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Mutual Funds: Competing in a World Recast

Volatile equities markets and heightened EU sovereign credit risk during the second quarter of 2010 have drawn significant attention to mutual fund performance. Beyond the challenges posed by the current market environment, mutual fund managers are also contending with a variety of strategic, operational and tactical changes that are reshaping their firms and the industry as a whole. Three key areas that should be firmly in their sights are:

* Assessing the opportunities and challenges of mergers and acquisitions (M&A) or other transactions

* Understanding the evolving roles of principal financial officers (PFOs) and independent directors

* Tax, accounting and regulatory developments and their implications

With nearly $1 trillion of assets under management changing hands, 2009 was a banner year for M&A. Faced with the prospect of new regulations that may restrict banks' proprietary trading, it seems likely that sell side divestments may accelerate. Meanwhile, expected increases in the capital gains tax may prompt privately held buy side managers to sell their businesses.

When putting their company up for sale, fund companies can improve their acquisition odds if they can articulate a clear and compelling strategic objective for pursuing a transaction that will benefit shareholders, clients and employees.

When a deal has closed, integration can overcome competing objectives and realize the full potential of an acquisition if management applies careful forethought and is committed to champion integration as a strategically important endeavor. The strategy should also respect and reconcile the different business cultures of the acquirer and the target, especially since financial services M&A success relies on the talent being acquired and their commitment to the new business.

Various stakeholders now expect principal financial officers and board directors to be more cognizant and inquisitive about risk management, and to question financial results and important business decisions. Mutual fund managers should keep in mind these areas that might warrant particular attention during board meetings:

* Unusual events: Is a particular fund or fund family generating unexpectedly large profits? Is the explanation reasonable, and is risk being managed transparently and appropriately?

* Lack of volatility: If the P&L of a relatively risky/profitable product appears unusually smooth, is the rationalization offered plausible?

* Valuation: Are liquid and illiquid instruments being designated and valued appropriately?

* Innovation: Is there a compelling business case for proposed new products? Are appropriate resources in place to support and manage risks?

Boards appear to be meeting with management more frequently, and board directors appear to be asking more probing questions. Fund executives will likely need to more thoroughly explain their strategies and decisions and, when requested, be willing to offer information at a more granular level outside of board meetings.

Over the past 12 months, a raft of tax, accounting and regulatory proposals have been floated. Some of these developments share an overarching theme: Disclosure.

* Uncertain tax positions (UTPs). The Internal Revenue Service has released a proposed plan that would require companies (not RICs) with more than $10 million in assets to attach a new schedule to their returns disclosing UTPs. If applied to RICs in the future, this approach could have a significant impact on how mutual funds assess their tax positions and related exposures.

* Derivatives. The Securities and Exchange Commission is examining the use of swaps and derivatives by mutual funds and exchange-traded funds. The SEC's focus is on ensuring that disclosure is appropriate and allows investors to adequately understand these products and their attendant risks.

The SEC has also decided to defer exemption requests from new ETFs that will rely heavily on derivatives. This decision will slow the pipeline for such products. Similarly, the Commodity Futures Trading Commission has proposed imposing commodity and energy position limit requirements while it examines the impact of investor/trader activity on the underlying markets.

* RIC Modernization Act of 2009. Most of these provisions fall into three categories: RIC qualification provisions, relief-type provisions and other beneficial provisions.

* EU refunds. A European court ruling held that imposition of different withholding tax rates on EU residents violated provisions permitting the free movement of capital. Fund managers should be cautioned to undertake a thorough cost-benefit analysis before deciding on a course of action, given the potential for substantial administrative and legal costs. Fund executives should also involve their boards of directors early on in the discussion process in order to develop a consensus on this issue.

Over the coming years, the U.S. mutual fund industry will undergo significant changes amid shifting regulation, increased competition and an aging demography. The industry will likely become more stratified between the ultra-large complexes and the niche players, while product innovation will seek to meet the growing need of guaranteed retirement income.

The fund executives who best understand the challenges and steer their organizations in the right direction today can secure the best business opportunities of tomorrow.