Op-Ed

The Global Fund-Leadership Playoffs: Europe vs. the U.S.

Robert C. Pozen and Theresa Hamacher

Europe has pulled ahead in the competition for leadership in the global fund industry, pushing the
United States, the longtime pacesetter, into second place. While the European fund model is
rapidly gaining acceptance in all parts of the world, U.S. funds remain strictly a domestic affair. As
a result, European funds have been growing at a much faster pace than their U.S.
counterparts–and we believe that Europe will continue to win this race unless the United States
makes some significant changes to its ground rules for mutual funds.

Even with the success of the European model, the U.S. fund market remains the largest in the
world, with assets topping $11.1 trillion at the end of 2009–accounting for more than half of fund
assets around the globe and equal to 78% of the U.S. gross domestic product that year. Almost
one fourth of U.S. household financial assets are invested in funds–the highest penetration rate in
the world. The size of the European fund industry pales in comparison; it’s about one third
smaller, with assets of only $7.4 trillion, equivalent to just 51% of the European Union’s gross
domestic product.

But while the United States still leads in size, asset growth in Europe has been much stronger.
From 2000 to 2009, assets in U.S. funds increased by 5% per year, a respectable pace given the
considerable turmoil in the markets and economy during that decade. During that same period,
however, European funds grew by a much more substantial 8.9% annually, while facing similar
macroeconomic challenges.

Europe’s premium growth rate isn’t just a larger percentage gain off a lower base. Rather, it’s the
result of the region’s better positioning in the global fund marketplace. Europe dominates crossborder
distribution of funds and is far ahead of the rest of the world in making more complex
investment strategies available to fund investors. Still, U.S. funds remain world leaders in one
very important respect: They are, overall, the lowest-cost investment vehicles available to
investors.

Let’s take a look at how the European and U.S. fund industries compare along these three
dimensions: cross-border distribution, access to sophisticated strategies, and investor costs.

Cross-Border Distribution
It was perhaps inevitable that Europe should lead the way in cross-border distribution of funds.
After all, one of the earliest goals of the European Union was the promotion of free trade among
member countries, and over the years, Europe has been steadily removing barriers to commerce
in goods and services within its borders.

That includes the cross-border distribution of investment funds, which has become much easier
thanks to the UCITS regulations–first adopted in 1985 and modified twice subsequently. This
regulatory framework allows an investment manager to register a fund in one EU country and sell
the fund in all EU member states. As long as the fund complies with the UCITS rules, the fund
automatically receives a passport to enter all EU markets. Today, about 75% of the European fund
assets are in UCITS funds. The brand has become so pervasive that many industry professionals
have to think twice before they can tell you what the acronym stands for. (It’s “Undertaking for
Collective Investment in Transferable Securities.”)

Like U.S. mutual funds, UCITS are subject to strict government oversight. With this scrutiny,
investors have a high degree of confidence that they know what they’re getting when they put
their money into a UCITS fund. Investors also have access to that money when they need it;
UCITS must allow investors to withdraw cash at least twice monthly, although most permit daily
redemptions, just like U.S. funds.

Unlike U.S. funds, however, UCITS are not required to distribute all their income annually, giving
UCITS a significant edge when it comes to taxation. Investors in a UCITS fund pay taxes on
capital gains only when they sell their fund shares–even if the fund realizes capital gains on its
portfolio before then. By contrast, owners of a U.S. fund may be hit with a tax bill whenever their
fund sells investments at a gain, even if they continue to hold their shares in the fund. As a
result, U.S. funds are tax poison to non-U.S. investors–no rational person would willingly ingest
them when there are more tax-efficient options available.

Investors around the globe–not just those in Europe–turn instead to UCITS, which provide an
attractive combination of tax efficiency, regulatory protection, and ready liquidity. UCITS have
proved particularly popular in emerging economies–which have an expanding middle class with
assets to invest, but generally don’t have a home-grown investment industry. UCITS have a
dominant share of the funds market in Hong Kong, Singapore, and Taiwan; Latin America has also
been a key contributor to the rapid expansion of EU-based UCITS funds.

U.S. fund managers who want to benefit from growth in the developing markets find that they
have little choice but to jump on the UCITS bandwagon. They set up a subsidiary in an EU country
that creates a family of UCITS funds for sale around the world. Because this subsidiary is largely
staffed by Europeans, the result is an export of jobs from the United States.

Access to Sophisticated Strategies
Yet the broad appeal of UCITS stems from more than their tax efficiency. They have the
investment flexibility that allows them to meet the needs of a wide range of investment
objectives. Not only can investors buy stocks and bonds through traditional UCITS, but they can
also now engage in complex investment strategies–previously available almost exclusively to
investors in hedge funds– through “alternative” or “sophisticated” UCITS.

These funds are known as “NewCITS”– perhaps a misnomer, because “new” implies a
fundamental break from the long-established UCITS framework. Fund industry officials in
Luxembourg, the largest home for UCITS, are quick to point out that NewCITS will be subject to
the same government oversight as their more-traditional counterparts. In fact, regulation of
NewCITS may turn out to be more stringent, because member states are likely to limit their sale
to only those investors who meet suitability requirements. In addition, NewCITS are subject to
regulatory limits on the overall level of risk that they can take. That’s a big difference from hedge
funds.

NewCITS clearly have the advantage over hedge funds when it comes to fees paid by the investor.
Contrast the management fee charged by many UCITS–generally in the range of 1.5% to 2.5% of
assets per year–with the “2 and 20” structure imposed by the typical hedge fund, which gives the
manager 2% of fund assets per year plus 20% of the gains on the fund’s investments (but not
minus 20% of the losses). NewCITS are a middle ground between traditional funds and hedge
funds, in terms of both investment risk and cost, giving overseas investors a choice that’s not
readily available in the United States. Because U.S. mutual funds are subject to fairly strict
regulatory limits on shorting and leverage, they don’t have the flexibility of NewCITS. As result,
U.S. investors who are interested in a more complex approach usually turn to hedge funds, with
their dramatically different risk and cost profiles.

Investor Costs
On the other hand, U.S. mutual funds have one very significant advantage over UCITS: They are
the most cost-effective investment vehicles in the world. Keeping a dollar invested in a U.S. fund
costs less than 0.9% per year–while the typical UCITS costs more than twice as much.

U.S. funds have such a cost advantage largely because funds are much bigger in the United
States. At the end of 2009, the average U.S. mutual fund had $1.4 billion in assets– more than 6
times the size of the average European fund. Bigger funds normally create at least some
economies of scale for U.S. fund managers, who can pass cost savings in administration and
customer service on to investors in the form of lower fees. The size gap is largely due to the sheer
number of Europe’s funds–33,000 in 2009 compared with 7,600 in the United States. That means
that Europe’s total assets–which are smaller than those of the United States–are spread over
more than 4 times the number of funds.

Funds have proliferated in Europe for two reasons. First, European fund managers often set up
funds that are sold in a single country–to accommodate the Danish preference for bonds, for
example, or the Swedish enthusiasm for stocks. The United States is more of a single-securities
market. With the exception of state and local tax-free bonds, investors in Alabama have much the
same reasons for buying funds as investors in Wyoming. Second, salesforces in Europe like to
promote new funds with innovative investment approaches or features, while U.S. investors tend
to favor funds with long track records.

One of the key reasons that U.S. investors prefer longevity is because they use funds extensively
in retirement plans. At the end of 2009, about one fourth of total private retirement savings was
invested in mutual funds. Funds made up an even higher proportion–about half–of the assets in
the fastest-growing retirement savings vehicles, individual retirement accounts and 401(k) plans.

This heavy representation in retirement plans is a unique advantage for U.S. mutual fund
managers when it comes to gathering assets. Europe and the rest of the developed world provide
pensions largely through Social Security-like public plans, which pay benefits to retirees by taxing
current workers, with no role for mutual funds.

There is yet another factor that has helped drive down U.S. fund costs: fierce competition. “Open
architecture” is almost universal in the United States, which means that investors can choose from
a wide variety of funds from many different providers in virtually every investment vehicle. In this
crowded environment, attractive pricing is one way that fund-management companies can appeal
to investors and their advisors. In addition, options available to U.S. investors are almost certain
to include index funds and exchange-traded funds, with their low costs. In Europe, by contrast,
neither open architecture nor index products have gained such widespread acceptance. Fund
distribution tends to be dominated by a handful of local firms that control the fund selection and
may prefer the high-priced house brand.

Looking Ahead
UCITS have already taken the lead in the fund industry, and their margin of victory is rapidly
expanding. If Europe can make progress on reducing fund costs, it will soon eliminate the last
advantage remaining to U.S. funds. To do this, the European Union will need to:

  • Eliminate the remaining barriers to cross- border sales of funds in Europe, creating a truly
    unified market for investment funds, allowing fund managers to offer fewer funds that each gather
    more assets than is common now. The most recent UCITS regulations go a long way toward
    realizing this goal. UCITS IV makes it more difficult for countries to impose their own additional
    regulatory requirements while making it easier to pool assets across borders.
  • Support more open architecture within Europe, leading to a more competitive market for funds
    and lower prices for consumers. Although distributors may resist this trend, investors will
    increasingly demand the best funds available, regardless of who manages them. This demand–
    combined with more regulations requiring disclosure of conflicts of interest–will slowly lead to
    greater openness.
  • Expand the size of its internal market by promoting private retirement savings. If even a small
    portion of these savings are invested in funds, it will increase economies of scale for fund
    managers and enable them to lower costs for investors. Unfortunately, given the tremendous
    popularity of public retirement programs in many parts of Europe, support for private savings
    plans will likely be limited to only a few countries, such as the United Kingdom.

And what must the United States do if it wants to come from behind and recapture the lead from
the European Union? The United States needs to:

  • Harmonize tax treatment of U.S. funds with their treatment in the rest of the world, so that fund
    investors are taxed on capital gains only when they redeem shares from a fund. This is a
    necessary first step to making U.S. funds attractive to non-U.S. investors. But this step will be
    difficult to get through a deficit- focused Congress because it’s likely to reduce tax revenue, at
    least in the short term.
  • Negotiate mutual recognition agreements with other countries once tax harmonization is
    achieved. These agreements would allow U.S. funds to be sold in Europe and other regions.
    However, mutual recognition is likely to be controversial, because it will allow the sale of non-U.S.
    funds within U.S. borders for the first time since the New Deal.
  • Give U.S. funds the flexibility to compete with NewCITS, enabling U.S. funds to appeal to a
    broader range of investors. This change would not be difficult technically because it could be fit
    into current U.S. regulations for mutual funds with a few changes. Nevertheless, it would require
    new approaches to monitoring risk levels and to ensuring that funds are marketed and sold
    appropriately.

There are obviously significant obstacles to the United States moving forward on any of these
initiatives, but the cost of inaction could be even greater. Without a change in the ground rules for
mutual funds, the United States risks becoming a minor-league player in an industry that it
created, watching on the sidelines while the World Series is contested overseas.

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