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Mutual Funds Weather the Storm

While most asset managers have survived the global financial crisis, they still face many uncertainties: internal cost pressures, changes in products, heightened investor demands, headcount reductions, fund closures and tighter regulatory scrutiny.

Thus, Ernst & Young recent brought industry leaders and E&Y executives together at seminars in New York and Boston to learn their views on important industry trends. They expressed confidence that this resilient sector will not only weather the storm, but emerge stronger, with more cost-efficient and effective operations. The changes will likely comprise new outsourcing strategies, product line and technology rationalization and holistic risk management.

Seminar participants predicted that the near future would bring more standardization to mutual fund firms, which could provide a long-term benefit since standardized products are already one of the industry's strengths. Firms will also more to standardize such operational imperatives as processing securities, outlining contract terms for derivatives and quantifying analysis and performance to improve portfolio management.

Executives expect a rationalization of product lines within complexes to continue as the effects of the financial downturn reverberate. But the recession also presents opportunities for firms to offer solutions to tens of millions of Baby Boomers who have had their assumptions about retirement security shaken and who are likely to embrace guaranteed income products.

Meanwhile, unusual credit spreads are opening further opportunities for strategic, special situation, tactical and event-driven funds that employ a broad array of investments, including equities, fixed income and debt of various credit risk levels-along with derivatives for hedging, investment and speculative purposes.

Participants are also considering opportunities presented by two government-sponsored programs, the Term Asset-Backed Securities Loan Facility (TALF) and the Public-Private Investment Program for Legacy Assets (PPIP). However, the Securities and Exchange Commission could limit the participation of mutual fund complexes due to TALF leverage ratios of as high as 20:1 and the potential for TALF to finance the PPIP funds.

While the financial crisis has prompted significant outflows from the hedge fund industry, mutual funds could gain those assets with absolute-return mutual funds and other hedge fund-crossover mutual funds that utilize alternative asset investment strategies such as mergers, short-term debt and trading in Special Purpose Acquisition Companies. In fact, mutual fund complexes have recently been launching hedge fund-like funds at the rate of about one a week.

Investors also seem to be increasing attracted to exchange-traded funds, whose 2008 net inflows outpaced those of mutual funds. The ETF sector continues to be characterized by innovation and evolution, as evidenced by the introduction of target-date ETFs, ETFs of ETFs, convertible bond ETFs, "qualitative" ETFs that employ active strategies with multiple sub-advisors, leveraged ETFs, currency and commodity ETFs, 130/30 ETFs and those that replicate hedge fund strategies.

While assets in money market funds have continued to increase, new challenges include low yields, principal protection and liquidity. Tighter regulation is likely to be on the horizon, including new requirements for minimum daily and weekly liquidity, portfolio maturity, credit quality and a floating net asset value.

While successful asset management have traditionally been conservative about mergers and acquisitions, an eventual upturn in the economy might spur consolidation, according to participants. Buyers might find themselves at an advantage, structuring payments contingent on the future performance of the acquired company or assets. Large banks and insurance companies might continue exiting asset management, and smaller asset managers might be forced to merge to remain competitive.

Globalization is also inevitable. To maintain success as the global economy improves, firms must establish a level of service outside the U.S. and create a physical presence in other countries to help attract foreign capital, participants said. Firms will need to incorporate local management into international operations to facilitate relationships and maintain them. The larger firms with international offices will leverage them for growth, leaving smaller, U.S.-only firms increasingly burdened by cost pressures and limited access to investor funds.

The financial crisis has hindered many markets, prompting the Financial Accounting Standards Board to issue new guidance on fair value. Participants said executives need to be very clear about: whether a market is active or not, whether volume is significantly down, whether quotes are accurate and whether a market or transactions have become disorderly.

Fund complexes must also comprehend the details of how best to use valuation techniques, pricing services and broker quotes under difficult conditions-and perhaps most important, how to disclose this information to third parties.

Disclosure also lies at the heart of FASB Statement No. 161, which lays out new reporting requirements for derivatives and hedging activities, which mutual funds increasingly use. Fund executives must disclose their objectives and strategies for using derivatives, and related credit risk issues, such as clauses that accelerate payment or require additional collateral.

Fund complexes must also be aware of the complicated tax compliance issues related to fund mergers and liquidations. Executives need to understand such issues as the reason a fund may need to realize gains or losses prior to a merger; the maximum amount of capital loss carryforward and recognized built-in losses of the merged fund that can be utilized after a merger; and the different methods of tax accounting both during and after a merger.

Without question, regulations will be changing in the near future, although it is not yet known how new regulations or a systemic risk regulation will impact registered funds. However, the SEC has said it is closely analyzing portfolio management, valuation, suitability of investments for clients, disclosure, insider trading controls and the safety of customer assets.

Certainly, all registered fund complexes have been greatly affected by the financial crisis. And they will continue to face challenges as regulators, investors and other important stakeholders demand more of them. But this upheaval also presents opportunities to emerge from this current predicament better positioned to face the future.


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