By Paul D. Ellenbogen, Ph.D., Director of Board Consulting Services, Morningstar Associates and Kirk Botula, Chief Operating Officer, ConfluenceNot long ago, with investors accustomed to seeing their assets climb at hefty double-digit rates, fund cost control focused mainly on advisory fees, while other costs of fund operations were lost in the background noise of spectacular growth.
All sorts of funds were established with the belief that their assets would quickly rise to a scale typically more than $100 million where their high initial fixed costs, expressed as a percent of assets, would scarcely be noticed.
To help, advisers gave temporary fee waivers to attract new investors. Breakpoints, where the adviser would lower fees, were put into place. As short-term tactics in a rising market, they seemed to make sense.
Problem is, when a $200 million fund becomes a $100 million fund, it quickly devolves into a death spiral where fixed expenses hurt new inflows. This adversely affects performance, triggers another round of expense increases, and prompts further performance decline.
Its a vicious cycle that funds rarely pull out ofand one that threatens more funds during the current downturn. When rapid growth turned out to be an illusion and fund assets fell through the floor, strategies once seen as smart emerged as liabilities.
The result has been a perfect storm for fund administrators: lower budgets, reduced staff levels, and increased workloads. So as administrators are seeking to gain better control over the expense management process, they are simultaneously being challenged to make major, systemic operational changes to do more with less.
Real control over expense management requires visibility, predictability and scalability. Consequently, fund sponsors are left with three possible options: They can allocate people to tackle the task, outsource the function, or choose to automate it through technology.
The standard approach to back-office decision support has been to delegate the task to staff resources. Talented fund analysts can create reports to provide visibility into expense trends and build forecasting and budgeting models. But where error-prone spreadsheets are used to manage data, the risk of error in both reporting and predicting persists. Plus, solving the problem with people makes scalability challenging and potentially unaffordable in todays market environment.
Fund sponsors that do not view rigorous expense management as a core competency may choose to outsource the function. Where outsourcing makes sense, its all about finding a partner that can deliver on the promise of visibility, predictability, and scalability. Thats because while the expense management function itself can be outsourced, accountability for expense control cannot.
Automation through technology overcomes this hurdle by permitting visibility into expense management operations, which is unavailable in an environment where data is trapped inside a multitude of spreadsheets or outsourced to a third party. And since automated solutions are fully scalable, in the next cycle expansion, the same quantity of work can be accomplished without adding staff, which can represent a considerable cost savings.
As of August 2009, 38% of all long-term, open-end, U.S. domiciled mutual funds (excluding funds of funds) fell below $100 million. Their numbers are likely to grow. In fact, every fund below $500 million is now in a squeeze. Not everyone will make it. But for the survivors, improving expense management will help them to manage through difficult times and prepare for a better tomorrow.
D.C.