The European market is alluring to U.S. firms, but making the jump isn't cheap or easy.
This article first appeared in the April/May 2011 issue of Morningstar Advisor magazine. Get your free subscription here.
In "The Global Fund-Leadership Playoffs: Europe vs. the United States," Robert Pozen and Theresa Hamacher have much to say in favor of Europe's UCITS fund regulation. In short, they argue that U.S. fund regulations have kept the mutual fund industry from competing as effectively globally as their European counterparts, while offerings under the UCITS regime have stolen the lead in asset growth. With that in mind, we thought it would be of interest to speak with the heads of two U.S.-based fund companies that have operations in Europe for their perspective on the challenges facing the U.S. fund industry and best practices from both sides of the Atlantic.
Greg Johnson, CEO of Franklin Templeton Investments, provides the perspective that comes with a long history of well-established operations in both markets. Franklin Templeton is a major player in Europe and Asia, with more than 252 funds domiciled in those regions, compared with 115 in the United States. Dodge & Cox Chairman Emeritus John Gunn and COO Tom Mistele bring a different point of view to the table. Their firm is well known and highly regarded in the United States, but it has only recently launched a foray into European markets with the establishment of a Dublin-domiciled UCITS range in late 2009. Although the participants differed in their responses to many of our questions, they all are fond of the collaborative nature of fund regulation in Europe and are excited by the growth prospects of new markets around the world. From London, we talked to Johnson on Feb. 24 and Gunn and Mistele on Feb. 25. The conversations have been edited for clarity and length.
Christopher Traulsen: Franklin Templeton has a long history in the United States, and the firm is a significant cross-border player. As CEO of the house, what are the key challenges that you see for the organization?
Greg Johnson: The most important issue that affects all investors globally, and maybe is even a bigger issue outside of the United States, is a focus on short-term performance. I think the cause of this short-term mind-set is the amount of information we get all day every day. Anytime you turn on an outlet, you have some reason to be concerned or to think that you need to change your investment mix. It's probably the most important role of the financial advisor, to get clients focused on the long term, and it's something we reinforce in our communications.
As we enter newer markets around the globe, we encounter the speculator versus the investor. We try to create investors. In these newer markets, that's always a challenge. We could be doing very well in a market, but if there is a short-term focus and a downturn occurs, then we could see significant redemptions.
In the United States, the big issue facing our entire industry is rebuilding investors' trust. Surveys show that investors' risk tolerance has shifted, but more importantly, it has shifted for the younger investor. Young investors used to have the highest tolerance for risk, and that's very appropriate because they can have a longer-term horizon and tolerate more volatility. But today, we've seen that the young investor actually has less risk and less equities in his or her portfolio than before.
Look at Japan, for example, which has had a very difficult period in its equity market; the younger Japanese investor has completely abandoned equities. If an investor's first exposure to mutual funds is a negative experience, whether they went through the technology bubble, the recent sell-off, and what some refer to as the "lost decade," that should be a big concern for our industry. It is for us. Obviously, we benefit from fixed- income investing, but we also have half of our assets in equities. We've been really talking about the case for equities in the decade ahead. We have our 2020 Vision campaign, which we started near the bottom of the market. We're trying to get investors' focus away from what's going to happen in three to six months and on the probability of returns over the next decade.
Now, some of this has turned a little bit, most recently in February, with strong equity flows coming into U.S. funds. But overall, the rebound that we've seen in the U.S. market has not been followed up with the equity flows that we'd expect.
The Pressure to Do Alternatives
Traulsen: A lot of houses in the U.S. argue that regulations are too restrictive; therefore, they're offering long-only equity funds. They'd like more opportunity to offer things that can have a little more downside protection. Is this something that you wish Franklin Templeton could do--offer types of products that current U.S. regulations don't permit?
Johnson: There are a lot of issues around trying to transition the retail investor into alternatives. Clearly, alternatives is a growth area, especially with advisors who can get cheap beta through ETFs and are looking for other sources of output that may not be correlated to the market. We see that trend. We certainly see it on the institutional side, and it's shifting over into the retail side.
I think the concern that regulators have, and we have as well, is that you have to be careful taking products that are less liquid, that are harder to value on a daily basis, and putting them into '40 Act vehicles that are made to mark-to-market daily. The strength of a mutual fund is the transparency, daily liquidity, and strict investment policies. These protections have served our industry extremely well. So, yes, there is an appetite for other types of products, but I would go back and look, for example, at "absolute return." Imagine if we sold a lot of absolute return vehicles and then had a period of negative 20% returns. To me, those are somewhat dangerous labels to put on a category.
I believe that long-only and having tolerance for down markets is still very appropriate for the retail investor. I get very concerned with the pressures to allow more around derivatives and investments that are tougher to value. Remember, the strength of a mutual fund is that daily liquidity feature. There are things you can do with tactical asset-allocation funds and real-asset funds that provide nice hedges for investors and that can be done in an open-ended, liquid fund.
Traulsen: One of the responses we've seen to the market downturn in Europe is "NewCITS," also known as "hedge funds light." A lot of fund houses seem to think it's a good way to gather new assets. Based on your earlier responses, I'm guessing that Franklin Templeton is not particularly interested in these vehicles.
Johnson: It's an area we have to be concerned about, because it's very hard for a typical retail investor to understand the risk that's involved with a hedge-fund-light-type product. Anytime you have that disconnect, you have a potential for problems. For those types of investments, we favor privately offered funds that focus more on the sophisticated investor than the mass-market retail investor.
I go back to the absolute return example. The term may mean one thing to the typical retail investor and another thing to the typical institutional investor. So, it's an area that we have to be careful about. We are not pushing hard to be broader-based, whether it's with NewCITS or other things. We'd rather do it in a privately offered vehicle.
Traulsen: You said that in some markets around the world there's a short-term mentality. Certainly, we've seen the same thing in some of the Asian markets, for example. In fact, I just visited one of your managers in India. As a house attempting to gain traction in these markets, how do you balance the tension between needing to attract interest from local investors and sticking to your belief in long- term investing?
Johnson: There's no easy answer. I think when entering a market, you have to be ready for very high redemptions when the market's not doing well. That's the reality of doing business in those markets. We try to diversify the overall company's assets the best we can. So, when one market is doing well and one isn't, it's not going to have a detrimental effect to our net-flow numbers.
The situation is the same as it was here in the States in the early 1980s. Banks were opening up for mutual fund distribution, and the big emphasis was on education and giving advisors tools to educate investors--focusing them on the long term and preparing them for volatility. It's the same thing we're doing now in other markets. We have learning academies across the world. We've taken many of the same tools that we developed in the States 20 years ago and are giving them to advisors to create investors, not speculators. But there are cultural barriers, too. In Asia, there is a short-term focus, and that's going to be hard to overcome.
Designed for Export
Traulsen: Is there anything about your experience with building a UCITS business and dealing with regulators in Europe that U.S. regulators could learn from?
Johnson: What makes UCITS and '40 Act mutual funds both very successful is the characteristics that I mentioned earlier--transparency, daily mark to market, and strict investment policies and restrictions around what they can do. Those are really what make them successful for the retail investor. When you start discussing what makes one more viable for a broader base around the globe, you have to go back to when the '40 Act was created. The thinking then wasn't that we were going to export it to other markets. UCITS were designed for exportability. They have been so successful that for a U.S. manager the big question is whether it's worth lobbying to push '40 Act funds to become more exportable. The fact is, UCITS are the vehicle of choice of these markets. We are very happy with our flagship Luxembourg-based UCITS fund range, which is doing very well. In many countries, you always have limitations around what you can and can't do with regard to taxes and M&A and things that may affect one given fund in one market.
But from the investment-management perspective, being able to export your '40 Act fund would only save you a very small portion of the cost. People who think they can just take a '40 Act fund, register it, and be successful really don't understand the business. It requires a major investment of people, services, and marketing to be successful in these markets. Simply registering a fund for sale is a very small portion of the investment required to be successful in Europe and Asia.
Traulsen: What about disclosure requirements? Compared with Europe, the SEC requires that a lot of extra information be given to investors. As somebody who has to balance the need to provide investors information with the need to run an efficient business, which has a better disclosure model?
Johnson: At the end of the day, regulators have to respond to their own environments, and obviously, it's politicized. If you have a problem in one area, the knee-jerk reaction politically and the pressure on regulators is to do something extensively and quickly. The question is always, how much disclosure is too much disclosure? I think that the United States is on the end of too much disclosure.
But I'll also add that the summary prospectus in the U.S. has been very effective in getting the key points out. So, if investors really want to dig and get something else--such as a Statement of Additional Information--it's there. But what's important is really that the summary document focuses on the important parts. The EU is about to require UCITS to do something similar.
Another difference has to do with relationships with regulators. Regarding UCITS, it's been more of a partnership with regulators; we work together. In the United States, it's a little bit more adversarial, more enforcement-oriented. The philosophy here has always been that enforcement is the best deterrent. If we had a bit more of a partnering approach, where there's a free flow of information, I think we could avoid a lot of the enforcement problems.
Traulsen: One of the criticisms I hear about the lighter regulation in Europe and the U.K. is that you'll ask a firm what a particular rule means and often they won't know. They say that no one knows the rules until someone gets slapped.
Johnson: It's true that the U.S. is more rules-based, and that's part of how we're regulated. With the private litigation environment, being rules-based is probably the only way we can operate. UCITS regulation, which is more principles-based, would benefit from more clarity; there are areas where the industry needs more specificity. Just because you're principles-based, you shouldn't be afraid to issue guidelines and rules that help the industry and investors. The optimal environment is somewhere in between the two.
EU Improves Environment
Traulsen: We also hear that although there is a lot of consultation in Europe the situation still can be frustrating, because the UCITS passport isn't quite the dream of the passport yet. That is, local regulators still layer on additional requirements, and distribution becomes hard. Do you see that improving at all?
Johnson: Yes, it is improving. Just look at our Luxembourg UCITS fund. The numbers speak for themselves. It is sold in 24 EU jurisdictions and 48 jurisdictions overall and has garnered assets in excess of $120 billion. So, clearly, it's a great example of the success of the UCITS directive in promoting cross-border fund sales. Sure, the system isn't perfect. But it's going to get better, at least in the EU, for two reasons.
First, UCITS IV--the soon-to-be-effective amendments to the UCITS directive--will make it significantly easier and faster to register funds for sale cross-border. The best estimates are that UCITS IV will reduce a roughly two- to six-month registration period, depending on the country you're registering in, down to about 10 days, if it all works smoothly. Clearly for somebody like us, who's a leader in the cross-border market, UCITS IV will only make things better.
The second development has to do with regulation. To be fair to the EU, they still have no SEC, no single securities regulator. That is going to change. There was the Committee of European Securities Regulators that was set up a few years ago to coordinate and set some uniform standards across regulatory borders. On Jan. 1, that organization became known as the European Securities and Markets Authority. Under UCITS IV, it will have more authority to set standards and lower the barriers to cross-border fund recognition. It should diminish the extent to which local rules can make it harder to distribute cross-border.
Traulsen: Compare the business- growth prospects of UCITS globally and U.S. mutual funds.
Johnson: In comparing the growth potential of UCITS and U.S. mutual funds, I wouldn't draw the conclusion that it's because one vehicle is better than the other. But the reality is that the UCITS business is going to grow a lot faster than the U.S. business. That's really a function of looking at the various markets that they serve and household penetration. Mutual funds have pretty much fully penetrated the U.S. market. In many of these other markets, the growth of the middle class, the opening of distribution, the creation of retirement programs--these things are what really gets us excited about the opportunity in these markets. Asia, Europe, and Latin America are all expected to grow faster than the U.S. market. Right now, UCITS are the vehicle of choice in many of those markets. So, we would expect to benefit from having that structure in place.
Traulsen: One of the things I look at in Europe is the incredible fragmentation of the universe and the difficulty a lot of fund houses have in gathering assets. We track about 75,000 fund classes across 36,000 funds just in Europe. Sixty percent of them have assets of less than 50 million euros. It seems to me there are many asset managers out there pursuing a smaller pool of money than what's in the United States. How does Franklin Templeton overcome the wall of products out there in order to grow assets in Europe?
Johnson: This is where the scale of a global organization is very important. As I mentioned, success is not determined by registering a UCITS and being available for sale. Success is built by being on the ground and having local people in local markets building relationships, building brand, servicing those investors. And for us, it's also having local asset managers in many of these markets that complement the other funds.
It also takes a while. We opened our first office outside of North America in Taiwan in 1986, and it was very unclear how quickly the overseas market was going to grow. We took a leap of faith back then. Since then, we were willing to invest our company resources in many international markets and now have offices in more than 30 countries, all based on the same reasons why we believed our U.S. investors should invest globally. We recognized that middle-class investors would emerge and would need investment vehicles. And that has happened--in a dramatic way--in the past five to 10 years.
Christopher Traulsen: What's the outlook for the U.S. mutual fund business?
John Gunn: We have a moderately priced market. Although unemployment is still high, corporate profits turned out to be a real bungee jump, so we're back up just about to the previous peak in corporate profits reached in June 2007. We're not quite back to the previous peak in the S&P 500. The other thing that we see--that we got interested in the 1990s and was the genesis for starting our international fund--is that we're in the midst of an amazing global economic transformation. Twenty years ago, the developing world of 4.5 billion people wasn't a significant part of the global economy. Then, with the end of the Soviet Union in 1991, free-market mechanisms and free-market economies proliferated out over the globe. The information economy accompanied it with cheaper computing power, cheaper electronic communications, ending isolation.
So, now we have 6 billion people who are, in any kind of historical economic sense, hurtling toward modernity. The fascinating thing is that our financial panic in the fall of 2008 led to an implosion in economic activity for a short period of time. In 2009, almost all of the emerging markets grew. Even Africa grew slightly. These are powerful trends. As a matter of fact, as the past six weeks in the Middle East have shown, more and more citizens are not isolated in these authoritarian countries. They in effect live in an electronic global village and see how rich people live and want a part of it.
How does that link into the whole mutual fund world? To me, it links into it because I think it's going to lead to a wide profusion of equity throughout the world. It's going to be the advantageous way to finance. Since 1980, banking has been losing share in terms of financing economic activity in the real economy. My guess is that equity is going to continue to grow very rapidly. The number of companies that might go public in China over the next four or five years is absolutely extraordinary. All of those assets are going to have to be managed in some way.
Traulsen: How does that mesh with what you're seeing in terms of investors' risk appetite? Certainly in the markets I'm in and what I'm hearing from the U.S. is that investors are far less enamored with equities than they once were, given the turmoil in markets during the financial crisis. Are you seeing that same trend?
Gunn: Well, you're right, and that's why the valuations within the equity market are extremely reasonable. After a couple of years of quite good performance in relationship to fixed income, there'll probably be more enthusiastic crowds.
Tom Mistele: One of the challenges for the entire industry in the U.S. is the stratification of fund ownership. It's heavily concentrated in U.S. investors 35 and older. Fund ownership under 35 is quite low. That's going to be a challenge for the fund industry. So, it's not surprising that you see fairly aggressive use of social media to interact with that younger investor group.
"Field of Dreams" Marketing
Traulsen: Dodge & Cox recently launched funds in Europe. I think you launched your first Dublin UCITS in December 2009. What was the appeal for you of coming over here? You'd obviously had tremendous growth and success in the U.S. Was it a case where you thought the U.S. market was saturated and that more opportunities for growth exist here?
Gunn: If you look at us right now, we have about $200 billion under management. A little over a third of it is fixed income. About a third of it is domestic equity. And a little less than a third is ownership of companies domiciled outside the U.S. We're building a presence there. We're long-term holders of a lot of these companies. We wanted to trail that and build up a client base outside the U.S. In our fashion, we believe in the kind of investment- management service that is low turnover, emphasizes stock selection, and charges low fees. We're doing "Field of Dreams" marketing. You build it and they will come--so we hope. It's always a little problematic. But we started the international fund, which is not quite 10 years old, with $8 million from the board of directors. It's now a $45 billion fund.
Traulsen: It does raise a good question, because distribution here is different than in the U.S. Here, we have a lot more products competing for a smaller pool of assets. How are you dealing with this distribution challenge? Or is it just a case of building your business the same way you did in the U.S.--do well, and people will notice you.
Mistele: Our assumption when we embarked on the study of this venture was that we would continue with our current investment style and process and scale based on existing systems. We're using the same investment committees, research process, global custodian, administrator, pricing agent, and global transfer agent--those were givens. Back in September 2009, as we looked at the market, I recalled seeing a survey on the criteria that European investors relied on in picking investment managers. The top five factors were clarity of investment process, performance, risk control, stability of the investment team, and investment management fees. Well, I thought I was reading one of our slides. Those have been fundamental principles for this firm since its inception. And we're relying on these principles to tell our story to non-U.S. investors.
Gunn: In the late 1970s, we hired the only consultant that we have ever had. Charlie Ellis of Greenwich Research came in and looked at our whole operation. His notion at that time, which I thought was very good, was that investment management is a very large business, but it's highly fragmented. In that case, you want to present a distinct profile in a fragmented business. So, we spent a lot of time just thinking what our distinct profile was and explaining it in many different ways. The idea is that you have a distinct profile, and maybe you turn off 80% of the market. It doesn't make any difference because the remaining 20% is huge.
The reason that not many people follow this strategy is that--I don't care how good you are--investment management has an enormously high error rate. So, if you have a distinct profile, every so often you're going to look like the dog's breakfast. We've had those periods, but we keep on coming through and coming back. That's the notion.
Mistele: We started out in the U.K. primarily because of its retail distribution review, which is essentially going to ban commissions in the U.K. It will drive distribution toward the advice-driven model. That plays to our strength. We're very aware of the strong headwind we face in terms of retrocessions that are paid overseas, which Dodge & Cox doesn't pay. In some cases, they have a stranglehold of some fund platforms.
Traulsen: It's fairly typical for a large-cap global fund in Europe and the U.K. to carry anywhere from a 1.6% to a 2.0% total expense ratio. You're at, what, 0.7% or something?
Mistele: 0.7%, yes.
Traulsen: That is something that certainly sets you apart here. It's very clear you're not paying for shelf space, as has been the norm here.
Mistele: That's right. To John's point, as they say in real estate, it's location, location, location. In our case, it's differentiation, differentiation, differentiation.
Gunn: If you're going to build a long-term successful business, you need long-term satisfied customers. If we would start over today, our fee level would be the same. It'd be the same everywhere, because to us it is a fair amount, and we believe that after the payment of fees, the shareholder will be left with an investment that outperforms most indexes over a long time period. If the fee levels at 1.5% to 2.0%, I think it's going to be very difficult to sustain.
The picture of investing today is totally different than it was 10 years ago. The mega-cap companies have probably never been cheaper in relationship to the broad market. If you take the top, the largest companies in the U.S., they have about 1.5 to 2 P/E multiple lower than the rest of the companies. We can see it in the equal-weighted S&P, which has outperformed the S&P nine out of the past 11 years. In effect, it has doubled over 11 years while the S&P has gone nowhere.
So we look out to a global economy that has a significant probability of growing at a historically high rate, led by the developing world, and we think that the overall returns of equities will be very large in relationship to fixed income. It may be very surprising how well the large companies do, which means, if you follow the logic chain, it's going to be very difficult to beat the indexes. Alternative investments in private equity, in hedge funds, with 2 and 20, I don't know how they do it. That's just a huge load to carry.
Doing What We Do
Traulsen: So, you think the ground will shift even more in favor of lower-cost fund companies, even in markets where that hasn't been the norm.
Can I follow up on that? When I think of Dodge & Cox, I think of value, quality, and long-term focus. You come to Europe, and investors here are not necessarily that interested in carving up the U.S. into a style box. They want something that can keep up with the S&P 500 year in, year out. Do you note that difference in this market as you try to explain to people what you do and to get the right kind of investors that will stick with you?
Mistele: We take every opportunity to remind investors of our three- to five-year investment horizon. You'd be hard-pressed to find a shareholders report that didn't stress that point. There is a trend toward a shorter time frame that we've run into as we speak to potential investors and consultants. Volatility is on people's minds. But we think it's important to stress this investment horizon. We also remind investors repeatedly that we're bottom-up investors and often deviate significantly from the S&P based on this bottom-up process.
Gunn: If you look at what people want out over a long time period, they want to have the purchasing power of their wealth preserved and, we hope, enhanced out over a five- to 10-year time frame. If people's objectives are to make as much money as possible without losing any--well, that's pleasant, but we can't do it. I don't know how to do that on a short-term basis. In fact, the only person I know who really built a very successful business advocating that was Bernie Madoff, but that didn't seem to work out.
In terms of alternative investments and all that, there's been all kinds of people advocating for them, and then they seem to explode every so often. So, our view of it is that, yeah, there's going to be volatility, but we are owners of companies that we think have management expertise and a strong business franchise, and we bought them at a reasonable to low value; they will continue to look at the changing economic environment and make adjustments, seeking opportunities and avoiding risk. At the end of the day, we think that the ownership of those companies is going to be a very rewarding experience. Our risk control is basically our individual stock selection.
Traulsen: But do you find that there's more resistance to that message in Europe?
Mistele: Yes, we do get some of that in meetings with institutional investors in Europe. We get questions like, How much are you going to beat the S&P in the next two or three years? That's not a typical question we would hear in the U.S. and not a question we would want to answer, because we don't know the answer. We're driven by our bottom-up investment process.
Gunn: I go back to the Charlie Ellis example. In Europe, maybe we turn off 90% of the people. I don't have the faintest idea. Not to sound arrogant about it, but it doesn't make too much difference, because we can't do anything else other than what we're doing. If we had a way of avoiding volatility and creating superior return, of course that's what we would do.
Flexible Regulatory Model
Traulsen: Having recently launched a Dublin UCITS, was there any thing about the UCITS regime that you find interesting or appealing that you wish applied in the U.S., or vice versa? Are there '40 Act rules that you think would be well applied in Europe?
Mistele: The UCITS regime is much more flexible. I was impressed in the very beginning with the dialogue that we had with the Irish regulators. We went in and met with them across the table. They asked very thoughtful questions. They'd clearly done their homework and knew of our firm. We often don't see that with the SEC, maybe because of its size or just their regulatory model. In Ireland, it was collaborative and less formal. The UCITS structure--being accepted in more than 50 countries--makes it really the global brand. The U.S. Investment Company Act model is really stilted by its structure and the current tax and regulatory environment. It's U.S.-bound, and I don't see any potential for it as a global brand. It's unfortunate, but many have tried to alter the structure to take it offshore, but they've been unsuccessful.
Traulsen: Are there other markets other than the U.K. on your radar?
Mistele: Yes. We started out in the U.K., because the retail distribution review there plays into our strong suit in the U.S. We're currently looking at the Nordic countries and primarily Switzerland, because of the institutional client base and the private banking relationships. The last estimate I saw was that in the U.K. 90% of the defined-benefit plans are no longer taking participants. We see similar trends in the Nordic countries and in some other European countries. They're moving more toward a defined-contribution model. What that'll look like is hard to say at this point in time. There've been many pension-reform proposals.
I don't think it'll look truly like the U.S. 401(k) model, which has been an area of growth for Dodge & Cox over the past 20 years. It'll have some of the same elements, however.
Christopher Traulsen, CFA, is Morningstar's head of fund research, Europe/Asia.