The next generation mutual fund wrap programs

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1 The next generation mutual fund wrap programs Wrap sponsors are restructuring the mutual fund wrap product Investor demand drives product differentiation The traditional mutual fund wrap program involves the allocation of the sponsor s customer assets across many different, third party mutual funds. This traditional wrap structure provides professional management and daily liquidity to both the sponsor and the investor. However, investors are seeking lower product expenses, greater tax effi ciency, and, ultimately, better performance. The use of external mutual funds challenges the wrap sponsor in several ways: Cost economies Although the wrap sponsor places assets with third party mutual funds, the sponsor has no control over the expense ratios of external third party mutual funds. Allocation effi ciency As wrap programs become signifi cantly larger, allocations and rebalancing of large sums of assets to/from third party mutual funds creates diffi culties for both the sponsor and external mutual funds in terms of costs, timing, and coordination. Tax effi ciency mutual funds incur daily subscriptions and redemptions from all shareholders, requiring the manager to buy and sell portfolio securities to manage cash infl ows and outfl ows. This portfolio turnover may impact both taxes and expenses of the third party fund. The new mutual fund wrap model A potential solution to these challenges for the mutual fund wrap sponsor may be to establish its own wrap sponsor mutual fund family with the wrap sponsor as the investment manager to the mutual funds. The wrap sponsor selects and manages third party sub-advisers for all asset management functions. This structure allows the wrap sponsor to directly manage and control all aspects of the underlying investments, as well as the allocation of client assets across investments and managers. usbfs.com

2 Potential benefits of a wrap sponsor mutual fund family Lower investment expenses Depending upon the third party mutual funds involved in the traditional wrap allocation program, there is potential for signifi cantly lower investment fund and overall wrap program expenses, perhaps basis points or more, depending upon the program. These cost savings are typically derived from lower investment management fees and fund expenses generated through the economies of scale in the sub-adviser model. In addition, third party funds typically are designed for multiple distribution channels, and can include many fund expenses not applicable to the institutional mutual fund wrap product. The wrap sponsor can determine the expense structure of the wrap sponsor mutual funds, including management fees, operating expenses and total fund expense level. Investment Management Oversight As the investment manager to the mutual funds, the wrap sponsor designs each mutual fund investment strategy, determining the investment objective and principal investment strategies for each fund, including diversifi cation, specifi c allowable investments, and risk considerations. Within the wrap sponsor s ongoing investment management responsibility, the selection and oversight of sub-advisers provides the wrap sponsor with greater involvement in the management of each mutual fund investment in the wrap program. The wrap sponsor also has more direct oversight and control of underlying investment performance of each sub-adviser, including daily transparency into portfolio activity, securities, and subadviser performance. Improved allocation effi ciency The wrap sponsor mutual fund model allows for more effi cient investment allocation and rebalancing. A large redemption from a third party mutual fund can create signifi cant liquidity and tax issues for the third party fund and its investors due to the necessity to liquidate securities on short notice. The sub-advised mutual fund model allows the wrap sponsor to effi ciently reallocate investor assets to a new or different sub-adviser with signifi cantly less impact to the investor. Investor tax effi ciency Greater control over the mutual fund investment management process in the wrap sponsor mutual fund program allows the wrap sponsor to effectively manage the tax effi ciency of each portfolio as necessary. Employing a sub-adviser model allows the wrap sponsor the ability to allocate and rebalance across sub-advisers within a portfolio without necessarily creating a taxable transaction for the investor. The traditional wrap program sponsor performs two valuable services for the investor selection of appropriate third party investment managers, and allocation of customer assets across these managers. In the selection process, the wrap sponsor conducts signifi cant due diligence of the underlying mutual fund(s) and investment manager(s), including review and documentation of the manager s compliance program, Form ADV, regulatory history, business continuity plan, code of ethics, organization structure and resources, investment philosophy, investment performance, etc. This process is essentially the same as the due diligence required of the investment manager in the selection and oversight of sub-advisers of the wrap sponsor mutual fund. Consequently, in the sub-advised wrap sponsor fund family, the wrap sponsor continues to perform all sub-adviser investment manager due diligence, while at the same time remaining in an independent oversight role of the daily investment activities. 2 U.S. Bancorp Fund Services

3 Traditional vs. next generation wrap program Traditional mutual fund wrap structure: Allocation across existing mutual funds operated by external investment managers. New mutual fund wrap structure: Allocation within proprietary portfolio(s) to sub-advisors managing asset-specific sleeves. Traditional mutual fund wrap program Next generation mutual fund wrap program Investment strategy model 1 Investment strategy model 1 Allocation mutual fund 1 mutual fund 4 Wrap sponsor proprietary mutual fund 1 Sub-advisor A mutual fund 2 mutual fund 5 Sub-advisor B Sub-advisor C mutual fund 3 mutual fund 6 Etc. (Sub-advisors/ sleeves) Etc. Proprietary mutual fund wrap program the basics The process to launch a wrap sponsor mutual fund product line involves the selection of a business partner experienced in establishing and operating mutual funds. The wrap sponsor will want to make several key decisions regarding the launch and migration of assets to the proprietary mutual funds. Sample key considerations for the wrap sponsor in developing a wrap sponsor mutual fund model include the following: Mutual fund structures The wrap sponsor will select the most advantageous mutual fund structure from the following three options (see table for a detailed description of each). The wrap sponsor controls investment management and branding in all options. The next generation mutual funds wraps program 3

4 Series trust A series trust is an existing SEC registrant ( Trust ) with all infrastructure and service providers in place. The administrator establishes a series, or fund, for each wrap mutual fund product. Benefits include cost economies, faster time to market for fund launch, and the wrap sponsor s ability to leverage existing expertise from the Board, service provider, fund officers, and CCO. Proprietary The wrap sponsor establishing their own proprietary mutual fund family trust will assemble the Trust board, service providers, CCO, officers, etc. Although a new trust launch will take generally one to three months longer, the wrap sponsor can be represented on the Trust board and is involved in all aspects of launching and operating the Trust. The administrator will assist in all aspects of the Trust formation. Hybrid The hybrid model is the formation of a proprietary trust and combines many of the series trust elements of a fund launch with the wrap sponsor s selection of service providers, Trust officers and Trustees, including representation, if desired, of the wrap sponsor on the Trust board. The administrator will assist in all aspects of the Trust formation. Investment adviser responsibilities The wrap sponsor, as the investment manager to the mutual fund trust, will be responsible for all aspects of investment management, including sub-adviser selection, due diligence, board reporting, and compliance. As investment manager to the Trust, the wrap sponsor is reviewed and approved annually by the Board of Trustees, requiring transparency and regular reporting of the Adviser s processes for performance management, portfolio compliance, adviser compliance, sub-adviser management, etc. assumed by the adviser in a propriety fund structure. Sub-adviser responsibilities The sub-adviser responsibilities to the Trust, Adviser, and Trust board include investment management and compliance with all applicable SEC 1940 Act, Internal Revenue Code, prospectus, and SAI investment policies and procedures. In addition, mutual fund sub-advisers are responsible for providing daily and periodic requested portfolio and compliance reporting to the investment manager and trust, as well as to the trust and investment manager CCO s. Fund investment strategies The wrap sponsor, supported by the administrator, will design mutual fund portfolios to align with the investment strategy allocation requirements for their wrap program, creating sleeves within each portfolio for each sub-adviser, and complementary strategies to meet the sponsor s allocation models. 4 U.S. Bancorp Fund Services

5 Fund expense structure The wrap program sponsor will determine the expense structure for each mutual fund, including management fee and total fund expense ratio, including fund expense caps, if desired. The administrator will develop fund expense projections to model all mutual fund costs based upon projected fund assets. Migration of client assets The wrap fund sponsor and the administrator will coordinate the client communication and transition from third party funds to proprietary mutual funds. This process generally involves coordination of wrap program documentation, timing the liquidation of third party funds, and coordination of investor assets into the wrap sponsor mutual funds. Mutual fund structures* Trust structure: Multiple Series Trust (MST) Proprietary Hybrid Description: An MST is an existing open-end SEC registered investment management company consisting of a series of mutual funds managed by unaffi liated investment advisers. Each fund is a separate series or separate portfolio within the Trust, allowing multiple, unaffi liated advisers to gain economies of scale within one fund complex, sharing a common Board, independent trust legal counsel, audit fi rm, and service providers. A proprietary trust is typically established specifi cally for a single investment manager s product line and distribution strategy. The investment manager takes the lead in organizing the Trust and is actively involved in the daily operations and administration of the Trust and the Trust Board meetings. The hybrid model combines service components to create a proprietary trust for a single investment manager, leveraging external resources. U.S. Bank takes the lead in organizing the Trust and works in conjunction with the investment manager for their specifi c needs and preferences. Fund board of trustees: In place, with mutual fund industry experience; the mutual fund Board generally includes an interested Trustee affi liated with the administrator. Generally selected and recommended by the investment manager; the mutual fund Board generally includes an interested Trustee affi liated with the investment manager. U.S. Bank and investment manager collaborate to create candidate pool, candidate interviewing, independence verifi cation, etc. Final selection by manager. Fund offi cers (president, treasurer, assistant treasurer, secretary): In place, provided by the MST, approved by the Trustees; generally employees of the administrator. Generally selected and recommended by the investment manager, approved by the Trustees; generally employees of the adviser. Provided either by U.S. Bank or third party partner. Investment manager role: Fund manager, approved by Board of Trustees. Fund manager, approved by Board of Trustees. Fund manager, approved by Board of Trustees. Service providers: (administrator, accountant, custodian, distributor, transfer agent, ) In place, provided by the MST, approved by the Trustees. U.S. Bank Legal Administration. Generally selected and recommended by the investment manager, approved by the Trustees. U.S. Bank Legal Administration. U.S. Bank and affi liates, approved by the Trustees. U.S. Bank Legal Administration. Trust independent legal, independent audit In place, provided by the MST, approved by the Trustees. Generally selected and recommended by the investment manager, approved by the Trustees. U.S. Bank recommendation, investment manager collaboration/ fi nal selection, approved by the Trustees. Trust chief compliance offi cer: In place, provided by the MST, approved by the Trustees. Generally selected and recommended by the investment manager, approved by the Trustees; commonly performed by the adviser CCO staff. Either investment manager CCO or U.S. Bank third party partner. Estimated time: Generally days. Generally days. Generally days. Mutual fund branding and active distribution: Determined and provided by the investment manager. Determined and provided by the investment manager. Determined and provided by the investment manager. * The services provided by U.S. Bank and its affi liates are shown on page 6. The next generation mutual funds wraps program 5

6 Wrap program mutual fund operating structure A mutual fund trust operates with a standard infrastructure composed of a Board of Trustees, service providers, independent legal counsel, and independent audit fi rm, with investment services performed by the investment manager pursuant to an investment agreement with the Trust. Emerging trend in mutual fund wrap programs The migration of mutual fund wrap programs into wrap sponsor mutual funds provides the wrap sponsor with signifi cantly more control over the investment policies, asset management, and costs of the underlying investments within their wrap program. The wrap sponsor continues to maintain independence from the daily portfolio management, which is delegated to the sub-advisers. The wrap sponsor can continue to actively manage the selection and network of investment management fi rm sub-advisers, but has the added benefi t of directly overseeing the underlying mutual fund products as well. Thorough analysis is required to determine the economic benefi t to the investor, the appropriate transition process specifi c to the wrap program, as well as the impact to the wrap sponsor. 6 U.S. Bancorp Fund Services

7 About the author Bob Kern is a Managing Director and Executive Vice President of U.S. Bancorp Fund Services, LLC. He began his career with U.S. Bancorp in 1982 and has served as a manager within the fund services subsidiary since From 1984 to 1994, Bob managed business development efforts as well as the mutual fund Transfer Agent operation including the Investor Services group, Account Services, Legal Compliance, Document Processing, and Systems Support divisions. During that time, Bob assisted in the management and implementation of both services and technologies related to Transfer Agent and shareholder services, Fund Accounting, Fund Administration, literature fulfillment, and fund distribution services. Through more than 45 years of continually enhancing our fund services, and by working with our clients to grow their business, we are fortunate to support more than 30 percent of all mutual fund complexes. Education and credentials Bob received his undergraduate degree from Marquette University in business administration with specializations in finance and marketing. Bob serves as a board member of U.S. Bancorp Fund Services, LLC, Quasar Distributors, LLC, and interested Trustee and Chair of Managed Portfolio Series, an open-end mutual fund multiple series trust. About us For more than 45 years, U.S. Bancorp Fund Services has leveraged specialized experience across our organization to provide seamless service solutions for our clients regardless of the complexity and depth of their products. With client relationships lasting since our inception, we know the foundation for strong relationships is built on open communication, trust, and accountability. Our managers and professionals will deliver the amount of support, guidance, and insight into the market our clients need to be successful. Headquartered in Milwaukee since 1969, U.S. Bancorp Fund Services currently provides services to more than 556 alternative, ETF and mutual fund clients with 3,352 portfolios and aggregate assets of $959 billion as of December, Our clients include mutual funds, investment partnerships, hedge funds, separately managed accounts, fund-of-funds, and offshore funds. It is a subsidiary of U.S. Bank, N.A., the fifth largest commercial bank in the United States with assets of $454 billion, noted in the third quarter 2016 corporate profile U.S. Bancorp Fund Services, LLC. All rights reserved. U.S. Bank is not responsible for nor guarantees the products, services, performance or representations of its affiliates or third party providers. The next generation mutual funds wraps program 7

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