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US MARKET ENTRY AND EXPANSION CONSIDERATIONS

AN INTRODUCTION TO THE MUTUAL FUND MARKETPLACE DECEMBER 2012

This Executive Insight report provides new and prospective entrants to the US retail asset management with a broad overview of the mutual fund market landscape. This report offers introductory information on t he following topics as they relate to US asset management and the mutual fund industry:

• Regulatory agencies, post-crisis investor behavior, and profitability; • Mutual fund development and distribution considerations; • Sub-advisory market overview and distribution highlights; • Institutional market overview, buyers, and vehicles; and • A number of best practices for investment managers entering the US

marketplace.

Strategic Insight an Asset International Company 805 Third Avenue, New York, NY 10022 Tel: (212) 944-4455, Fax: (212) 730-7730 Also available at www.sionline.com

STRATEGIC INSIGHT

US Market Entry and Expansion Considerations

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CONTRIBUTORS Strategic Insight would like to thank the following firms in providing valuable perspective on US market entry and expansion issues, considerations, and challenges: ALPS Fund Services

Brown Brothers Harriman

Foreside Financial Group

Gemini Fund Services

Huntington Asset Services

Morgan Stanley

Northern Trust

SEI

In addition, Strategic Insight would like to thank all of the anonymous contributors for sharing their insights. Without these firms sharing their candid experiences, this paper would not be possible.


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EXECUTIVE SUMMARY

This Executive Insight provides prospective entrants into US retail asset management with a broad overview of the mutual fund, sub-advisory, and institutional markets. This introductory paper is designed for non-US asset managers seeking to enter or expand within the US by organic means (as opposed to acquisition) and for existing US asset managers considering launching their first mutual funds. Information within this report was obtained through interviews with service providers and asset managers, Simfund databases, and other industry data sources. Key highlights of this paper include: • The US asset management marketplace is highly attractive due to its sheer size. US

Households represent approximately $47 trillion in financial wealth as of the second quarter in 2012.

• The US asset management market is strictly regulated by several different agencies, requiring new entrants to have a clear understanding of applicable rules and regulations.

• US mutual fund investors have sustained an aversion to risk since 2008, evident by the record flows into bond funds and deposits into savings accounts. Among investors that demonstrate higher risk appetite and willingness to add to their stock fund holdings, equity income, global asset allocation, and emerging markets strategies have been beneficiaries.

• International equity has been an area ripe for mutual fund product innovation. This is particularly true for flexible, multi-asset class strategies.

• The order in which major milestones are executed is integral to the success of a fund launch for new US entrants. Major milestones for US mutual fund launch include determining distribution strategy, hiring legal counsel, determining the product’s legal structure, and striking selling agreements with key distributors.

• With the mutual fund market being heavily distributed via financial intermediaries, rising distribution expenses evidenced in recent years add to the challenges of reaching profitability.

• Sub-advisory and institutional market entry requires less paid in capital by the manager, making the time to breakeven shorter and the breakeven AUM lower than mutual funds. However, assets become more concentrated in fewer relationships and the sales cycle is generally longer than for mutual funds.

• Best practices for US market entry include: o Acknowledge the social and business culture, o Prepare for the regulatory framework, o Hire local experts, and trust them, o Finalize a distribution strategy before product launch, o Be patient and set a five- to seven-year plan for entry, and o Have firm-wide commitment to the market expansion.


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TABLE OF CONTENTS

CONTRIBUTORS .......................................................................................................................... 2

EXECUTIVE SUMMARY ............................................................................................................. 3

TABLE OF CONTENTS ................................................................................................................ 4

TABLE OF EXHIBITS ................................................................................................................... 5

I. US ASSET MANAGEMENT ........................................................................................................ 6 MARKET SIZING ........................................................................................................................... 6 REGULATORY ENVIRONMENT ...................................................................................................... 6 INVESTOR BEHAVIOR ................................................................................................................... 7 INVESTMENT PACKAGING ............................................................................................................ 9 PROFITABILITY OF PUBLIC US ASSET MANAGERS ..................................................................... 10

II. MUTUAL FUNDS ..................................................................................................................... 11

SIZING AND COMPETITIVE LANDSCAPE ...................................................................................... 11 PRODUCT DEVELOPMENT .......................................................................................................... 13 LAUNCHING A MUTUAL FUND ................................................................................................... 13 KEY DISTRIBUTORS ................................................................................................................... 16

III. SUB-ADVISORY ...................................................................................................................... 19

SIZING AND COMPETITIVE LANDSCAPE ...................................................................................... 19 KEY DISTRIBUTORS ................................................................................................................... 22 WINNING SUB-ADVISORY MANDATES ....................................................................................... 22

IV. INSTITUTIONAL ...................................................................................................................... 23

SIZING AND COMPETITIVE LANDSCAPE ...................................................................................... 23 PRIMARY BUYERS ...................................................................................................................... 24 INSTITUTIONAL VEHICLES ......................................................................................................... 25

V. BEST PRACTICES .................................................................................................................... 28


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TABLE OF EXHIBITS

EXHIBIT I.1: US HOUSEHOLD FINANCIAL ASSETS ........................................................................... 6

EXHIBIT I.2: BANK DEPOSITS AND MONEY MARKET MUTUAL FUNDSS .......................................... 8

EXHIBIT I.3: ALL BOND FUND NEW SALES VS. INTEREST RATES ..................................................... 9

EXHIBIT I.4: TYPES OF NON-TAXABLE ACCOUNTS ........................................................................ 10

EXHIBIT II.1: US MUTUAL FUND OVERVIEW ................................................................................. 11

EXHIBIT II.2: ACTIVE VS. PASSIVE INTL/GLOBAL MUTUAL FUNDS ............................................... 12

EXHIBIT II.3: MUTUAL FUND MARKET CONCENTRATION .............................................................. 12

EXHIBIT II.4: POST 2008 ACTIVELY MANAGED FUND LAUNCHES ................................................. 13

EXHIBIT II.5: THE STRUCTURE OF A MUTUAL FUND ...................................................................... 14

EXHIBIT II.6: MUTUAL FUND DISTRIBUTION TAXONOMY ............................................................. 17

EXHIBIT II.7: MUTUAL FUND ASSETS BY INTERMEDIARY DISTRIBUTION CHANNEL ...................... 18

EXHIBIT II.8: RETAIL FINANCIAL ADVISER HEADCOUNTS ............................................................. 19

EXHIBIT III.1: SUB-ADVISORY OVERVIEW .................................................................................... 20

EXHIBIT III.2: INTL OBJECTIVES & AVERAGE ACTUAL ADVISOR FEES ......................................... 21

EXHIBIT III.3: INTL SUB-ADVISED MANDATES BY ACTUAL ADVISOR HEADQUARTERSERS .......... 22

EXHIBIT IV.1: US INSTITUTIONAL INVESTORS ASSETS .................................................................. 23

EXHIBIT IV.2: TOP 5 MANAGERS OF US INSTITUTIONAL TAX EXEMPT ......................................... 24

EXHIBIT IV.3: US DEFINED CONTRIBUTION ASSETS BY VEHICLE ................................................. 25


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I. US ASSET MANAGEMENT MARKET SIZING By various measures, the asset management industry in the United States is the largest in the world. Broadly, the US market is comprised of household financial wealth and financial assets of institutional investors.

As of the first quarter 2012, US households represented $47 trillion in assets based on

figures reported by the Federal Reserve Z.1 report and the Investment Company Institute. Retirement accounts represented approximately $19 trillion, or 40%, of household assets, while taxable accounts represented $28 trillion, or 60%, of household assets. Exhibit 1.1

Exhibit I.1: US Household Financial Assets Source: Federal Reserve Z.1 Report, ICI REGULATORY ENVIRONMENT Public scrutiny on asset management practices reached an all-time high following the 2008 financial market crisis. The regulatory changes made since the crisis impact many areas of the asset management business, while the more recent regulatory proposals extend further into business practices for manufacturers, distributors, and financial advisers.

The three most significant regulatory bodies impacting the asset management industry are

the Securities and Exchange Commission (SEC), the Department of Labor (DOL), and Financial Industry Regulatory Authority (FINRA).

Cash Accounts, $8.7T, 18%

Individual Securities, $19.6T , 42%

IRA, $5.2T, 11%

Private DB, $2.5T, 5%

DC, $4.8T,10%

Govt/Muni DB, $4.7T,10%

Annuities (excl. DC/IRA), $1.7T, 4%

US Household Financial Assets, 1Q2012$47 Trillion Total

Retirement Accounts

$19 Trillion40% of Total

Taxable Accounts

$28 Trillion60% of Total


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The SEC has long been responsible for ensuring that investment advisers and investment companies comply with 1933, 1940 Act regulations and other applicable securities laws. The two divisions of the SEC that most frequently interact with investment advisers are Examination and Enforcement. The SEC created a specialized Asset Management unit in 2010 as part of an organizational restructuring of its enforcement division.

All employer-sponsored retirement plans fall under the jurisdiction of the DOL. Such

retirement investments include $4.5 trillion in defined contribution plan assets, $4.7 trillion in government and municipal defined benefit plan assets, and $2.5 trillion in private defined benefit plan assets. The DOL also has authority to propose regulations impacting the individual retirement account (IRA) market.

FINRA is the self-regulating body overseeing the securities industry in terms of

regulation and licensure. The agency regulates the trading of securities and has authority over 4,380 brokerage firms, 163,150 branch offices, and 633,000 registered securities representatives. The agency is dedicated to investor protection and works to ensure that four standards are consistently maintained: anyone who sells a securities product has been officially tested, qualified and licensed; every securities product advertisement used is truthful, and not misleading; any securities product promoted or sold to an investor is suitable for that investor's needs; and, investors receive complete disclosure about the investment product before purchase. INVESTOR BEHAVIOR The last several years marked a significant change in investor risk tolerance, evident in risk-off attitudes towards equities, a doubling of bond fund assets, and gains in banking deposits which expanded dramatically since 2008. This risk aversion, triggered by the 2008 financial crisis, persisted in the background of weak global economic developments and sovereign debt concerns. Despite stock price recoveries, safety and income remain the most common theme, both in the US and in other developed capital markets. For example, in the U.S., since 2008, investors have added $2 trillion to near zero-yielding bank savings and money market deposit accounts, bringing bank deposits to over $6 trillion as of 2012.


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Exhibit 1.2

Exhibit I.2: Bank Deposits and Money Market Mutual Fundss Source: Strategic Insight, Federal Reserve

The sustained aversion to equities over the past several years results from continued economic sluggishness where investors have been presented with global and domestic economic worries repeatedly. Whether it is the fear of a US double-dip recession, Eurozone contagion, China slowdown, and much more, a constant release of disconcerting economic news has heightened demand for assets perceived to be safe. Conservative risk appetites have translated to record new sales of bond funds. Bond fund assets, sales, and net flows attained all-time highs at periods when interest rates have been at all-time lows (following three decades of falling long- and short-term interest rates).

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$7,000

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$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

Bank Deposits and Money Market Mutual Funds1994 - August 2012 ($B)

Savings and MMDA

CDs below $100,000

CDs over $100,000

Money Market Mutual Funds


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Exhibit 1.3

Exhibit I.3: All Bond Fund New Sales vs. Interest Rates Source: Strategic Insight, US Treasury INVESTMENT PACKAGING Asset managers can distribute their strategies the US retail marketplace via a number of different accounts and vehicles. Legislation has helped to ingrain mutual funds in particular in the investment savings plans of Americans. Exhibit 1.4 highlights the different types of accounts available to investors based on the tax status.

There are two main types of investment accounts for retail investors: taxable accounts and non-taxable (tax-deferred) accounts. In taxable accounts, investment gains and earnings are taxed in the year earned. In non-taxable accounts, taxes on gains and earnings are generally deferred until withdrawal, as with any kind of retirement account. (Note that in a US mutual fund, net capital gains realized during the year are passed through the investors who need to report such during the year, even when the fund is not yet sold. These reported taxable gains are added to the tax cost basis of such investments.)

$-

$20

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$120

0%

2%

4%

6%

8%

10%

12%

14%

New

Sales ($B)

Rat

es (%

)All Bond Fund New Sales vs. Interest Rates

1984 - July 2012

New Sales 90 Day T-Bill 30-Year T-Bond


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Exhibit 1.4

Exhibit I.4: Types of Non-Taxable Accounts Source: Financial Research Corporation, a division of Strategic Insight The primary product vehicles that are found within investment accounts include 1933 and 1940 Act investment companies, such as mutual funds, exchange-traded funds, and closed-end funds. Moving towards high-net-worth individuals, vehicle choice may also include unregistered hedge funds, funds-of-hedge funds, bank and real estate investment trusts, master limited partnerships and separately managed accounts. PROFITABILITY OF PUBLIC US ASSET MANAGERS The profitability of publicly traded US asset managers may be a useful reference point for asset managers seeking to enter this market. Strategic Insight annually reviews public managers’ profitability in a report called Money Management Financial Comparisons. The most recent analysis reviewed 20 asset managers who managed a total of $7.7 trillion at year-end 2011 (inclusive of all managed assets disclosed in the annual 10-k).

In 2011, the average pre-tax operating margin (as a percentage of money management

related revenues) for the public companies was 40%, up slightly from 39% in 2010. These margins ranged from a high of 63% to a low of 18%.

(The calculation of pre-tax operating margin excludes the following when disclosed as

separate line items: revenue and expense line items that are specific to a manager’s distribution related revenues and expenses, and line items that relate to a company’s capital structure, non-asset management income and expenses, non-recurring events. This methodology allows for a view of operating margins purely related to the function of managing assets, both on the revenue and cost side, as best as possible from available disclosure.)

Employer Contribution Tax (Contribution/Sponsored (Employer/Self) Withdrawal)

Employee Retirement

E: NA C: Pre-tax or after-taxIncome Security Act S: Yes W: Taxable

E: Yes C: Pre-taxS: No W: Taxable E: Yes C: Pre-taxS: Yes W: Taxable E: Yes C: Pre-taxS: Yes W: Taxable

Small Business Job E: Yes C: Pre-taxProtection Act S: Yes W: Taxable

E: NA C: After-taxS: Yes W: Tax free

Roth 401(k) & 2001 E: Yes C: After-tax403(b) (Available 2006) S: Yes W: Tax free

Types of Non-Taxable Accounts

Roth IRA 1997 Taxpayer Relief Act No

Economic Growth and Tax Reconciliation Act

Yes

SAR-SEP IRA 1986 Tax Reform Act Yes

SIMPLE IRA 1996 Yes

SEP IRA 1978 Revenue Act Yes

401(k) 1978 Revenue Yes

Name Year Created Act

Traditional IRA 1974 No


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II. MUTUAL FUNDS SIZING AND COMPETITIVE LANDSCAPE As of the second quarter in 2012, the US mutual fund market, excluding funds-of-funds and exchange-traded funds, represented over $11 trillion in assets. Stock and bond mutual funds (all fund types excluding money markets), under $9 trillion, netted $167 billion in net flows through the first half of the year (dominated by bond fund inflows), on pace to surpass full year net flows achieved in 2011.

The mutual fund landscape is highly competitive. As of June 2012, there were 688 asset

managers, reflecting 6,470 portfolios (excluding ETFs and mutual funds investing only in variable annuities). Through 2Q12, the top 10% of asset managers by AUM accounted for 90% of the past three years of net aggregate mutual fund net inflows intake.

Exhibit 2.1

Exhibit II.1: US Mutual Fund Overview

Source: Strategic Insight Simfund MF. Exclude ETFs and funds-of- funds.

The risk-averse investor sentiment since 2008 has led to a 79% change in Taxable Bond

fund assets over three years, since June 2009. Among equities, US-based mutual funds continue to experience net redemptions in aggregate, while demand for international/global equities has begun to re-emerge resulting in first half 2012 net flows of $33 billion.

International/global equity funds experienced a sharp decline in demand from 2007 (peak

net inflows at $180 billion) to 2008 (net redemptions of $59 billion), but flows have remained in annual positive territory since. A positive demand for international/global funds is in contrast to investor preference for US equity (excluding funds-of-funds and ETFs), which has not resurfaced with positive annual net intake since 2006.

6/12 Assets

($B)

3 Year % Change

2011 Flows ($B)

1H2012 Net Flows

($B)Domestic Equity 4,144 43% -82 -15International Equity 1,587 45% 34 33Taxable Bond 2,302 79% 129 121Tax-Free Bond 634 34% -13 28Money Market 2,422 -32% -135 -184Total above 11,088 19% -66 -17

US Mutual Fund Overview


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While the majority of international/global mutual fund assets (92%) reside in actively

managed strategies the market share of passive funds has increased by 33% over three years. Further, passively managed international/global funds garnered roughly half of 2011 total net flows, and about a third of net flows through the first half of 2012.

Exhibit 2.2

Exhibit II.2: Active vs. Passive Intl/Global Mutual Funds

Source: Strategic Insight Simfund MF. Exclude ETFs and funds-of-funds.

Among international equity funds, the broader-developed region funds (international and global) represent the majority of assets at 81%. However, Emerging Markets Equity has attracted investor interest and is on pace to surpass 2011 net intake. Global Asset Allocation and International Total Return (stock funds emphasizing high dividends) are also flow-leading objectives, as investors have increasingly sought out flexible, multi-asset class, and income portfolios (for both international and US based equity funds).

From a competitive standpoint, assets are highly concentrated in the mutual fund industry among the largest players. The concentration of assets is similar when comparing international/global assets to total long-term mutual fund assets. For example, the Top 20 Managers by assets (excluding ETFs, funds-of-funds and money markets) control 69% of total long-term fund assets. Similarly, the Top 20 Managers by international/global assets control 73% of international/global fund assets.

Exhibit 2.3

Exhibit II.3: Mutual Fund Market Concentration

Source: Strategic Insight Simfund MF. Exclude ETFs and funds-of-funds.

6/09 6/12 6/09 6/12 2011 1H2012Active 1,031 1,456 94.0% 91.7% 17,254 21,282Passive 66 131 6.0% 8.3% 17,030 11,602Total 1,097 1,587 34,284 32,884

Assets ($B) Market Share Net Flows ($M)Active vs. Passive International/Global Mutual Funds, Assets and Flows

All Long-TermInternational / Global Equity

Top 3 Managers 37% 35%Top 10 58% 57%Top 20 69% 73%Top 50 86% 91%

Top 100 95% 98%

Mutual Fund Market Concentration by 6/12 Assets


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PRODUCT DEVELOPMENT Mutual fund product innovation has been extremely robust post-market crisis as investors with heightened risk sensitivities seek out global and balanced investments. Excluding ETFs and index funds, international equity has been the area with the most product launches since January 2009.

Exhibit 2.4

Exhibit II.4: Post 2008 Actively Managed Fund Launches Long-Term Fund Launches

Source: Strategic Insight Simfund MF. Excludes money market, ETFs, index funds and funds-of-funds. Reflects portfolios launched in January 2009 and after.

Within International Equity, Global Asset Allocation is the recent favorite for product development. Asset managers have introduced global flexible portfolios that attract financial advisors seeking balanced solutions. Advisor preference has moved beyond a single plug-and-play asset class, to selecting funds that reflect superior asset allocation across asset classes, security types, styles, regions, and currencies. The product development in go-anywhere strategies supports the strong flows into the objective highlighted previously.

The appetite for flexible multiple asset class portfolios persisted in parallel to interest in

equity income and emerging market strategies. Investors demand for income reaches beyond bonds to include domestic and international asset classes, and emerging markets continues to not only be top-selling category but also a category of continued innovation (including balanced strategies). LAUNCHING A MUTUAL FUND The vast mutual fund market can be tapped by launching private labeled mutual funds or by sub-advising a mutual fund. This section pertains to the former method, launching private labeled mutual funds.

The legal structure of a mutual fund is consistent regardless of the method used to launch

mutual funds. All mutual funds have a Board of Directors that oversee the funds activities, including contracts with service providers.

# Portfolios 8/12 Total Assets ($B)

Median Fund Assets ($B)

Domestic Equity 480 75 25International Equity 487 66 21Taxable Bond 261 131 106Tax-Free Bond 50 12 62Grand Total 1,278 284 33

Post 2008 Actively Managed Fund Launches


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Exhibit 2.5: The Structure of a Mutual Fund

Exhibit II.5: The Structure of a Mutual Fund Source: Investment Company Institute, Strategic Insight. Many providers offer multiple services. Please contact vendors for a full listing of their services. Privately labeled mutual funds may be built from scratch using the company’s own resources or by outsourcing the non-core competencies to a third party. The services most commonly outsourced are underwriting/distribution, fund administration, custody, and transfer agency. Compliance consultants are available to assist with the selection of the Board of Directors. The independent public accountant is always a third party. Major Milestones. The order in which major milestones are executed is integral to the success of a fund launch for new US entrants. Hire legal counsel and conduct risk assessment Determine distribution strategy Determine structure: Launch own fund or join an existing series trust File with the SEC Have organizational meeting where advisor and vendors are approved Strike selling agreements with key distributors Target an operational day


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Cost considerations. Legal counsel charges an hourly rate, at times amounting to $700 per hour, according to several sources. The legal counsel helps to prepare the federal registration statement, contracts, filings with individual states, and corporate documents. Fund administrators noted that legal counsel is often the main driver of fees for launching a mutual fund, and that the location of attorney (e.g. high-finance New York versus vacationland Maine) significantly impacts the costs. One industry executive commented that legal fees to start a RIC (Registered Investment Company) will cost “$200k - $300k on the cheap end,” and that fees also depend on how much an asset manager can offset legal consulting with internal capabilities.

The Investment Company Act of 1940, a federal statute expressly governing mutual fund

operations, requires that a mutual fund register with the SEC as an investment company. It also requires that each new fund have assets of at least $100,000 of seed capital before distributing its shares to the public; this capital is usually contributed by the adviser or other sponsor in the form of an initial investment. The ICI notes that this initial process typically costs the fund sponsor several hundred thousand dollars. Series Trusts. However, not all managers enter the US retail mutual fund market with their own Registered Investment Company (a “RIC”). A cost-efficient alternative is to join a series trust that is offered by an administrator or distributor. A series trust is a single registered entity that has the power to create an unlimited number of separate portfolios. Portfolios under the series trust share the same board of trustees, but each portfolio has its own assets, liabilities and shareholders, and each portfolio is independent of the others.

Series trusts offer lower overhead due to sharing a board of trustees, fund officers, a

Chief Compliance Officer (CCO), etc; shorter start-up time (roughly half the time needed to start an independent fund—e.g. 75 business days versus 120 business days); and lower fund break-even points than an independent fund.

The number of service providers that offer series trusts has increased significantly over

the past five years. The increase in the number of vendors is due to a growing base of financial advisors that want to provide professionally managed, cost efficient solutions to a varying client base. The low cost of the service is a benefit to financial advisors with limited resources in terms of time and capital. Investment managers focusing on ‘alternative’ strategies (that have traditionally worked in the institutional market using separate accounts and hedge funds) are also attracted to the series trust because of its ease. Firms that offer series trusts include ALPS Distributors, Beacon Hill (in partnership with administrator Northern Trust), UMB Fund Services, Gemini Fund Services, Huntington Asset Services, SEI, US Bancorp among others.

Distribution. There are two components of distribution that can be outsourced: statutory distribution and active distribution.

Statutory distribution is the framework of how the fund meets regulatory requirements of

the SEC and FINRA, by incorporating as an SEC-registered broker/dealer. The roles of the statutory distributor include NSCC linkage, facilitation of broker selling agreements, processing 12b-1 distribution fees, maintenance of FINRA representative registrations, and compliance review of sales and advertising materials.


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Some of or all statutory distribution may be executed by an internal unit or be outsourced to a third party, such as Foreside or Northern Lights Distributors, LLC. Another option with statutory distribution is to private label the broker/dealer, so that investors and advisors see that the fund is distributed by the manager themselves.

The primary advantages of using an existing broker/dealer is leveraging the selling

agreements that have already been established, and foregoing the costs and paperwork involved with registering an affiliated broker/dealer. Over time, some firms that outsource medallion (statutory) distribution services at entry may reach enough scale to create their own internal broker/dealer. There is a break-even point between outsourcing the functions and doing it in-house.

Active distribution refers to representatives of a particular firm or strategy selling directly

to buyers. This active distribution is less commonly outsourced to third parties, but a number of firms take advantage of this service for any number of reasons. Firms that hire third parties to do active distribution are generally boutique asset managers with limited resources. Also non-US asset managers, or traditional institutional managers, lacking experience and relationships in the retail market may also choose to outsource. Jobs performed by an outsourced active distributor include: intermediary sales support, product positioning, sales channel reporting, wholesaling, market research, and design website strategies. Fees and expenses. Mutual funds incur fees and expenses in their ongoing operations. It is not uncommon to find that operating costs as a percent of fund assets exceed incoming revenue from advisory fees during a fund’s nascency. Similarly, operating costs as a percent of fund assets if charged to the fund in full will often significant reduce the fund’s performance, resulting in managers providing reimbursements to the fund for a certain period of time. Operating costs include audit, custodian, legal, shareholder servicing (transfer agent), directors, and other fees. Expenses that are not operating include advisory, administrative, or 12b-1 related fees. Both operating and administration fees decline as assets increase due to economies of scale. KEY DISTRIBUTORS The three core mutual fund distribution channels are direct-to-investor, retirement and institutional, and intermediary (or adviser)-sold. Direct. This channel includes platforms through which retail investors can directly access funds, ETFs and individual securities. Fund platforms include both fund supermarkets and fund wraps. The primary providers of this distribution service include Charles Schwab, Fidelity Investments, TD Ameritrade, and Vanguard. Most non-US asset managers do not allocate significant resources to this channel, most often due to lack of brand name recognition. Retirement & Institutional. This channel includes mutual fund and ETF sales through retirement plans (particularly defined contribution plans) as well as corporate, nonprofit, foundation and endowment organizations. Retirement and institutional investors generally allocate sizeable investments to the lowest cost share class without embedded distribution expenses. Due to a number of limitations, ETFs have not made a significant entry to the

http://www.icifactbook.org/2006/06_fb_sec5.html


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retirement business yet, but are used elsewhere in the institutional market, for example, among private banks. Intermediary. This broad channel includes a number of advisor-assisted retail sales channels: Wirehouse (National) Broker/Dealers, Regional Broker/Dealers, Independent Broker/Dealers, Banks and Thrifts, Insurance Carriers, and Independent Registered Investment Advisors (RIAs). Advisor-sold share classes often have distribution expenses (historically typically in the form of a Rule 12b-1fees but increasingly without such) embedded in the total expense ratio. Some advisors are compensated on commissions at point of sales (generally today such accounts for less than 10% of sales through intermediaries), but a growing segment of the intermediary landscape – likely over 80% today -- is adopting fee-based service models. (Generally in the US today, fees-for service / advice are unbundled today from investment management fees.) Exhibit 2.6

Mutual Fund Distribution Taxonomy

Exhibit II.6: Mutual Fund Distribution Taxonomy Source: Financial Research Corporation, a division of Strategic Insight


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Exhibit 2.7

Exhibit II.7: Long-Term Mutual Fund Assets by Intermediary Distribution Channel Source: Strategic Insight Simfund Pro, 7.0 and Strategic Insight estimates. Excludes ETFs and funds-of-funds.

According to Strategic Insight Simfund Pro 7.0, the independent/regional broker/dealer channel controls $1.3 trillion in mutual fund assets, or roughly 15% of the market, excluding ETFs and funds-of-funds. Examples of leading independent broker/dealers include LPL, Ameriprise, Northwestern Mutual, Cetera Financial Group, Lincoln Financial Advisors, and Corporation, and Commonwealth Financial Network. Examples of leading regional broker/dealers include Edward Jones, RBC Capital Markets, Stifel, Nicolaus & Company, and Raymond James.

Registered Investment Advisers (RIAs) are one of the fastest growing channels,

representing $1.1 trillion in mutual fund assets as of August 2012, when including dual-registered advisers. RIAs range in asset under management: some oversee more than $1 billion, while others manage less than $100 million. They also range in their skills and services, analytics used, and selection of investment vehicles (some make heavy use of ETFs for beta exposure, while using complex active strategies to generate alpha for their clients’ portfolios).

As of August 2012, the third largest intermediary distribution channel by mutual fund

assets was the wirehouse channel, representing an estimated $1.1 trillion of long-term mutual fund assets. The four major wirehouses (who have a nationwide branch network and employ over 50,000 financial advisors) are Merrill Lynch/Bank of America, Morgan Stanley Smith Barney, Wells Fargo Advisors, and UBS Wealth Management.

$1,312

$1,094 $1,065

$500 $473

$144

$-

$200

$400

$600

$800

$1,000

$1,200

$1,400

Independent RIA Wirehouse Bank Private Bank Trust Co

Long-Term Mutual Fund Assets by Intermediary Distribution Channel ($B) 8/12


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Exhibit 2.8

Exhibit II.8: Retail Financial Adviser Headcounts

Source: Financial Research Corporation, a division of Strategic Insight

A significant portion of mutual fund assets reside in intermediary channels, and high concentration of fund distributors is among the reasons for the rising costs of distribution to broker/dealers. The costs for distributing to broker/dealers include distribution/marketing fees (partly paid via Rule 12b-1 fees collected from investors, but increasingly from the fund managers resources), sub-transfer agent fees, and other soft dollar costs. Additionally, broker/dealers are making it increasingly difficult for small managers with limited resources to gain platform placements. One fund executive explained, “For instance, <a leading wirehouse> may require the fund family to have at least six funds, 12 sales people for support, and $25 million assets…Each additional fund may require an additional $50 million.”

Expanding within the retail mutual fund marketplace requires on-the-ground, experienced

wholesalers. Selling agreements with major distributors should be established prior to staffing wholesalers, as they cannot perform their function unless the agreement is in place.

III. SUB-ADVISORY SIZING AND COMPETITIVE LANDSCAPE There are two retail-distributed vehicles that asset managers may sub-advise portfolios of: variable annuities and mutual funds. Variable annuities are accumulation and income retirement savings, tax-deferred products offered by insurance firms that typically invest in balanced portfolios. Variable annuities are at times funded by tax-deferred accounts (about one-quarter of all VA assets are held in DC or IRA accounts), but often VA investments are funded by taxable savings.. The following sub-advised market analysis reflects mandates that are managed by firms that are unaffiliated with the sponsor/ advisor.

As of June 2012, the US sub-advisory market held $1.6 trillion in assets, divided among mutual funds (65%, or $1.0 trillion) and variable annuities (35%, or $557 billion). Through the first half of 2012, sub-advised mutual funds have netted $21 billion in net intake while sub-advised variable products netted $9 billion.

2011 2012 est. 1-Year ChangeWirehouse 55,180 55,257 0.1%Regional 38,382 40,179 5%Independent 131,540 136,469 4%RIA 26,577 27,532 4%Bank 38,349 41,078 7%Insurance 69,520 65,495 -6%Totals 359,548 366,010 2%

Retail Financial Adviser Headcounts


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Exhibit 3.1

Exhibit III.1: Sub-Advisory Overview 2Q12

Source: Simfund SV. Reflects unaffiliated actual advisors and unaffiliated sub-advisors. Excludes funds-of-funds.

International sub-advised net flows were the highest in the first half among the broad

fund types with $15.7 billion. Approximately one-fifth, or $320 billion, of the sub-advisory market resides in international/global equity mandates. Although the majority of international sub-advised mandates (assets and portfolios) reside in mutual funds, the 1H2012 flows were quite similar between mutual funds and variable products at $8 billion each.

The largest objective by sub-advised assets as of June 2012 was International Growth, with $110 billion, followed by Global Asset Allocation ($62 billion) and International Total Return ($43 billion). Global Asset Allocation led net intake among sub-advised mandates with $10.2 billion through the first half, followed by International Emerging Markets Equity, with $4.2 billion.

Total Assets

% of All Sub-

AdvisedMandate

Count

1H2012 Mandate Net

FlowsDomestic EquityVariable 295 645 -2.4Mutual Fund 608 975 9.4Total Domestic Equity 902 56% 1,620 7.0

International EquityVariable 114 237 7.8Mutual Fund 206 577 7.9Total International Equity 320 20% 814 15.7

BondVariable 140 154 5.5Mutual Fund 203 333 6.5Total Bond 344 21% 487 12.0

Money MarketVariable 9 10 -0.4Mutual Fund 27 41 -2.8Total Money Market 35 2% 51 -3.2Total above 1,601 2,972 31.4

Sub-Advisory Overview 2Q12 ($B)


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Exhibit 3.2

Exhibit III.2: Intl Objectives & Average Actual Advisor Fees

Source: Simfund SV. Reflects unaffiliated actual advisors and unaffiliated sub-advisors. Excludes funds-of-funds.

The largest sub-advisors of international mandates include Northern Cross (sub-advisor to the Harbor International Fund), Bank of New York Mellon, BlackRock, Franklin Templeton, and MFS. As the Top 10 managers by international mutual fund AUM represents 57% of total international mutual fund assets, the top 10 managers of international sub-advised mandate assets represent 45% of the total international sub-advised assets, meaning that the international sub-advisory market is moderately less concentrated than the international mutual fund market.

The majority of international sub-advised mandates are managed by advisors whose parent is US-based, denoting some home-bias in the hiring of sub-advisors. Despite the growing need for international sub-advisors, few manufacturers have extended their search beyond U.S. borders. The reasons most manufacturers stick close to home when seeking international management expertise may include the wide selection of qualified managers within the US, cultural and industry differences, and unfamiliarity of foreign brands.

Objective Name (SI) Mandate Total

Assets $MAverage Actual

Advisor Fee* 1H2012 Net Flows ($M)

Int'l Growth 109,668 0.41 1,931Global Asset Alloctn 61,636 0.59 10,209Int'l Total Return 43,178 0.32 -114Int'l Emerg Mkt Eqty 30,911 0.60 4,168Global Growth 25,616 0.44 675Global Equity Sector 18,942 0.50 -703Global Total Return 18,051 0.35 -302Int'l Small Cap 7,674 0.49 -330Int'l Singl Cntry Eq 1,347 0.54 -24Int'l Japanese Eqty 1,067 0.22 216Int'l China Equity 921 0.86 38Int'l Latin Amer Eq 273 0.10 7Pacific Eq w/o Japan 252 0.26 18Int'l European Eqty 178 0.20 16Pacific Eq w/ Japan 98 0.08 3Grand Total 319,815 0.47% 15,811

International Objectives & Average Actual Advisor Fees


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Exhibit 3.3

Exhibit III.3: Intl Sub-Advised Mandates by Actual Advisor Headquartersers

Source: Simfund SV. Reflects unaffiliated actual advisors and unaffiliated sub-advisors. Excludes funds-of-funds. KEY DISTRIBUTORS As noted earlier, mutual funds and variable annuities are the primary audience for the retail sub-advisory market push. There are a select group of mutual fund manufacturers that heavily rely on third party managers, a number of whom have insurance roots. Leading mutual fund firms that extensively hire sub-advisors (across all asset classes) include Principal Funds, John Hancock, Transamerica, ING and Russell. WINNING SUB-ADVISORY MANDATES There are three ways to gain market share in sub-advisory: by winning a mutual fund mandate, by winning a variable annuity sub-advised mandate, and by launching a variable insurance trust that is added to insurance providers platform and asset allocation products.

Once the distribution strategy for the sub-advisory market is determined, investment

managers may look for mandates. However, searches in the retail sub-advisory market are rarely public, so asset managers often have sales teams in frequent communication with hiring firms. Hiring firms conduct non-public manager searches because they see little upside to making manager searches a public process. Public searches may negatively impact investor and/or distributor perception, and trigger outflows from the product. Additional reasons for keeping searches private are because of capacity constraints on behalf of the hiring manager/consultant, and it protects the reputation of the outgoing sub-advisor.

Many hiring firms, (or investment consultants working on their behalf) directly reach out

to potential sub-advisors in order to be more efficient with resources. Many hiring firms use quantitative screening information to help narrow down which investment advisors they will consider. A popular data source and screening tool for hiring advisors and investment consultants conducting searches is eVestment Alliance.

Headquarters 12/11 Assets 6/12 Assets% Share

6/126/12 Mandate

CountUSA 209,978 230,629 72% 492England 20,400 22,388 7% 53Canada 17,675 17,530 5% 44France 13,508 14,966 5% 25Scotland 11,563 14,034 4% 21Other or not classifie 17,399 20,269 6% 179Grand Total 290,522 319,815 100% 814

International Sub-Advised Mandates by Actual Advisor Headquarters


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Sub-advisors learn about new opportunities directly from the advisor, investment consultants, and third party data that tracks change catalysts. Many sub-advisors utilize external market research to rank competition in the sub-advisory market, based on performance, flows and fees. Data sources that can be used to uncover new opportunities include Strategic Insight’s Sub-advisory suite comprised of a database and quantitative and qualitative reports. The initial cost of entering the sub-advisory market is lower than that of a mutual fund. However, sub-advisory sales are considered institutional in nature, meaning that the sales cycle is longer and much more involved. Replacing a sub-advisor on a portfolio or adding a new sub-advisor may take up to a year, as first the need for a change must be established, and then a lengthy due diligence process begins. Another consideration for entering the sub-advisory market is sales support. Most successful sub-advisors in the US market have at least one or two external wholesalers focusing exclusively on sub-advisory opportunities.

IV. INSTITUTIONAL SIZING AND COMPETITIVE LANDSCAPE US institutional investors held $17.6 trillion in assets as of year-end 2011 marking the highest level since 2007, according to the Organization for Economic Cooperation and Development (OECD).

Exhibit 4.1

Exhibit IV.1: US Institutional Investors Assets

Source: OECD's Stat Extracts. Reflects insurance corporations and pension funds and other forms of institutional savings, excludes open and closed-end mutual funds.

$11.6 $11.3 $10.9

$12.8 $14.1

$15.1 $16.7

$17.5

$14.2 $15.9

$17.3 $17.6

$-

$2.0

$4.0

$6.0

$8.0

$10.0

$12.0

$14.0

$16.0

$18.0

$20.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

US Institutional Investors Assets ($T)


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According to an annual survey of institutional asset managers conducted by Pensions & Investments, the top five managers of institutional tax exempt assets reflected a total of $3 trillion at year-end 2011, or approximately 17% of the institutional marketplace. Of the five managers ranking in the top five by total US institutional assets, two have enviable affiliate businesses in asset servicing (State Street and Northern Trust) and two are top tier defined contribution recordkeepers (Fidelity and Vanguard).

Exhibit 4.2

Exhibit IV.2: Top 5 Managers of US Institutional Tax Exempt

Source: Northern Trust, Pensions & Investments. Includes assets passed to sub-advisors.

PRIMARY BUYERS The primary buyers of institutional products include retirement plans, foundations and endowments, insurance firms, and high-net-worth individuals or family offices.

Defined contribution plan sponsors, particularly those overseeing plans with more than $100 million in assets, are target markets for institutional separate accounts and collective investment trusts. Collective investment trusts are estimated to hold $0.9 trillion, or about 21%, of defined contribution assets by year-end 2012. Institutional separate accounts are estimated to account for $0.5 trillion of DC assets by year-end 2012. Collective investment trusts and separate accounts are also estimated to represent a significant portion of the public and private defined benefit market.

Top 5 Managers of US Institutional Tax Exempt

Rank Firm 12/11

Assets ($B)1 BlackRock Inc. 8322 State Street Global Advisors 6953 Fidelity Investments 5744 Northern Trust 4605 Vanguard Group Inc. 452


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Exhibit 4.3

Exhibit IV.3: US Defined Contribution Assets by Vehicle

Source: Investment Company Institute, Strategic Insight, Pathfinder. INSTITUTIONAL VEHICLES While institutional investors have a broad array of complex vehicles to choose from, including hedge funds, master limited partnerships, real estate investment trusts, and more, separate accounts and collectives are most within Strategic Insight’s purview, and thus are examined below. Separate accounts. While separate accounts are common structures in the institutional market, our conversations reveal that new demand may be nearing a plateau as the availability of collective investment funds continues to expand in the defined contribution market. These structures are most commonly found as standalone investment options among the $1 billion+ plan segment or as underlying funds in unitized custom products.

Separate accounts have varying levels of management fees and revenue sharing, and very

high minimums. While most single asset class separate accounts used in institutional defined contribution plans do not offer revenue sharing (a type of distribution expense paid directly from the advisor), many separate accounts that are found in large and mid-size plans, particularly stable value, do offer revenue sharing.

Operational impediments reported by retirement plan recordkeepers include trading,

performance reporting, absence of track record (since usually only a composite available),

2.5 2.6 2.7 2.8 2.9 3.0 3.2

0.9 1.0 1.1 1.1 1.2 1.3 1.3 0.5 0.5 0.6 0.6 0.6 0.7 0.7

$0.0

$1.0

$2.0

$3.0

$4.0

$5.0

$6.0

$7.0

2011 2012P 2013P 2014P 2015P 2016P 2017P

US Defined Contribution Assets by Vehicle ($T)

Mutual Funds Collectives Separate Accounts Company Stock Brokerage/Other Stock


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burdensome documentation, and concerns regarding the custody and transparency of assets. The concern over the custody and transparency of assets is heightened for a recordkeeper when the custody is done by a third-party. These impediments would also apply to unitized custom products (custom single asset class or asset allocation funds-of-funds), given their structural similarity. Collective investment funds. The attraction to collective investment funds (CIFs or ‘collectives’) was initially sparked by institutional plan sponsor demand for low-cost fee structures. CIFs operational expenses are driven lower by the absence of SEC reporting and filing fees, as well as marketing and distribution expenses. More often than not, revenue sharing is not embedded in the CIF expense ratio.

Expectations that fee disclosure regulations will bring scrutiny to inconsistent revenue

share arrangements within the plan lineup results in sustained demand for these low-cost investment options, especially those without embedded recordkeeping offsets. Other developments that lend to increasing demand for collectives include daily liquidity and trading (through NSCC) and Morningstar’s expansion of their CIF database improving reporting to recordkeepers and plan sponsors.

Collectives are highly flexible vehicles and can be used for nearly any strategy or asset

class. The most common actively managed strategies are stable value, lifecycle, and traditional strategies like US large-caps and international equity.

Passive strategies are generally dominated by major custodians and recordkeepers with

trust units (e.g. BlackRock, Northern Trust, Wells Fargo, JPMorgan, etc). As the collective index market is controlled by a handful of very large players, it is difficult for a new entrant to gain critical mass and become profitable. Fees and Minimum Investments. Since CIFs are currently not subject to the mutual fund fee disclosure requirements of the SEC, CIF fee structures are not entirely transparent. Retirement plan participant disclosure regulations require that CIFs provide at least annual updates of total expense ratios, which over time will facilitate the benchmarking of collective fund fees.

Like mutual funds, CIFs can be offered in multiple share classes with varying

management fees, distribution expenses, and minimums. Unlike mutual funds, however, the management/advisory fee of the CIF can vary with the share class. A sliding management fee allows the plan sponsor to take advantage of economies of scale.

Partnering with a Custodian. Many asset managers do not have an in-house trust department, creating the need to partner with a trustee or custodian. Custodians including SEI, Northern Trust, Hand Benefit Trust, and Unified Trust, among others who frequently work with asset managers to package strategies in a collective fund vehicle. Recordkeepers with trust units, like Wells Fargo, also work with asset managers to bring a strategy to a collective fund structure.

Since CIFs fall under state banking regulations, the incorporation and launch process may

vary slightly state to state. Usually there needs to be a declaration of trust with the state, and state


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approval prior to launch. Initial funding is often challenged by the fact that, by Office of the Comptroller of the Currency (OCC) regulations, collective investment funds fall under an ‘A2 structure’, which is for exclusive use by certain qualified retirement plan assets. This challenge results in some managers using their own retirement plan to help fund the CIF.

If partnering with a third-party custodian, time to launch should be incorporated into

product planning. The time to launch is impacted by legal, compliance, and contractual paperwork, resources across firms, asset class, and various other components. Asset class may add up to an additional month in lead time. For example, a domestic strategy might be launched in 90 days, while an international strategy might take up to 120 days. Distribution. The most common way to get a new CIF on a recordkeeper platform is by advisor or plan sponsor request, as ERISA assets are required to fund the CIF. Once the plan sponsor has confirmed the request for the CIF, the recordkeeper and manager then enter a participation agreement as typical with mutual funds. Lead time to add the product to the recordkeeping platform varies as does operational capabilities across recordkeepers. A third party custodian can also assist with distribution of an established collective vehicle, as they generally have strong relationships with the various recordkeeping platforms. Profitability. Launching a collective fund can be more cost-effective than launching a mutual fund. One custodian commented that “the all-in cost (of a collective) could be 1/10th of the cost to launch a mutual fund, after taking into account all of the legal and compliance work that’s involved with SEC registration.”

Another point of consideration is that CIFs (and separate accounts) over time have

managed to offer attractive fees because they are not required to register with the SEC, nor are they subject to many of the same reporting requirements. While fee disclosure regulations do not impose SEC registration, they do impose new reporting requirements on collectives, thereby fractionally increasing some operational costs in the short term. Although not currently on the DOL/SEC docket, it is not unthinkable that all products made available to DC participants (including collectives and separate accounts) might be subject to further regulation in the future, which may increase costs over the long run.


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V. BEST PRACTICES Executives identified a few critical areas for success for non-US asset managers (or institutional entrants) seeking to enter the US retail market. Many of these guidelines can also be applied to other markets that are not native to the ambitious firm.

Acknowledge the social and business culture. This includes understanding the US work/life balance, recognizing normal business hours and offering time zone support, and respecting numerous social and business customs.

Prepare for the regulatory framework. Firms should have a sufficient understanding of

local regulations and the ability to adhere to a variety of reporting requirements. In addition, firms should seek external consultants and legal counsel to ensure they are interpreting rules correctly and abiding by them.

Hire local experts, and trust them. Hiring local goes beyond seeking third-party advice

on business practices, to also having the knowledge of, experience with, and relationships in US asset management in-house, on the firm’s payroll. On-boarding US wholesalers and product managers can do more than educate home office executives on the marketplace: trusting these executives with autonomy emanates respect for the local businessmen and their experience, which will be positively noted by distributors when they meet and speak with these ambassadors. For this reason, it’s also important to hire wisely. While experienced, top-tier wholesalers and product managers often demand a market premium, they are generally considered a required expense because these experts will be representing and promoting the brand to potential buyers.

Finalize a distribution strategy before product launch. Asset manager and fund

administration executives alike reiterated the importance of fully vetting out the target market and distribution strategy prior to launching a product. This is especially true for a mutual fund product launch, which generally has more costs involved in the initial outlay. These costs, particular legal counsel and employee compensation, may balloon if major milestones are not tackled in the right order.

Be patient and set a five- to seven-year plan for entry. A long-term entry plan is

appropriate for firms that decide to enter the mutual fund market, as many gatekeepers at recordkeepers and broker/dealer distributors will not recommend a fund to investors without a three-year track record. Firms that decide to enter the institutional and sub-advisory markets should also consider a five-year plan, as the sales process may take up to a year for a single mandate.

Have firm-wide commitment to the market expansion. Without firm-wide buy-in to the market expansion, the project may not be allotted the resources needed for success on an ongoing basis. One asset manager executive noted that, “It is important to expand and unify the vision internally in order to build the brand externally.”


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Copyright 2012 Strategic Insight, an Asset International Company, and when referenced or sourced Morningstar Inc. and Lipper Inc. All rights reserved. The information, data, analyses and opinions contained herein (a) include confidential and proprietary information of the aforementioned companies, (b) may not copied or redistributed for any purpose, (c) are provided solely for information purposes, and (d) are not warranted or represented to be correct, complete, accurate, or timely. Past performance is no guarantee of future results. The aforementioned companies are not affiliated with each other. Reproduction in whole or in part prohibited except by permission. Any data or commentary in this report is for the internal use of client management companies only and is not to be disseminated to the general public and sales intermediaries in the form of regulatory or other reports, promotional material, or advertising without the prior written consent of Strategic Insight. This report has been prepared using information and sources we believe to be reliable; however, we make no representation as to its accuracy, adequacy or completeness, nor do we assume responsibility for any errors or omissions or for any results obtained from the use of this report, including any action taken with respect to securities referred to in this report. Our employees may from time to time acquire, hold or sell a position in securities mentioned herein. We may from time to time perform services for any company mentioned in this report. This report is not a prospectus or representation intended to use in the purchase or sale of any securities mentioned in this report. Strategic Insight is available by subscription and by single copy upon request to the publisher.

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