In the fast-evolving financial services industry, fund distribution has become one of the core matters. Investors aim to be closer to their funds, which constantly try to produce alphas. The objective is to generate more revenues and decrease costs. Because of this, digitized solutions and disintermediated models are now key to the distribution value chain. This article provides insights into how funds distribution solutions may be redesigned in the coming years. Most notably, we predict a switch from the B2B2C model to a more direct distribution model.
An extensive number of links in the value chain
The B2B2C model is the most widespread model in Europe. It has five intermediaries between the investor and the asset manager. These include distributors, fund platforms, clearing and settlement house, transfer agent and custodians. The use of distributors by asset managers to sell and distribute funds creates a large panel of potential investors. But distributors can’t always reach the wide spectrum of investors asset managers would like access to. Furthermore, the efficiency of distributors is sometimes questionable in regard to digitization, local market presence and level of fees.
Fund platforms are already present in the current model. But they haven’t been used to their full potential. Platforms are a great tool for comparing and tracking past performances. However, the distributor still wants to maintain its role with the investor as intermediary. This is to enable a full understanding of and comparison between funds. Clearing and settlement houses play a historical role in the value chain. They enable the proper and timely execution of transactions. Transfer agents keep track of the register by ensuring proper settlement of the transactions. They record the investors’ shares while the custodians enable the safeguarding of investor assets on both sides.
Current state of the industry
Worldwide regulated open-ended fund assets amounted to €47.1 trillion during the first quarter of 2020. This represented a 28 percent increase since 2015. The increase is the result of several factors. They include very low interest rates, an increase in retail sector interest for diversified investment, and greater accessibility to the fund market.
Worldwide net cash flow to all funds amounted to €617 billion in the first quarter of 2020. This is compared to €808 billion recorded in the fourth quarter of 2019. With a 11.7 percent decrease, Europe is the second most affected continent after the US. The worldwide domiciliation of investment fund net assets at the end of Q1 2020 reveals the United States and Europe held the largest shares in the world market with 47.9 and 32.3 percent, respectively. Overall, five European countries ranked among the top ten largest fund domiciles in the world. They are Luxembourg (with 8.8 percent of worldwide investment fund assets), Ireland (5.8 percent), Germany (4.6 percent), France (3.8 percent), and the United Kingdom (3 percent).
Luxembourg and Ireland represent almost half of the European figure. Together, they domiciliated over 13,500 cross-border funds in 2018 (latest data available). The cross-border funds within that year had an average number of additional registrations and reached a mean of 8.3. This is compared to 7.7 in 2008. It highlights an increasing interest in cross-border distribution. Of the funds domiciliated in the two biggest European players, Germany, United Kingdom, Switzerland and France are the predominant destinations for cross-border registrations.
Current challenges & opportunities for asset managers
The B2B2C model may appear to be quite complete. There is a clear breakdown of the roles each party plays in the distribution value chain. But several shortcomings are apparent. First, a bigger number of intermediaries leads to higher costs for investors. Each intermediary requests a remuneration, which induces multiple fees layers. Second, the information exchange, e.g. fund prospectus, KIID and investor information, becomes heavier over time. And it is a major consumer of resources. In addition, several redundant tasks are executed across the process chain such as AML/KYC activities.
Since 2012, a constant diminution of fees earned by fund managers has been observed. Two factors contribute to this situation: higher transparency and the emergence of ETFs. With the implementation of MiFID II, fund managers must now fully disclose their costs and charges to clients. What was before perceived as a black box is now wide open. This allows clients to compare the different offers in the market. And it ultimately leads to harsher competition within the industry. Alongside the regulation, the growing popularity of ETFs has weakened fund managers. Due to a passive investment model, an ETF requires a lower managerial fee. Combined with no load fees, they are recognized as an enticing alternative to funds. Managers must convince the market that the extra charge their clients incur is justified by higher performance.
The market today is mostly composed of institutional investors. For example, pension funds and insurance companies. However, in the recent years, the retail market has grown. Households are turning towards the capital market. This is due to the ever-low interest rate on bank deposits. For novice investors, funds offer a significant advantage: risk diversification with low (or no) involvement. However, the retail sector remains a widely unexplored opportunity. This is true for most of the funds present in the industry and especially in Europe.
Retail investors mostly invest in their banks’ in-house funds. This is because these are generally the only ones marketed by bank advisors. The open architecture is not new to the market. But it is not as widespread in Europe as it is elsewhere. Marketing external funds requires a steeper regulatory framework. Yet there is a strong belief among fund professionals that open architecture is in the end investor’s interests.
Additionally, current investor behavior is not just driven by profit maximization, but also by social value. Millennials are sensitive to global warming and local economies. They tend to direct themselves towards Socially Responsible Investments (SRI) that generate social/environmental value. However, it’s not just millennials who are showing interest towards SRI. The EU jumped on the SRI trend by designing a taxonomy for sustainable activities applicable for the whole financial services industry. The importance of market scrutiny is growing. Fund managers do not have the luxury to market a fund for which there is no demand. This would result in a waste of time and capital.
The current European distribution model can still be enhanced. In particular, the current regulatory and crisis context are ideal for improvement. GDPR regulates companies to seek the approval of clients before personal data is transferred to external third parties. But the more intermediaries in the process, the trickier it is to deal with GDPR. It leads to more contractual agreements, more data protection clauses and more oversight of the data processing register. On the other side, the COVID-19 crisis has led to massive redemptions, as times of crisis generally do. This contributes to a significant reduction in safekeeping fees on the custody side and a general lack of liquidity in the financial markets. Of course, a high number of intermediaries in the fund distribution chain is clearly not an advantage in times of crisis. It leads to longer redemption times and a negative feeling from investors.
Uberization of the fund distribution model
As observed, the B2B2C model faces different challenges and concerns. This is why a new D2C model is gaining interest. This Direct-to-Consumer model is not as widespread in continental Europe as it is in the US. The model leverages platforms, which are typically present in the B2B2C model, to their full potential. The model allows for a high disintermediation of the value chain. And it makes it possible for asset managers to distribute funds straight to end investors through the central platform.
The platform becomes a one-stop shop for the end investor. And it acts as a clear, all-in-one solution for the asset manager. It encompasses the clearing, settlement, transfer agent and custodians’ roles in a digitalized solution. The centralized platform will lead to a mutualization of the cost of order processing. It also registers management, process simplification, KYC-AML checks mutualization and simplification, standardized GDPR agreements, and other meaningful organizational advantages.
Several financial services players have provided existing D2C solutions to asset managers. However, a new type of actor could enter the fund distribution market: technology giants. As digitalized solutions enter the market, technology leaders could join the platform solutioning competition. This may be done is similar manner to the last few years of the payment industry, e.g. the rise of Apple Pay, Amazon Pay and Alipay.
Fueling the model with cutting edge technologies
The model on its own is akin to a sports car without an engine. The engine must be built around meaningful technologies. And it must focus on three main goals. First, provide the best service and the appropriate product to end investor. Second, provide the most relevant information to both the investor and the asset manager. And third, optimize the processes through a centralized connection that brings together the whole ecosystem of actors.
Distributed ledger technology (DLT) is the new flagship of digitized assets. This technology provides platforms with a substantial reduction in the post-trade settlement period. And it allows for almost instantaneous payments. However, there are still some concerns about this technology. Specifically, there are questions regarding permissioned networks vs. networks without permission, interoperability, scalability, uncertain regulatory frameworks, and immutability among others. It’s true that DLT faces challenges. But it is an incredibly easy-to-adapt technology that enhances the central role of platforms. And there are many diverse uses of DLT technology. For instance, it supports smart contracts that improve security for both sides of the contract while reducing transaction costs.
Machine learning (ML) and AI are already at the core of many financial services transformations. Distribution model platforms are no exception. ML and AI enable the clear optimization of processes through time and information aggregation.
Data analytics and visualization: with an integrated role, platforms have become the most relevant source of information for asset managers. Analytics allow for the identification of clear investor groups, behaviors and targets.
Businesses seeking to develop a consumer-centric approach must incorporate platforms. This will enable asset mangers to collect data on clients. This can be further empowered using data analytics and visualization software. Asset managers can then identify clear investor groups and determine their behaviors. From there, they can develop marketing plans to target the most profitable segments.
Time to take a clear positioning
The platform D2C model provides many insights for the future of the fund distribution industry. Stakeholders within the chain must determine their positioning with regards to this fast-evolving environment. And they should pay attention to local regulators’ restrictions. Disintermediated actors in this new value chain can reinvent themselves and determine their new value proposition in an exponentially competitive market. They should optimize their business processes and identify available outsourcing solutions and room for automation, blockchain and AI (e.g. KYC/AML processes). Cloud transformation and data governance, along with cybersecurity, are cutting-edge enablers for a deep repositioning. Central actors should also explore the potential for data monetization.
With the aforementioned constraints and the current times of crisis, asset managers must make these critical moves now:
- Rationalize their cost structure
- Embrace the platform universe and exploit open architecture
- Rethink their market positioning
- Enhance the presence on unexplored sectors (e.g. geography, retail, trend, etc.)
Together, these recommendations lead to a common conclusion. The time of D2C-central platform models has emerged. The first players to realize their full potential will gain an important strategic advantage over their competitors.