The days of an investment manager defining itself as a private fund manager, separate account manager or regulated fund manager are gone. In an effort to fully capitalise on growth opportunities and sustain existing relationships, investment managers must be flexible and consider offering their strategies in multiple packages, particularly with convergence well underway, and facing an extremely competitive landscape with an investor-empowered marketplace.

As stated in our early 2013 paper, The Retail Alternatives Phenomenon, given market conditions in the last five years, the demand for retail alternatives is not difficult to understand. Alternative strategies traditionally utilised by hedge funds are increasingly being packaged as UCITS in the European market and as mutual funds in the US. Still in the midst of a multi-year market rally, a slew of hedge fund firms are launching predominantly long-only funds, betting that at least some stocks have further to climb.The moves come amid a brutal stretch for hedge managers dedicated to shorting. The new funds also represent a shift by hedge fund managers into the kind of old-fashioned stock-picking more associated with High Street OEICs or Main Street USA mutual funds.[1] Individual investors are also moving to absolute return investing and embracing alternative strategies for the same reasons institutional investors have: they need to tamp down volatility, hedge against major downturns and bridge the gap between actual and targeted returns.

This trend presents private fund managers with a vast new market at a time when the growth of institutional allocations to alternatives, while strong, may be slowing. Alternative assets have more than doubled since 2008 and are expected to double again in the next five years, according to Strategic Insight.[2] Cerulli also reports that close to 90% of asset managers questioned in the US are looking to develop four or more alternative mutual funds over the next 12 months[3], perhaps because the retail market offers private fund managers the chance to diversify their revenue streams, earn more consistent fees and market their capabilities with fewer restrictions.

European managers looking across the pond at the $13 trillion US mutual fund market [4] may salivate at the potential opportunity. Yet, in this packaging-agnostic environment, one size does not fit all. Rather, the investment manager’s specific investment strategy and target investor segment(s) drive the necessary product structure – whether it be an open-ended ’40 Act mutual fund, limited partnership, collective investment trust, separately managed account, UMA model submission-only or other structure. We also created a sort of roadmap to help managers think through the steps needed to successfully launch and distribute products in the US. The nine steps below don’t provide the answers, but are intended to help managers think through the issues and make the “go/no go” decision with eyes wide open.

In determining the most appropriate structure, managers should carefully consider the following nine questions:

1. What type of investor do I want to target?

• The critical success factors vary, depending on the desired target market. Do you want an institutional investor base? Or a retail investor base to diversify revenue sources?
• The answer to this question will affect every other decision you make.

2. Is the investment strategy I employ suitable for this target investor type?

• It is fine to decide to target a certain type of investor, but you need to ensure that the investment strategy pursued is one that that target investor finds suitable and appropriate. For instance, a statistical arbitrage hedge fund or private equity portfolio with a multi-year lock-up and high minimum investment levels would clearly not be suitable for the mass retail market.
• On the other hand, while direct investment by most retail investors may be inappropriate, consultants designing customised target date funds are increasingly incorporating non-correlated strategies to broaden sources of diversification. Collective investment trusts (CITs) and ’40 Act mutual funds are two product packages that are acceptable in the retirement plan channel, where target date funds are gathering the vast majority of flows.

3. Within the target investor base, what sub-classification of investor am I looking to target?

• The underlying market segments – foundations and endowments, ultra-high-net-worth individuals, mass-market retail, etc. – each have their own nuances and specific rules of engagement.
• The buying criteria and the ease of penetrating those segments are different.

4. Will the productpackaging allow me to employ my strategy effectively?

• The Investment Company Act of 1940 and the Securities Act of 1933 are two of the primary regulations affecting the structure of many products offered to US investors. ’40 Act funds must adhere to liquidity and diversification requirements and leverage limits.
• For instance, a highly leveraged quant trading strategy may not be permitted under ’40 Act rules, while a European long/short equity portfolio may fit in well “as is” or with slight modification.
• 3(c)1 and 3(c)7 funds (a.k.a. private funds) have worked well in the institutional and private bank segments but have not been widely adopted in the retirement channel. On the other hand, CITs provide slightly more flexibility than mutual funds in allowable holdings; however, CITs are governed by the Employee Retirement Income Security Act (ERISA), which adds a regulatory complexity that managers need to fully understand.
• Private funds generally charge incentive fees, in addition to management fees. While theoretically possible, it is extremely difficult to receive a performance fee when managing a ’40 Act fund.
• Managers to ’40 Act funds, whether directly or via a sub-advisory relationship, must be registered with the SEC.
• While ETFs are continuing to take significant market share in the US across segments, there are critical success factors that must be considered, such as first-mover advantage, low fees, brand awareness and trading volume to ensure tight spreads.

5. Which distribution channel(s) should I consider attacking in order to penetrate the prospective investor base?

• Decide if you want to market directly to the end investor or whether you’d prefer selling through an intermediary. Going direct is typically cost-prohibitive for most managers, particularly those with no obvious name recognition.
• Consultants, gatekeepers (e.g., fund selection or research teams at intermediaries) and sub-advisory sponsors offer a more leveragable approach.
• As noted, each segment will have specific critical success factors. For example, field-level sales teams are critical for the wirehouse channel. The sheer number of financial advisors (FAs) in each wirehouse requires field-level sales teams to penetrate effectively. Even the historically open architecture RIA custodians (such as Schwab, Fidelity and TD) are now requiring advisors in the field to specifically request new fund families to be added to their platforms. Some are also requiring documented asset expectations from their RIA network, thus requiring sales teams to garner interest and mandates in advance of their being put on the platform.

6. What is my plan to differentiate myself from the competition?

• The US market is huge – over $13 trillion in mutual fund AUM alone – but rife with fierce competition. Does your firm/fund have a quantifiable and repeatable alpha-producing strategy? How strong is your brand in your local country and will it translate in the US? Will your target audience recognise your firm’s name and/or brand, and if so, will it have a favourable impact?
• If there is no brand recognition outside of your home country, leveraging your consultant relationships, pursuing sub-advisory arrangements, or working with family offices may be the most cost-effective means of gaining traction in the US.

7. What infrastructure/resources do I need to distribute my product(s) effectively?

• Depending on the answers above, what resources do you have available to support the distribution efforts? Are you willing to hire a wholesaling and/or consultant relations team to actively pursue the institutional or retirement markets? Will you hire wholesalers and key accounts managers to focus on key distributors in the retail space? These are expensive hires, and it takes time to gain traction.
• Once those decisions have been made, will the suggested pricing of the product be sufficient to both attract prospective investors and return to your firm an acceptable profit margin? Is the pricing of your strategy in line with the market while achieving the goals of your organisation?
• A well developed distribution strategy should clearly define the channels and advisor type that the strategies in question can be best matched against. With the increased growth in fee-based investing versus commission/transaction-based, investment managers must also carefully consider the appropriate share class for the intended buyer within that market. If the manager is focused on truly institutional business, such as consultants, endowments and foundations, etc., a high-minimum, low-TER institutional share class is generally preferred. Moving to more retail-based sales, a retail or investor share class fund with no up-front load (but including a 12b-1 or shareholder servicing fee) is more prevalent, particularly with the rise of No Transaction Fee platforms, such as Schwab’s OneSource and Merrill Edge. While there is still a segment of the wirehouse and independent broker/dealer market that prefers up-front loads, the development of an A share class, with waivable load, needs to be balanced against the longer-term trends of fee-based investing.

8. Do I understand the regulatory and technical framework to effectively deliver my strategy to market?

• The SEC requires that all mutual funds designate a chief compliance officer (CCO) – do you hire an experienced CCO or assign those compliance duties to another employee? While a private fund manager must have a CCO, it is not required that the underlying private funds do.
• In addition to speed to market, there may be several benefits to leveraging a series trust solution, rather than building stand-alone funds, that provides the infrastructure to address all facets of mutual fund operations.
• ’40 Act mutual funds and CITs are generally traded via the NSCC FundSERV system, whereas private funds may be processed via AIP processing, or even manually. The efficiency and resource allocation requirements vary, as do the potential operational risks, according to how the products are structured and traded.
• 3(c)7 funds have “qualified purchaser” requirements that investment managers must adhere to when offering their strategies.
• They also will want to understand the liquidity needs of their target market. For example, if trying to attract retirement assets, the 401(k) market has yet to embrace anything greater than daily liquidity.

9. How long will it take to gain traction (assuming performance is not a negative factor)?

• Having answered the foregoing questions, what’s the bottom line? When can you expect to achieve reasonable revenue and margin objectives?
• As with all product launches and distribution strategies, realistic expectations must be set early on. Success does not come easily, nor does it come quickly.
• There are also myriad milestones that mutual funds, ETFs and separate accounts have to meet in the US market to garner attention from key allocators (e.g., three-year track record, minimum fund size). Understanding these key gatekeeper/allocator nuances is just as important as adhering to the stringent regulatory requirements.
• In addition to the operational and marketing aspects needed, there are regulatory and other issues that need to be addressed. If you plan to target the retirement market, for example, you must understand and abide by ERISA rules and regulations. Additionally, many investors demand strict risk management and compliance policies and procedures as industry best practice, regardless of whether they are required by law.
• This ultimately boils down to “how committed are we?” Is the decision to target the US part of a long-term strategic plan, or must you succeed within a short period of time due to budgetary, parent company or other demands? Success stories abound, but the list of failures or less than rousing successes is long. Entering the incredibly competitive US market must be based on a well thought-out strategic decision.

The important role of the consultant in building a US distribution strategy
Aligning with respected consultants who can act as coaches, as well as potential allocators in the large retirement space, sub-advisory community, and other institutional markets in which they dominate, may be a smart first step. Additionally, many consultancies have refocused to develop customised plans for their corporate clients, including those offering outsourced CIO (OCIO) services and custom target-date/target-risk strategies that could present an interim step to full US distribution. Collective Investment Trusts and institutional separate accounts may also be the preferred vehicle, due to the low-cost advantages and holdings flexibility that they offer.

Another consideration for building a consultant-focused approach to US distribution is the migration of consultants from being based predominantly on the defined benefit-oriented retirement system to one based on defined contributions.

Having traditionally been focused solely on the institutional space, these consultants have started playing an increasingly important role in the retail arena. Indeed, they have been hired into, or consult for, retail platforms to apply their robust due diligence processes against traditional and alternative packaging.

Building an infrastructure that supports the consultant community and aligning with well respected service partners that have a dominant US footprint can open doors to a vast distribution landscape that is in constant search of innovative and differentiating products.

For the EU fund manager, ’40 Act packaging in products, such as mutual funds and ETFs, provides an extremely flexible and potentially lucrative vehicle to deliver best thinking to the public at large. Mutual funds and ETFs have a clear foothold in the retail market and are pervasive through individual investors’ pension, 401(k), 403(b) and personal accounts, but require significant resources and patience to penetrate. The considerations laid out above act as a decision tree to help managers identify the strategies that best fit the myriad avenues in which the products can be consumed. While opportunities abound, it should not be underestimated that the barriers to entry and costs associated with achieving the generally accepted milestones for successful US distribution are high. However, for managers willing to make the strategic bet and take the risk, there are clear paths to aid in their success.

Footnotes

1. “Wall Street Journal”, ‘Long only’ Funds Lose Their Hedge, November 10, 2013
2. “Strategic Insight”, Alternatives Industry Analysis 2013, October 2013
3. Ignites, Alt Fund Launches to Explode Over Next Year: Report, July 26, 2013
4. Investment Company Institute, “2012 Investment Company Fact Book”, 52nd edition, 2012