directed brokerage, shelf-space payments continue with

greater transparency and SEC wants to revise the “soft-dollar safe harbor” and payments from 12b-1 plans

● What impact will come with the arrival of “the post accumulation era”?



● Advisors: a slow share gain– The pricing problem is being fixed– Investing is if anything getting more complex and scary

● DC (other than advisors): a slow share gain– Powerful tax advantage

● Other institutional uses: a slow share loss– Corporate cash management not a high growth business– Bank trust departments – average to below average prospects

● Direct to investor: a mixed to declining share picture● Supermarkets gain share (only slightly) of direct-to-investors● Growth opportunities in capturing IRA rollover and affluent investor segments—watch out

for LSA, RSA, ERSA—Social Security reform● Flight to quality post-regulatory firestorm● Signs that some groups are focusing on “retirement income”

Distribution Channel Landscape Trends



Fee-Based Multi Manager ShiftOver the next 10 years the major distribution channels (advisor and direct) will remain intact, but the transformation to fee-based, multi-manager packaging will be nearly completed (2/3 of assets)

Likely implications:• Much of traditional load pricing formats will become vestigial appendages,

increasingly jettisoned as firms rationalize products• Virtually no investment manager will have a “lock” on any segment, and the

identity of the investor will largely be lost• Proprietary product lines will need to morph into multi-manager offerings or

recede into the background• Sub-advisory arrangements will continue to gain share• Investment managers will increasingly need:

– Clean, well defined, well supported investment products– Good records, risk adjusted and style-specific– Willingness to do business in any package



SEC and NASD Attack Sales Process

SEC and NASD have been examining and attacking the sales process:• breakpoints, • what is the right class, • reducing the situations where B shares can be used, • concerned about the sales process involving variable insurance products• NASD bringing enforcement cases involving cash and non-cash comp



Pending Changes Impacting “Redemption Fees” and 4:00 PM Close

• As a cornerstone of rule changes to eliminate “market timing” and “late trading”the SEC proposed two rules that have been widely criticized:

– mandatory redemption fees – hard 4:00 PM close

• The staff of the Division of Investment Management may recommend that the Commission adopt a much narrower requirement regarding redemption fees leaving it to the board to make sure that whatever policy the fund group has to restrict or eliminate market timing is enforced.

• The concern is how to gain leverage to require intermediaries, especially those running omnibus accounts comply. It is clear that we need an effective deterrent to abusive market timing.



More On Proposed Hard 4:00 PM CloseHere again the SEC is struggling to have a process in place to stop late trading.

In response to the concerns expressed by commenters, the SEC staff is reviewing several issues:

• the technological capabilities of retirement plan administrators and other service providers and fund intermediaries so that they can obtain a more complete understanding of the various systems issues and alternatives to the hard 4:00 PM close proposal.

• the suggested approach of imposing procedures and controls on the acceptance and cancellation of fund trades combined with an independent audit of the procedures.

• the extent to which there are tamper-proof time-stamping systems.



Point-of-Sale• SEC, concerned about sales practices and moving to greater transparency has

proposed a “point-of-sale” disclosure requirement for three product areas:– mutual funds– variable insurance products – 529 products

• The SEC proposal contained six samples, and the NASD’s comment letter contained an alternative disclosure document

• This limited application of the point-of-sale disclosure could cause brokers to prefer other investments over mutual funds

• Unclear how this will be adopted, but it goes to the new regulatory approach. It will be negative at first (first 18 months) but ultimately, the industry will find a way to move on.



Changing Economics of Distribution• SEC and NASD have outlawed directed brokerage for sales.

• SEC and/or the NASD are instituting enforcement actions for failure to fully disclose the nature, level and method for paying for shelf-space—some significant settlements.

• SEC is awaiting a special committee’s views on how to re-define what is included under the safe harbor under Section 28(e)—this will reduce the commission dollars.

• SEC is awaiting the same special committee’s views on what should happen to distribution plans under Rule 12b-1. Any change will increase the direct payments to cover the cost of distribution payments.



Some “Unintended” Consequences• Things will change even though most don’t see it coming

– Regulatory purgatory will not end for several more years

• Need to address whether one fund fits all investors and all markets?

– Need to determine whether the fund vehicle is the right choice—e.g., daily valued pooled

• Platform providers (Schwab/Retirement) will want to try and keep the contact with customers

– How will they be affected if hard 4:00 PM close is adopted? How to respond to the proposed mandatory redemption requirements?



Some “Unintended” Consequences (Cont.)

• Costs will rise, forcing margins to fall, forcing consolidation of fund groups and products—greater use of indexation

• Brokerage changes will impact advisors and brokerage firms

• Point-of-sale disclosure will cause brokers to sell other products not impacted

• If mutual fund product becomes marginalized, where will the investment talent go? SMA, Hedge, Private Equity, etc?

• Significant new round of outsourcing will occur to cut costs

• Margins shrink to those achieved by other service businesses?



Investment Managers Separate AccountsFunds

Individuals

Brokers/Planners

DBPlans

Insur.HouseAccts.

Found./Endow.

HNWI

Consultants/Alliances

Distribution – Then (1980s)



Investment ManagersSeparate A/CsPooled A/CsFunds

Individuals

Brokers/Planners

DiscountBrokers

DBPlans

Insur.HouseAccts.

Found./Endow.

DCPlans

Insur.Cos.

HNWI

Small/Mid.

Banks

Consultants/AlliancesTrust Cos.

TPAAlliances

FundWrap

ManagedMoneyFund

Wrap

Distribution – Now (2004)

Alt.Investments



Investment ManagersSeparate AccountsPooled AccountsFunds

Individuals

Distribution – Tomorrow (2005-06)?

How badly will the distribution model be changed by the

current regulatory initiatives?

Alt. Investments



Investment ManagersSeparate A/CsPooled A/CsFunds

Individuals

Brokers/Planners

DiscountBrokers

DBPlans

Insur.HouseAccts.

Found./Endow.

DCPlans

Insur.Cos.

HNWI

Small/Mid.

Banks

Consultants/AlliancesTrust Cos.

TPAAlliances

FundWrap

ManagedMoney

Distribution – Tomorrow (2005-06)?

Alt.Investments



Fund Sponsoring OrganizationXYZ Fund Corporate

Entity

Distribution Services

Administrative Services

Investment Advisor

Broker / Dealer or

RetirementProvider

End Client

3rd Party Service Providers

(Custody, TA,Acctg, etc.)

Financial Advisor

<- Management fee

Trail ->Adv Fee

Sub Tran Fee

<- Sub Tran Fee<- 12b-1

<- Rev Sharing

12b-1/

Admin Fee -> Management Fee ->

Complexity of Financial ArrangementsIs There Enough Money to Satisfy All Parties?



Open Architecture Is a Permanent Phenomenon and Will Continue to Grow• Consumers enjoy real benefits from open architecture

• Transparency assures that the best performing products are certified as such

• Escalating intermediation of the supply chain assures that distributors have access to high performing product

• New disclosures will show consumers exactly who they are paying, for what services

• Fear of litigation and new compliance procedures will force disclosure of every possible conflict

• After three to five years of transition• Distributors will enjoy long relationships with adequate margins and stable

earnings • Manufacturers will have good margins on reduced revenues, from lean

operations



Open Architecture Is a Permanent Phenomenon and Will Continue to Grow (Cont.)But during the transition years:

• Performance will be absolutely essential – the only certain route to sales• Business practices and cost structures (insourcing vs. outsourcing) will

undergo radical change• Transition costs will impinge on margins• Marketing costs will be high, as will retraining costs and fixed-facility write-

downs

It is likely that for the next two years at least:• Today’s public and private “pure play” firms will be better positioned• “Conglomerate” firms will struggle to redefine and restructure



Distributor or Producer? It’s a Hobson’s ChoiceDistribution and manufacturing have been identified as separate core competencies – firms with strong distribution need access to quality products but are questioning the rationale for owning the manufacturing capability.

• Product providers are expanding product array.• Distributors moving toward open architecture.



Distributor or Producer? It’s a Hobson’s Choice (Cont.)

Current players will need to choose between distribution and production. Most will pick distribution because of the perceived value of clients, but in either case the next few years will be very ugly:

• There are many ways to win as a distributor, with diversified profits from an array of services, but the distribution choice requires:

– A large array of capital, commodity or operational capabilities to underpin profitability.– Unconstrained asset management product choice in order to leverage relationships.– Easily disclosed fee structures and service partnerships to avoid conflict.– Shuttering mediocre products, unwinding bundled products and finding new providers.

• Production margins can be more robust and reliable than distribution margins, but the production choice requires:

– Obsessive product quality in an intermediate-horizon “investment culture.”– New proprietary research, trading and risk management infrastructure.– A global network of unaffiliated distribution partners and client service capabilities.– Shedding costs, pruning the lineup, rebuilding systems and sharpening incentives.



Questions From The Participants



A sharesAppendix

Return on$10,000 less:

Fee12B-1Other

Total/yr

Initial investment Mgt fee Return to S/H12B-1 fee Other expenses

0.75%0.25%0.50%1.50%

Fund Sponsoring Organization

Retail Fund Buyer

Broker-Dealer

Financial Advisor

Management Services


ABC FundCorporate Entity

$10,000

$9,500

$400

$160

0.25%/yr

0.25%/yr

0.10%/yr

0.75%/yr

0.10%/yr

Other Service Suppliers

0.50%/yr



B sharesAppendix


Fee12B-1Other

Total/yr

** Drops to 0.25% after year 7 * Starts in year 2


0.50%2.25%

0.75%1.00%


Retail Fund Buyer

Broker-Dealer

Financial Advisor

Management Services



$10,000

$10,000

$400

$160

1.00%/yr **

0.25%/yr *

0.10%/yr *

0.75%/yr

0.10%/yr


0.50%/yr



C sharesAppendix


Fee12B-1Other

Total/yr


0.75%1.00%0.50%2.25%


Retail Fund Buyer

Broker-Dealer

Financial Advisor

Management Services



$10,000

$10,000

$100

$40

1.00%/yr

1.00%/yr*

0.40%/yr*

0.75%/yr

0.10%/yr


0.50%/yr* Starts in year 2



Share Classes: Who Gets WhatAppendix

Initial Ongoing Initial Ongoing Initial OngoingShareholder Exchange

$10,000 for $9,500

investment

Return on $9,500 less 1.50%/year

Exchange $10,000 for

$10,000 investment


Exchange $10,000 for

$10,000 investment


Broker-Dealer $240 0.25%/year $240 0.25%/year * $60 0.70%/year * (less costs of operations)Financial Advisor $160 0.10%/year $160 0.10%/year ** $40 0.40%/year **

Fund Sponsor $100 0.65%/year ($400) 1.40%/year*** ($100) 0.65%/year**** (less costs of operations)

* 0.10% for the first year** Starts in year 2*** 1.65% for first year; drops to 0.65% after year 7**** plus additional 0.75%/year for first year

A Shares B Shares C Shares

© 2007 SEI Investments Developments, Inc.© 2007 SEI Investments Developments, Inc.

We hope you found today’s presentation valuable and informative.

Please feel to send comments and suggestions to [email protected]. Your feedback is important to us.

Presentation slides will be made available early next week. You will be notified by e-mail.

MARK YOUR CALENDARS: The next seminar will be on December 9, 2004 at 1:00 EST.

The SEI Knowledge Partnership is a service of the Investment Manager Services unit of SEI. This information is provided for educational purposes only and is not intended to provide legal advice. SEI does not claim responsibility for the accuracy or reliability of the data provided.

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