The traditional mutual fund wrap program involves the allocation of the sponsor’s customer assets across many different third-party mutual funds. This traditional wrap structure provides professional management and daily liquidity to both the sponsor and the investor. However, investors are seeking lower product expenses, greater tax efficiency, and, ultimately, better performance.
The use of external mutual funds challenges the wrap sponsor in several ways:
Cost economies: Although the wrap sponsor places assets with third-party mutual funds, the sponsor has no control over the expense ratios of external third-party mutual funds.
Allocation efficiency: As wrap programs become significantly larger, allocations and rebalancing of large sums of assets to/from third-party mutual funds creates difficulties for both the sponsor and external mutual funds in terms of costs, timing and coordination.
Tax efficiency: External mutual funds incur daily subscriptions and redemptions from all shareholders, requiring the manager to buy and sell portfolio securities to manage cash inflows and outflows. This portfolio turnover may impact both taxes and expenses of the third-party fund.
A potential solution to these challenges for the mutual fund wrap sponsor may be to establish its own wrap sponsor mutual fund family with the wrap sponsor as the investment manager to the mutual funds. The wrap sponsor selects and manages third-party sub-advisers for all asset management functions. This structure allows the wrap sponsor to directly manage and control all aspects of the underlying investments, as well as the allocation of client assets across investments and managers.
The traditional wrap program sponsor performs two valuable services for the investor – selection of appropriate third-party investment managers, and allocation of customer assets across these managers. In the selection process, the wrap sponsor conducts significant due diligence of the underlying mutual fund(s) and investment manager(s), including review and documentation of the manager’s compliance program, Form ADV, regulatory history, business continuity plan, code of ethics, organization structure and resources, investment philosophy, and investment performance. This process is essentially the same as the due diligence required of the investment manager in the selection and oversight of sub-advisers of the wrap sponsor mutual fund. Consequently, in the sub-advised wrap sponsor fund family, the wrap sponsor continues to perform all sub-adviser investment manager due diligence, while at the same time remaining in an independent oversight role of the daily investment activities.
Lower investment expenses: Depending upon the third-party mutual funds involved in the traditional wrap allocation program, there is potential for significantly lower investment fund and overall wrap program expenses, perhaps 15-30 basis points or more, depending upon the program. These cost savings are typically derived from lower investment management fees and fund expenses generated through the economies of scale in the sub-adviser model. In addition, third-party funds typically are designed for multiple distribution channels, and can include many fund expenses not applicable to the institutional mutual fund wrap product. The wrap sponsor can determine the expense structure of the wrap sponsor mutual funds, including management fees, operating expenses and total fund expense level.
Investment management oversight: As the investment manager to the mutual funds, the wrap sponsor designs each mutual fund investment strategy, determining the investment objective and principal investment strategies for each fund, including diversification, specific allowable investments and risk considerations. Within the wrap sponsor’s ongoing investment management responsibility, the selection and oversight of sub-advisers provides the wrap sponsor with greater involvement in the management of each mutual fund investment in the wrap program. The wrap sponsor also has more direct oversight and control of underlying investment performance of each sub-adviser, including daily transparency into portfolio activity, securities and sub-adviser performance.
Improved allocation efficiency: The wrap sponsor mutual fund model allows for more efficient investment allocation and rebalancing. A large redemption from a third-party mutual fund can create significant liquidity and tax issues for the third-party fund and its investors due to the necessity to liquidate securities on short notice. The sub-advised mutual fund model allows the wrap sponsor to efficiently reallocate investor assets to a new or different sub-adviser with significantly less impact to the investor.
Investor tax efficiency: Greater control over the mutual fund investment management process in the wrap sponsor mutual fund program allows the wrap sponsor to effectively manage the tax efficiency of each portfolio as necessary. Employing a sub-adviser model allows the wrap sponsor the ability to allocate and rebalance across sub-advisers within a portfolio without necessarily creating a taxable transaction for the investor.
The process to launch a wrap sponsor mutual fund product line involves the selection of a business partner experienced in establishing and operating mutual funds. The wrap sponsor will want to make several key decisions regarding the launch and migration of assets to the proprietary mutual funds. Sample key considerations for the wrap sponsor in developing a wrap sponsor mutual fund model include the following:
The wrap sponsor will select the most advantageous mutual fund structure from the following three options. The wrap sponsor controls investment management and branding in all options.
Series trust: A series trust is an existing SEC registrant with all infrastructure and service providers in place. The administrator establishes a “series,” or fund, for each wrap mutual fund product. Benefits include cost economies, faster time to market for fund launch, and the wrap sponsor’s ability to leverage existing expertise from the board, service provider, fund officers, and CCO.
Proprietary: The wrap sponsor establishing their own “proprietary” mutual fund family trust will assemble the trust board, service providers, CCO, officers, etc. Although a new trust launch will take generally one to three months longer, the wrap sponsor can be represented on the trust board and is involved in all aspects of launching and operating the trust. The administrator will assist in all aspects of the trust formation.
Hybrid: The hybrid model is the formation of a proprietary trust and combines many of the series trust elements of a fund launch with the wrap sponsor’s selection of service providers, trust officers and trustees, including representation, if desired, of the wrap sponsor on the trust board. The administrator will assist in all aspects of the trust formation.
The wrap sponsor, as the investment manager to the mutual fund trust, will be responsible for all aspects of investment management, including sub-adviser selection, due diligence, board reporting, and compliance. As investment manager to the trust, the wrap sponsor is reviewed and approved annually by the board of
trustees, requiring transparency and regular reporting of the adviser’s processes for performance management, portfolio compliance, adviser compliance, sub-adviser management, etc. assumed by the adviser in a propriety fund structure.
The sub-adviser responsibilities to the trust, adviser, and trust board include investment management and compliance with all applicable SEC 1940 Act, Internal Revenue Code, prospectus, and SAI investment policies and procedures. In addition, mutual fund sub-advisers are responsible for providing daily and periodic requested portfolio and compliance reporting to the investment manager and trust, as well as to the trust and investment manager CCOs.
The wrap sponsor, supported by the administrator, will design mutual fund portfolios to align with the investment strategy allocation requirements for their wrap program, creating sleeves within each portfolio for each sub-adviser, and complementary strategies to meet the sponsor’s allocation models.
The wrap program sponsor will determine the expense structure for each mutual fund, including management fee and total fund expense ratio, including fund expense caps, if desired. The administrator will develop fund expense projections to model all mutual fund costs based upon projected fund assets.
The wrap fund sponsor and the administrator will coordinate the client communication and transition from third-party funds to proprietary mutual funds. This process generally involves coordination of wrap program documentation, timing the liquidation of third-party funds, and coordination of investor assets into the wrap sponsor mutual funds.
A mutual fund trust operates with a standard infrastructure composed of a board of trustees, service providers, independent legal counsel, and independent audit firm, with investment services performed by the investment manager pursuant to an investment agreement with the trust.
The migration of mutual fund wrap programs into wrap sponsor mutual funds provides the wrap sponsor with significantly more control over the investment policies, asset management, and costs of the underlying investments within their wrap program. The wrap sponsor continues to maintain independence from the daily portfolio management, which is delegated to the sub-advisers. The wrap sponsor can continue to actively manage the selection and network of investment management firm sub-advisers, but has the added benefit of directly overseeing the underlying mutual fund products as well. Thorough analysis is required to determine the economic benefit to the investor, the appropriate transition process specific to the wrap program, as well as the impact to the wrap sponsor.
Bob Kern worked for U.S. Bank from 1982 to 2018. In his most recent role before retiring, he managed global business development efforts of mutual fund, exchange-traded fund and alternative investment product services in the U.S. and Europe.