Investors love mutual funds. Even after late trading and market timing abuses surfaced in late 2003, investors poured money into equity mutual funds at a record pace this year; net inflow was more than $100 billion for the first quarter. Overall, $7.6 trillion is invested in more than 8,000 funds.
Investors hate scandal. From September 2003 to the end of March 2004, they pulled a total of $43 billion from the 17 fund companies (including Janus and Putnam) that figured most prominently in trading scandals, according to researchers at Financial Research Corp. For the most part, that money flowed to other mutual fund brands with more pristine reputations instead of to alternative investments.
Investors want integrity. The trading abuses focused attention on other industry practices harmful to shareholders, including payments from fund companies to brokers to push their funds and the failure of brokers to credit big investors with discounts. Proposed bills in Congress and Securities and Exchange Commission regulations aim to protect investors by boosting the already prominent role of IT across the mutual fund supply chain.
The proposals center on “straight-through processing,” an industry buzz phrase for automating mutual fund transactions so that the entire process-from placing a trade to final settlement-is fast, relatively seamless and less subject to manipulation. Though a straightforward concept, straight-through processing requires substantial integration and cooperation among members of the mutual fund supply chain. This supply chain (which includes fund companies, brokers, 401(k) and pension plan administrators, and a set of middlemen who aggregate, clear and reconcile transactions) is already highly automated. The manual processes that remain, however, have left investors vulnerable to trading errors and abuses as well as high management fees. Using IT, members of the mutual fund supply chain can improve efficiency, manage risk and improve regulatory compliance-all critical moves for maintaining investor confidence in mutual funds.
“Quality, integrity, reliability-that’s table stakes,” says Susan Kozik, executive vice president and CTO of TIAA-CREF, one of the world’s largest retirement organizations, with more than $300 billion in assets, including mutual funds, under management. “If there’s a failure in any part of my value chain, I’m exposed.”
Most of the time, companies count IT investments for regulatory compliance as a cost of doing business, rather than an opportunity to gain, or to preserve, competitive advantage. Straight-through processing does entail costs, but the benefits will reverberate across the mutual fund industry.
For Fund Managers, INTEGRITY DRAWS INVESTORS
Some mutual fund managers are already using straight-through processing, but regulatory rumblings are encouraging more widespread adoption (which ultimately could increase shareholder returns).
In November 2003, the U.S. House of Representatives, by a 418-2 vote, passed a bill requiring that mutual fund companies disclose their fees more plainly to investors. The Senate is currently considering the measure, along with several other bills aimed at protecting mutual fund investors. The possibility of getting dinged by regulators for failing to keep costs down puts a new premium on being lean, says Erwin Martens, TIAA-CREF’s executive vice president of risk management. “Operational oversight has to be rock-solid, first-class,” he says.
But even before Congress got involved, intermediaries-such as the brokers who execute the trades and the custodians who hold the funds’ assets-were pushing for automation. “There’s a clear link to automating those processes and reducing head count,” says Bill Brucella, TIAA-CREF’s vice president for investments information technology, because fewer people are needed to review transactions manually. Automation also reduces mistakes that can lead to trade errors that cost thousands of dollars to correct. “We send the trade to a broker, the broker and custodian match up what we’re doing, and we expect to get a 99 percent success rate,” Brucella says.
At a Senate hearing last fall, as mutual fund abuses were unfolding, New York Attorney General Eliot Spitzer alleged that investors are being overcharged billions of dollars for sky-high management fees. IT can’t address one of Spitzer’s goals: getting fund companies to negotiate lower fees for advisory services. But IT can play a key role when it comes to reducing the tens of billions of dollars in annual transaction costs that the fund companies accumulate through securities trades.
Three years after TIAA-CREF embarked on its straight-through processing initiative, that automation has contributed to a halving of trading costs, Brucella says. Lower expenses mean higher returns for investors. “Commission costs go right to the bottom line performance of the fund,” he says. The majority of TIAA-CREF’s equity transactions now are executed using an industry-standard messaging protocol called FIX.
With the mutual fund industry’s ethical woes continuing to make headlines, TIAA-CREF has begun to roll out new systems designed to ensure the integrity of the trading process. Integrity goes deeper than having a good reputation, observes Martens. Mutual funds need documented business processes to prove to investors that their operations are above board. Investors “are going to go to the funds that have high integrity,” he says. TIAA-CREF manages retirement plans for 15,000 academic and research institutions. According to market research company Celent Communications, the largest category of IT spending by securities companies this year-an estimated $7.6 billion-is for systems that support institutional trading. “Institutions want nothing to do with scandals. [There’s] a systematic voting for quality,” Martens says.
To ensure that TIAA-CREF’s trades comply with regulations and the company’s policies, Brucella deployed a centralized order desk in April to aggregate trade requests from the company’s fund managers, institutional clients and program trades. One application automates compliance checks in real-time to ensure that fund managers aren’t trading improperly in their own accounts (another problem Spitzer uncovered in his investigations of mutual fund improprieties). “By eliminating any manual steps, it eliminates any mischief that could occur, whether it’s intentional or not,” says Kozik. “Straight-through is hands off.”
For Fund Middlemen, EFFICIENCY is expensive
For mutual fund intermediaries such as Charles Schwab, the benefits of additional investments in straight-through processing are less clear. There’s no question that some level of IT investment will be necessary to restore investor confidence. Brokers and 401(k) plan administrators assert, though, that at least when it comes to catching illegal late trades, an electronic audit trail would be a quicker, less expensive and less disruptive fix than the methods proposed by the SEC.
In December, the agency proposed that intermediaries-who initiate around 80 percent of mutual fund transactions for individual investors in the United States-accelerate their processing of buy and sell orders to deliver them to fund companies by 4 p.m. EST, when U.S. markets close. Then unscrupulous brokers would be unable to slip illegal late trades into the batches of aggregated transactions that they currently send to fund companies after 4 p.m.
Critics of the SEC’s proposal say there’s little benefit to processing mutual fund orders earlier because it won’t reduce fees or limit investors’ financial risk. Unlike stocks, mutual fund shares are priced only once a day, after the market closes and fund companies calculate the value of the funds’ underlying securities. Whether an investor places an order at 10 a.m. or 3:30 p.m., the settlement process doesn’t start until after 4 p.m., notes Don Boteler, vice president of operations and training with the Investment Company Institute, a trade association for fund companies.
This ability to trade in batches keeps costs low and is the reason that brokers can offer “supermarkets” of no-load funds and that 401(k) plans have no transaction fees, says Gavin Little-Gill, senior analyst with TowerGroup, a financial services industry research company. In public comments, Schwab Senior Vice President and Deputy General Counsel Koji Felton wrote that implementing the SEC’s proposal to combat late trading would require such an extensive reprogramming of order processing and settlement systems that it would raise transaction costs shared by Schwab and the companies whose funds it offers by $4 million a year-charges that would be passed on to investors.
Felton notes that many fund companies and intermediaries already have systems capable of time-stamping orders. If these systems are upgraded to establish an electronic audit trail that could track every order, from the time the broker receives it to the time it is transmitted to the fund company, it would be far less disruptive to the industry. For Schwab, such a change would create a one-time cost of between $300,000 and $1 million, with no recurring transaction costs.
This blanket objection to aggregating and processing orders in real-time amounts to a failure of imagination to some observers, such as Shaw Lively, a research manager with IDC Financial Insights (a sister company to CIO’s publisher). “I think the best outcome would be that a short-term burden results in a longer-term benefit for the industry,” he says. “This is a case where deadlines and processes got built in an era before there was a lot of technology.” (Some systems date back nearly two decades.) Many brokers still don’t have completely automated systems for entering and transmitting orders, Lively says-an investment they would have to make if electronic audit trails are required.
One idea advocated by fund companies and brokers alike is to require most trades not executed directly by fund companies to use an automated clearinghouse, such as the National Securities Clearing Corp. (NSCC). Each year, 38 million mutual fund transactions totaling $578 billion are settled electronically using NSCC’s Fund/SERV system, and the company offers other services that make it possible for trading parties to automate most of their transactions. No one is sure, however, exactly what percentage of mutual fund trades Fund/SERV covers. TowerGroup’s Little-Gill estimates it’s about half. In comments to the SEC, Eric Roiter, senior vice president and general counsel with Fidelity, writes that under the central clearinghouse scenario, the NSCC, fund companies and intermediaries would incur some up-front systems development costs, but “ultimately, we believe that centralization of order flow will provide greater operational efficiency and economies of scale.”
For Transfer Agents, INTEGRATION IS OPPORTUNITY
Transfer agents-the middlemen who process, buy and sell orders and maintain shareholder records for mutual funds-stand to gain the most from any regulatory push that encourages straight-through processing. As the requirements for processing and recordkeeping become more stringent, mutual fund companies have an incentive to offload these tasks to specialists.
In March, the SEC proposed a way to discourage market timing cases by requiring mutual funds to charge a 2 percent fee on sales of shares within five days of purchase. Another proposed rule, requiring better disclosure by mutual funds of investors’ eligibility for discounts on sales charges (called “breakpoint discounts”), would push brokers and fund companies to do a better job aggregating a shareholder’s investments in multiple accounts. A recent joint study by the SEC, the National Association of Securities Dealers and the New York Stock Exchange found that investors eligible for discounts on sales charges (worth an average of $364 per transaction) were overcharged about one-third of the time.
Industry experts say both the market timing problem and the failure to offer sales-charge discounts result from the inability of brokers and fund companies to share investor trading and account information. The SEC’s breakpoint discount proposal would require that brokers share investor account data with the mutual funds so that the mutual funds could verify that eligible investors received discounts (and also detect market timers who they have previously barred from trading).
This task of aggregating thousands of investor trades and accounts provides a potentially greater role for transfer agents. Tim Lind, another senior analyst with TowerGroup, says that today, outsourced transfer agents provide shareholder account maintenance and recordkeeping services for only about a quarter of total shareholder mutual fund accounts. Otherwise, fund companies perform these tasks themselves. But Lind expects more mutual funds to outsource their recordkeeping and the IT investment that goes with it. By outsourcing, fund companies could shift the risk of maintaining systems needed for processing transactions, tracking trades and performing the analysis necessary to catch unscrupulous activity, he says. Fund companies could also benefit from economies of scale that transfer agents achieve by servicing many customers.
Because the mutual fund supply chain includes so many parties, information needs to pass back and forth easily as trades are processed. PFPC, a mutual fund transfer agency, has recently invested in Web services technology and relational databases that enable its mutual fund company customers to access business applications through a portal. For PFPC, the shift to Web services enables the company to support customers as they roll out new products and services or expand in global markets without “being locked into proprietary systems,” says PFPC CIO Michael Harte.
For the Mutual Fund Industry, inaction is not an option
Some within the mutual fund industry argue that new regulations and the IT investments needed to comply with them, won’t stop anyone bent on making illegal or unethical trades. But tracking transactions more assiduously makes it more likely that cheaters will be dissuaded or, if not, will get caught. This matters to investors, who have shown their willingness to pull out of funds that aren’t managed honestly, and thus it matters to the fund companies, which must now compete on more than simply how well their funds perform.
The current IT transition in the mutual fund industry to straight-through processing of trades will do more than discourage mischief; it will also reduce business risks and promote greater efficiency. Straight-through processing isn’t a panacea for the industry’s troubles, but it provides a way to address them. “Five years ago, everybody did their own thing,” observes TIAA-CREF’s Martens, and regulators were content to push standards and integration more gently. With the recent scandals, he says, “they’ve stopped gently pushing and said, ’You’re going to get on board.’”