US retail alternatives: Ten significant touch points for success
A world away from their historic market of institutional and high-net-worth investors, a new growth opportunity is opening up for US alternative investment managers. Retail investors are beginning to place their savings in alternative mutual funds and, if the trend continues, they’re likely to fuel an increasingly large proportion of hedge and private equity managers’ profit growth.
Illustrating the scale of the opportunity, the number of US alternative mutual funds has grown at a year-on-year rate of 14% since the end of 2008, while assets under management have expanded at an even faster pace of 27%, according to data from Strategic Insight Simfund MF. Alternative mutual fund assets totalled US$199 billion at the end of June 2013, with alternative mutual funds accounting for approximately 9% of net long-term mutual fund flows during the first six months of the year.¹
This growth in retail demand for alternative funds spells opportunity for both specialist alternatives managers and generalist mutual fund managers. But alternative funds have more complex investment strategies than traditional mutual funds, which in turn lead to greater product introduction risks. As a result, launching alternative mutual funds takes a significant amount of planning. Indeed, the entire cycle from product planning to launch might take up to two years – and this is one of the few occasions when every function within the firm has an important part to play.
The touch points
In our view, asset managers need to prepare carefully before launching alternative investment funds, if they are to capitalize effectively on their opportunity and minimize reputational risk. When doing so, we believe they should look into the following ten critical touch points:
- Preliminary vetting
Test how well clients will receive the new products by performing focus groups with senior distribution professionals. What’s more, hire external research and subject matter experts to understand your market – ie what type of alternative investments are in demand, what would draw investors to your firm and what level of fund raising is realistic.
- Investment process & products
Assess the investment opportunity and research competitors’ alternatives products. Develop an investment philosophy and process; determine potential asset classes for inclusion and, in turn, the products to be constructed. Perform due diligence on these products, forming an appropriate long-term strategy. Acting as a selector of external asset managers requires additional due diligence, in line with hosting a new type of Investment Company Act of 1940 fund on your firm’s platform.
- New product approval
Alternative investment products should be vetted and approved to ensure appropriate buy in from key stakeholders and senior management, as well as risk and control functions. The Federal Reserve, SEC and FINRA expect to see evidence of this process. As alternative products are new for the retail buyer, they require greater due diligence by your new product approval committee, which must examine the reputational, regulatory and legal risks.
- Regulatory ‘buy-in’
Given the complexity of these products, and their marketing to retail investors, your firm should consider discussing the products with the SEC and FINRA rather than functional regulators. Regulators will be very interested in the products, helping you to address any questions regarding suitability, sales process, supervision and record keeping.
You will need to roll out a training program for the sales force, supervisors and back-office personnel. A combination of portfolio specialists and compliance professionals should conduct this training.
- Customer suitability
You should build compliance with FINRA’s Rule 2111, called the ‘Suitability Rule’, into every part of your process – including new product approval, training, marketing and surveillance. The rule requires an investment or strategy to be suitable for a customer based on his/her investment profile. If your firm acts as an investment adviser to the customer, it has a heightened fiduciary duty, including to disclose any potential conflicts of interest, and to ensure the financial advisor is recommending the best product for the customer.
- Marketing & education
During the client marketing process, financial advisors must educate clients about the new products, including: the risks, the differences between the new products and ‘traditional’ mutual funds, and the fund’s underlying investments. You must be able to demonstrate this education process.
Front-office supervisors (including branch compliance) and back-office compliance surveillance must understand the new products, their risks, how they fit in the customers’ suitability profile and what red flags to be aware of. This will require training. What’s more, new surveillance modules might need to be introduced (eg added to cross-product switching reviews, etc). You must also monitor the funds’ investments to ensure that investments remain appropriate, meeting clients’ objectives and risk tolerances.
- Technology & operations
New alternative products might require new types of operational inputs and surveillance. Operations might be required to perform system updates to accept this new product (eg a new product code).
- Transparency & valuation
Finally, you must tackle the issues around transparency and valuation that affect certain investment strategies employing tools such as short selling and derivatives.
What’s the CEO’s role?
Adapting an organisation to take advantage of the retail alternatives opportunity is an exercise that is best led by the CEO. Conducting an exercise that brings together activities as diverse as valuation, client suitability and education is so complex that the CEO, with a view over the entire firm, is in the best position to coordinate all the different elements.
But given the growth trend of alternative mutual fund assets – and the promise of greater profitability than traditional mutual funds – addressing the touch points we have highlighted will help you to prepare a path to success.
¹Figures are based on specific strategies classified as ‘alternative’ within the Strategic Insight Simfund MF database. Some industry observers use a wider definition, including strategies such as flexible global asset allocation and unconstrained global bond. If this broader definition is used, the magnitude to the ‘alternatives’ opportunity becomes much greater.