Editor's note: This is the second of three articles on how an advisory practice can be streamlined by 1) reviewing a client roster and reducing it to those clients who have the best current and future profit potential, 2) improving investment management oversight by cutting back the number of mutual funds and mutual fund families that an advisor manages, and 3) deciding whether to adopt a generalist or specialist business model.
Last month, we examined how advisors can streamline their businesses by reducing the number of clients they have and focusing on those with the greatest profit potential. This time around, we're going to take a look at the logistical problem of mutual fund overload and how to reduce the number of funds advisors manage so they have more time to interact with their top-tier clients.
Tracking too many mutual funds can clutter an advisor's mailbox, desk and hard drive, eating up valuable time that could otherwise be spent with clients. Most important, no matter how many hours they devote to the job, having too many funds to follow makes it all but impossible for advisors to stay up-to-date on each fund: How it's doing, who's in charge, the sector weighting, whether or not there's been style drift-the very details that clients rely on advisors for. Individual investors who don't manage their own mutual funds look to their advisors to give them the latest information and to put those funds squarely within the context of their financial plans. If advisors can't do that because they have too many funds to handle, clients may find an advisor who can.
It's a pretty simple argument, really: Having fewer mutual funds makes it easier to master the fine print regarding the funds and to communicate the information to clients. Having fewer funds also frees time advisors can devote to client interaction in general. Again and again, our research has shown that interaction is what clients want-and that it's also the best route to profitability for advisors in terms of winning more assets and referrals.
How Did We Get Here?
There's no definitive study on how many funds the average financial advisor uses, but some industry estimates range as high as 200. Even if it is only half that, it is too many to effectively track. So how did it get that way?
First and foremost, there was the advent of open architecture-a world where any advisor (and most clients) can access virtually every mutual fund. And there are a lot of them out there to choose from; as of March 2002, ICI is tracking 8,389 mutual funds.
Open architecture has clearly been a plus for advisors. It levels the playing field for independents by enabling them to offer their clients the same mutual funds that the leading financial services firms offer. And, because advisors at those firms can give their clients access to top funds from other companies through wrap programs, they can be more consultative and less salesy because they're not exclusively pushing their own products. Advisors certainly have seized the opportunity afforded them by open architecture: A 2001 survey conducted by Prince & Associates of 1,419 independent advisors found that 81.2% of their business came from mutual funds.
The barrage of information also has contributed directly to mutual fund overload. Advisors all are used to navigating Morningstar and Lipper for mutual fund news. Through the media, there's a steady stream of high-profile "funds of the month" and "managers of the year." Wholesalers drop by to pitch last quarter's top performer or corner advisors at conferences. Add the fact that during the 1990s, mutual funds seemed to go nowhere but up, and it's easy to see how they mounted up-and got out of hand.
The problem is further compounded by the fact that investors and advisors may amass mutual funds without having in place a well-defined process for selecting, monitoring or exiting those funds. As a result, in addition to having too many funds to keep up with, an advisor's book of mutual funds can become under- or overweighted by asset class and style, can camouflage some bottom feeders and can suffer from style or asset overlap. Worst of all, some funds may have changed to the extent that they no longer fit a given client's risk tolerance and objectives.
Cutting The Roster
So what can be done once an advisor has too many funds to keep track of? The first step is to develop a core menu and process for vetting any mutual fund families and individual funds added from here on in. The second step is to gradually cull existing funds until an advisor gets down to a lean menu of solid performers that he or she can know inside out.
Developing a core menu and process is a little like draft day in professional sports-you start with hundreds of prospects, put them through their paces and narrow down to a manageable list of core funds. Before beginning, however, it's important for each advisor to decide how many funds with which he or she is comfortable, perhaps three or four per asset class and style and 30 to 40 overall.
Once that decision has been made, an advisor should review and rank entire fund families before moving on to the individual funds. Does the fund family have a history of strong performance? Is its process sound and consistent? Is there a range of funds to choose from? And what does the firm offer in the way of service and administrative support?
Having selected a number of fund families, advisors can vet each fund. The main criteria should include the fund's performance vs. its benchmarks and peers over one, three, five and 10 years; Lipper and Morningstar rankings; the level of risk; style purity; a disciplined investment process; the composition of the management team and its experience; expenses and fees; and marketing materials.
A couple of approaches can be used to grade families and funds. One would be simply to use the readily available Lipper and Morningstar rankings and then cut from the bottom accordingly. The second option would be for advisors to rank the funds for themselves based on an expanded or customized list of attributes, using a base value of zero and going from there. Each positive percentage point of performance, for example, would be worth one point, and a manager might get a point for each year he or she's been on the job. Once such a system is in place, it is relatively easy to plug in the details of each fund and come up with a ranking.
It's also important to have a sell discipline based on such factors as prolonged underperformance, higher risk, style drift or a change in manager. If possible, once the ideal number has been achieved, an advisor should try to drop at least one fund for every one added by getting out of the lowest-rated performer in the same category (without losing sight of the possible tax implications for the clients invested in the fund).
During the second phase, advisors can gradually reduce the number of existing funds. Start with those that have underperformed. Look for those that overlap. Find others that may no longer suit a client's risk tolerance or financial objectives. Slowly but surely, the number of funds can be winnowed to a more manageable total.
Making The Case To Clients
Any downsizing has to be managed carefully, of course. How will it sit with a client if an advisor is getting rid of the very fund that he or she has previously recommended or is a pet choice of the client? Reducing the number of funds has to be in the best interest of an advisor's clientele. Advisors need to consider all relevant factors, including sales charges and fees, tax consequences and the availability of free or low-cost fund exchanges. Most important, an advisor has to remember that an individual client's unique needs all can't be fit neatly into a grid. Over time, it will be the advisor's level of knowledge about the funds, and the client's exposure to the ranking process and the thinking behind it, that will help the client feel comfortable with the recommended changes.
In any case, now's the time to cut. Mutual fund fever has abated somewhat, and the expectations of double-digit performance have been curbed. Some investors were scorched by having had an overconcentration in technology funds, and the majority of mutual fund investors have lost money over the last two years. As a result, clients are willing to listen to suggestions based on hard numbers. Further, our research consistently has shown that many affluent investors are ready to move away from mutual funds to other products that allow for greater customization, like managed accounts, or appeal to their sense of exclusivity, like hedge funds.
Most clients don't want a second career tracking mutual funds. They're willing to listen to their advisors-that's why they hired them to begin with-and to let their advisors help them choose, track and sell mutual funds that are right for them, especially if those advisors are well-informed about each and every mutual fund with which they're working. And by having fewer funds to track, advisors actually may be able to find the time to have those conversations.
Hannah Shaw Grove is managing director and chief marketing officer of Merrill Lynch Investment Managers. Russ Alan Prince is president of the consulting firm Prince & Associates.