Mutual Fund Distribution Guide

Mutual Fund Distribution Guide Portland, Maine Berwyn, Pennsylvania Boston, Massachusetts Columbus, Ohio

Table of Contents ntents Introduction...2 Intermediary Channel...3 Broker-Dealers... 3 Wirehouses... 4 Regionals... 5 Independents... 5 Registered Investment Advisers (RIAs)... 6 Other Intermediaries... 6 Clearing Firms... 7 Direct Channel...8 Check and App... 8 Fund Platforms... 8 Fund Supermarkets... 9 Platform Onboarding... 9 Conclusion and Contact Information... 11 Glossary...12 1

Introduction Your plan is in place, your team has been assembled and your investment objectives are set. You are almost ready to launch your mutual fund. Yet before your fund enters the marketplace, you will need a distribution plan. How will investors find your fund? Who will be your target market? What will the purchase process look like? And who will be your key partners in this new market endeavor? Foreside s Mutual Fund Distribution Guide will help answer these essential questions. We will show you the two channels of mutual fund distribution and introduce you to the key players. We will explain the different types of broker-dealers that participate in this process, and how they work with advisers like you to attract and maintain investors. Along the way, we will also discuss aspects of the compensation, regulation and strategy involved in launching and operating your fund. Before we get to these channels, however, we want to review one of the most important decisions facing you, the investment manager: whether to sponsor and operate a proprietary fund or launch a product as a series of an existing shared trust. This decision is based on a number of factors including the strength of the advisory firm s brand name, the existing product lineup, and how the firm wants to position the product in the market. A proprietary offering allows you to control all aspects of the fund including the selection of the board of directors, policies and procedures, service providers, and contract terms related to launching, marketing and operating the trust. In the case of a shared (or series) trust, these decisions are taken out of your hands. The board of directors is in place and you will be asked to adopt the policies and procedures of the trust as well as their existing service providers. With this loss of control, there is a gain in efficiency. Shared trust series are typically quicker to market, less expensive to launch and can often leverage existing intermediary selling agreements. This decision, therefore, requires knowledge of the role of these intermediaries in the distribution process, which we will now cover in detail. Figure 1, at right, shows the basic structure of the two distribution channels. Investors can purchase fund shares directly from the fund company via the fund s transfer agent or by using a fund platform this is the Direct Channel. Alternatively, investors can enlist an intermediary such as a brokerdealer, bank or registered investment adviser (RIA) to facilitate their mutual fund transactions this is the Intermediary Channel. Direct Channel Figure 1 - Mutual Fund Distribution Overview Figure 1 - Mutual Fund Distribution Overview Fund Direct or via Fund Supermarkets Individual Investors Intermediary Channel Mutual Funds Intermediaries, including: Broker-Dealers Banks Insurance Companies RIAs 2

Intermediary Channel In today s market, a growing percentage of fund holdings are facilitated via intermediaries. Consumers are attracted to the intermediary channel because it guides them through a crowded, often complex investment landscape. Intermediaries assist consumers throughout every point of an investment transaction. They offer advice on where and how much to invest; they give the consumer access to a wide variety of investment options; they offer a single point of purchase for multiple investment products; and, post-purchase, they transmit the regulatory filings and other reports to the consumer on behalf of the fund. To facilitate the sale of shares, intermediaries enter into agreements with mutual fund companies, advisers, and/or their service providers. The type of agreement and the executing parties depend on the nature of the intermediary s business as well as their compensation requirements. Those that seek payment only in the form of sales loads and 12b-1 fees typically enter into selling agreements (also known as dealer agreements) with the fund s principal underwriter. Intermediaries that require compensation other than load and 12b-1 payments enter into operating agreements (also known as servicing agreements). The mutual fund company and/or the fund adviser are a party to these agreements in order to facilitate such payments.the process of entering into an agreement may take several weeks. The time is spent performing due diligence on the investment product and its sponsor, quantifying internal demand for the product or strategy, and negotiating the terms of the agreement. In addition, the intermediary must collect operational information in order to establish a fund profile on their back office systems. This will ensure that trading capability exists and that the terms of the prospectus are systematically enforced with regard to minimum investment amounts, sales load and breakpoint schedules, and short term redemption fee details. In this section, we will discuss four different types of intermediaries: broker-dealers, RIAs, banks and insurance companies. We will also discuss clearing firms, and the role they play in the process. Broker-Dealers A broker-dealer is a regulatory designation that refers to an institution that trades securities on behalf of its clients (acting as a broker) and also for its own account (acting as a dealer). Brokerdealers can be small boutiques serving a select clientele, large international financial institutions, and many other organizations in between. Typically, a client interacts with a broker-dealer via one of its financial adviser employees, who advises the client on the purchase or sale of securities. From the other side of the transaction, funds use broker-dealers as a medium for selling shares to investors. 3

Intermediary Channel Broker-dealers are regulated by the Securities and Exchange Commission (SEC), pursuant to the Securities Exchange Act of 1934, and the Financial Industry Regulatory Authority (FINRA), which is a self-regulatory organization. Broker-dealers are also subject to various state securities laws, known as blue sky laws. We will discuss in detail the three main categories of broker-dealers: wirehouses, regionals and independents. Wirehouses The term wirehouse was coined in the early 20th century to refer to brokerage firms with offices in different cities that were connected via telegraph and telephone wires. In the networked age, the name can be applied to any large financial institution that uses electronic means to connect branches in different locations. The most common usage of the term wirehouse in today s financial industry is to refer to a full-service brokerage firm with a national (and often global) reach that offers clients a range of services including financial advice, research, investment banking, trading and more. Currently there are four major wirehouses, known as the Big Four : Merrill Lynch/Bank of America, Morgan Stanley Smith Barney, UBS Wealth Management and Wells Fargo Advisors. $1.59 trillion of long-term mutual fund and exhange-traded fund (ETF) assets under management were distributed via wirehouses in 2013. This makes wirehouses the third largest intermediary channel, after independent broker-dealers ($2.05 trillion) and RIAs ($1.62 trillion). 1 Examples of wirehouse onboarding requirements may include: Existing fund assets that exceed a certain dollar amount (i.e., $50 million or more) A quantified demand for the product within the wirehouse A track record of a certain length (i.e., one to three years) An expense ratio that does not exceed a certain threshold A demonstrated national distribution plan The annual minimum payments may run from $75,000 to $250,000. 1 Data Source: Press Release from Access Data, a Broadridge Financial Solutions, Inc. company, dated February 3, 2014. 4

Intermediary Channel Regionals As the name suggests, regional broker-dealers are focused in a specific geographical area. They are not as large in size or scope as wirehouses, and their products and services, while varied, are typically more limited than those offered by the Big Four. Among the many reasons investors choose regionals are: they may prefer working with a smaller firm; they may prefer to invest with a company that is based nearby and shares their culture and values; or they may prefer to engage with a firm that has less day-to-day media scrutiny. Examples of regional broker-dealers include Edward Jones, RBC Capital Markets, Stifel, Nicolaus & Company and Raymond James. Independents The final category of broker-dealers is the largest of the three: independent broker-dealers. Unlike wirehouses, independent broker-dealers are staffed by registered representatives (e.g., financial advisers, brokers) acting as independent contractors rather than employees. The services offered remain largely the same; however, these independent financial advisers are afforded flexibility to conduct their business outside of the oversight of a large institution. The partnership allows the financial adviser to take advantage of the parent company s compliance and technological resources while remaining independent in its investment focus. $1.553 trillion of long-term mutual fund assets under management are distributed by independent broker-dealers as of the second quarter of 2013. The total AUM increased by 26% since the second quarter of 2012, outpacing the gains made by wirehouses and RIAs. Some of the largest independent broker-dealers are LPL Financial LLC, Commonwealth Financial Network, Northwestern Mutual, Ameriprise Financial and Lincoln Financial Network. Independent and regional broker-dealers typically enter into a selling agreement with a fund s principal underwriter, but may also require a networking fee reimbursement agreement. This is a separate form of agreement between the broker-dealer and fund adviser that is related to servicing the underlying client s account. To the extent the broker-dealer assumes responsibility for supplying transaction confirmations, periodic account statements, annual tax reporting and other shareholder services, they may seek a per account fee in order to offset the associated costs. 5

Intermediary Channel Registered Investment Advisers (RIAs) Registered investment advisers (RIAs) are intermediaries who advise clients on funds as part of a comprehensive financial planning strategy. RIAs can work directly with mutual fund complexes or fund supermarkets to facilitate purchases on behalf of their clients, or they can work with another intermediary such as a broker-dealer or a bank. RIAs are the second largest intermediary channel, with $1.62 trillion of long-term mutual fund and ETF assets under management distributed in 2013. This amount is a 17% increase over 2012. Figure 2 shows several ways RIAs are different from the financial advisers who operate within the independent broker-dealer structure. Figure 2 - How are RIAs different from Financial Advisers? Registered Investment Advisers (RIAs) Subject to the Investment Advisers Act of 1940 Receive a fee based on assets Must provide clients with a brochure that contains the information filed with the SEC in Form ADV Part 2 Fiduciary duty requires them to place a client s interests ahead of their own Financial Advisers (FAs) Subject to SEC Act of 1934, due to the fact that they work for the Broker-Dealer Receive commission on trading Have no such disclosure requirement Recommendations based on suitability standard Other Intermediaries Banks also serve as intermediaries in the mutual fund marketplace, offering funds to their retail clients. A bank s trust department can provide these services, especially for smaller, regional banks. A small bank may also provide mutual funds to its clients via a referral relationship with another intermediary, such as a local independent broker-dealer. Alternatively, a bank can offer mutual funds to its clients using a platform or a fund supermarket, thereby connecting these consumers to the direct channel. This is especially common for larger national banks. We will discuss fund supermarkets in greater detail in the next section. 6

Intermediary Channel Insurance companies also act as intermediaries in the mutual fund marketplace via variable insurance products. Variable insurance policies allow the insured to invest a portion of his or her premium payments into various investment products known as sub accounts, which may include mutual funds. Clearing Firms Before we move on to the Direct Channel, we want to discuss clearing firms and the role they play in the intermediary distribution process. Clearing firms (also known as clearing corporations, clearing houses or carrying firms) work with exchanges to handle the confirmation, settlement and delivery of transactions and ensure that they are executed promptly and efficiently. Clearing firms maintain mutual fund platforms that provide access to thousands of funds available for purchase. The difference between these platforms and the fund supermarkets (which we will discuss in the next section) is that these platforms are only available to intermediaries and not to retail investors. Clearing firm platforms are accessed by broker-dealers who employ their clearing services. These relationships typically require multiple agreements in order for the introducing broker-dealer to have access to a fund, including a selling agreement between the broker-dealer and the fund s distributor as well as a services or operating agreement between the fund company (or affiliates) and the clearing firm. Pershing, National Financial Services (NFS) and Apex Clearing are examples of some of the larger clearing firms in the U.S., based on the number of broker-dealer clients. Broker-dealers that do not use clearing firms are self-clearing. Figure 3 illustrates how clearing firms fit into the distribution process. Figure 3 - How Do Clearing Firms Fit Into the Mutual Fund Distribution Process? Shareholders place trades with their broker. The broker submits the trade to their clearing firm via their back office system. The clearing firm submits the trade to the fund via Fund/SERV. The fund confirms the trade back to the clearing firm. The clearing firm confirms the trade to the broker. The broker confirms the trade to the shareholder. The shareholder pays the broker who moves it into an account at the clearing firm and they settle with the fund via NSCC. 7

Direct Channel Now that we have reviewed the intermediary channel and the different types of intermediaries, we will briefly discuss the direct channel, whereby mutual funds are accessed without the assistance of an intermediary. The direct channel allows the investor to take control of fund selection and can reduce the overall cost of investing, as it may eliminate some of the fees that financial advisers and RIAs would charge. Investors can approach the direct channel in two ways: by filling out an application and submitting payment directly to the fund (known as the check and app process); or by using a fund platform. Check and App Check and app, like wirehouse, is a pre-digital term that is still widely used today. In the check and app process, fund purchases are initiated via an application filled out by the investor or his or her intermediary. The investor sends the application, accompanied by a paper check, directly to the mutual fund company hence the name check and app. Check and app is increasingly out-of-favor among investors, fund management and investment advisers. Sending a check in the mail takes much longer than submitting payment electronically, and that is time that the investor could be in the market. The process is also cumbersome during tax season, when an investor must sort through various statements and tax forms sent separately from each of the funds he or she invests in. From the fund management side, all this correspondence with individual investors is expensive, as are the marketing costs associated with attracting the attention of the general public. Fund Platforms The digital age version of the check and app process is the fund platform. A fund platform provides customers with an online marketplace where they can select from thousands of funds and other investment products and purchase those products directly via the intermediary s online portal. In addition to the ease of purchasing online, fund platforms also allow investors to access their tax forms and account statements anytime online, all in one place. A fund platform s customers can be individual consumers (direct channel) or financial institutions acting on behalf of their clients (intermediary channel). 8

Direct Channel There are two types of fund platforms fund wraps and fund supermarkets. Fund wraps are online services offered by financial advisers to their clients as a way to invest in a wide variety of mutual funds for one annual fee. Fund supermarkets are operated by large investment firms and offer individual and institutional consumers a one-stop-shop to purchase any of an extensive selection of funds. Fund Supermarkets As discussed above, direct investors buy funds in discount brokerage accounts via online supermarkets, such as those operated by Charles Schwab, Fidelity and TD Ameritrade. Fund supermarkets also attract investment professionals. RIAs who custody assets with these firms also use them for mutual fund clearing services, while broker-dealers leverage their platform and trade clearing services. Supermarket providers also serve as third-party administrators for retirement plans and insurance companies. Fund supermarket providers typically offer a no-transaction fee (NTF) and a transaction fee (TF) option to their customers. The NTF option is geared toward retail investors and share classes with a distribution plan that can be used to offset ongoing asset-based fees. The TF option is geared toward institutional investors and fee-based advisory programs. It is designed for share classes with the lowest expense ratio. In order to be available to the correspondents (see Glossary) and other investment professionals who use the supermarket providers services, a fund must have an agreement in place with the supermarket provider. RIAs and correspondent firms most often leverage the agreement that is negotiated by the supermarket entity and a separate form of agreement with the fund s distributor is not required. Platform Onboarding Supermarket providers typically require demand on the part of one of their clients in order to initiate the onboarding process. The process of onboarding a fund onto a fund platform typically takes eight to 12 weeks. The onboarding fees are typically in the $5,000 to $25,000 range. The ongoing assetbased and per-account fees are fairly standard across the industry, with the NTF option at 40 basis points (bps), the TF option at 10 bps, and the per-account fee in the $15 to $20 range per year. Minimum monthly, quarterly or annual fees may also apply. 9

Direct Channel The platform onboarding process begins with advisor and product due diligence. This due diligence is followed by contract processing, including the negotiation and execution of a contract between the fund and the platform provider. After both of these steps are complete, operational set up begins. Some examples of industry onboarding requirements include: Operational compatibility (for example, National Securities Clearing Corporation (NSCC) eligiblity and daily liquidity) Agreement to pay implementation and ongoing service fees Quantified internal demand for product Effective registration statement prior to due diligence review Fund or Advisor AUM levels (most often fund, from $25 million to $250 million) Marketable performance record Track record of a specific length, i.e. one-to-three years as an open-end mutual fund Once the onboarding process is complete, trading of the fund via the platform can begin. This trading is often facilitated via Fund/SERV, an automated transaction processing service offered by the NSCC. The onboarding process is slightly different when the distribution arrangement is more complex, such as when the platform provider also acts as the financial intermediaries clearing firm. One such example is the Pershing FundCenter Platform onboarding process. To begin, a fund must first have an operations agreement in place with Pershing, in order to be available to a broker-dealer that clears through Pershing. This agreement is between Pershing, the fund company and the distributor. Next, the broker-dealer must have an agreement of its own in place. It is most often in the form of a selling agreement with the distributor. Each broker-dealer may have its own due diligence and onboarding requirements for funds. The broker-dealer must submit the executed agreement to their Pershing service rep when requesting access to the fund. 10

Conclusion and Contact Information We hope this Mutual Fund Distribution Guide provided you with some helpful information to assist you as you develop the distribution strategy of your fund(s). At this point, you probably have questions specific to your firm. To learn more about the dealer agreement process, the on-boarding requirements of fund supermarkets or any other questions about the mutual fund distribution process, please contact Foreside. We would be happy to discuss your firm s goals and objectives, and how Foreside can help you achieve them. Mark Baltimore Managing Director, Global Distribution Services +1 (614) 416-9043 mbaltimore@foreside.com 11

Glossary 12b-1 fee: an annual distribution and marketing fee on a mutual fund, generally between 0.25-1 percent of a fund s average net assets per year. The name 12b-1 derives from an SEC rule that authorizes them. Broker-Dealer: an institution that trades securities on behalf of its clients (acting as a broker) and also for its own account (acting as a dealer) Check and App : fund purchases that are initiated via an application filled out by the investor or his or her intermediary, which is sent directly to the mutual fund company, accompanied by a paper check Clearing Firm: a firm that works with exchanges to handle the confirmation, settlement and delivery of transactions and ensures that they are executed promptly and efficiently (also known as a clearing corporation, clearing house or carrying firm) Correspondent: a broker-dealer, bank or financial institution that acts on behalf of another financial institution with limited or restricted access to a financial market (often an international one) where a transaction must occur Financial Adviser: a professional who provides financial advice, guidance and other services to clients (see Figure 3 for differences between financial advisers and registered investment advisers) Fund/SERV: an automated transaction processing service offered by the NSCC (see below) that facilitates trades placed by financial intermediaries Independent Broker-Dealer: a broker-dealer that is staffed by financial advisers acting as independent contractors rather than employees of the broker-dealer Intermediary: an institution such as a broker-dealer, bank or registered investment adviser that is enlisted by investors to facilitate mutual fund transactions National Securities Clearing Corporation (NSCC): a subsidiary of the Depository Trust & Clearing Corporation (DTCC) that provides clearing, settlement, risk management, central counterparty services and a guarantee of completion for certain transactions for virtually all broker-to-broker trades 12

Glossary Operating Agreement: an agreement between a financial intermediary and a mutual fund company and/or its affiliates which assigns responsibility for operational and shareholder servicing duties; may call for revenue sharing payments over and above load and 12b-1 payments. The mutual fund company is typically a party in order to leverage the underlying agreements in place with its various service providers (also known as a servicing agreement) Regional Broker-Dealer: a broker-dealer that focuses its business in a specific geographical area Revenue Sharing: any payment made to a financial intermediary by an investment adviser or another affiliate of a fund; may provide a financial intermediary greater incentive to sell shares of a particular fund Registered Investment Adviser (RIA): an intermediary that advises clients on funds as part of a comprehensive financial planning strategy Selling Agreement: an agreement between a financial intermediary and a mutual fund s principal underwriter, which allows for the distribution of fund shares and for the intermediary to be compensated in the form of load and 12b-1 payments Transfer Agent: a financial institution appointed by a corporation to maintain records of investors. Mutual fund transfer agencies are primarily responsible for processing capital stock transactions, facilitating the calculation and disbursal of dividends, and preparing and mailing shareholder account statements, tax information and other shareholder notices. Most mutual fund transfer agencies also maintain customer service departments to respond to shareholder inquiries. Wirehouse: any large financial institution that uses electronic means to connect branches in different locations 13