Comparing the Cost Effectiveness of Service Providers - February 2009
Written by C. Meyrick Payne of MPI & Simon Collier of Sondent Group   

     One of the difficult tasks that a fund director faces involves assessing the reasonableness of the fees charged by either an affiliated or independent service provider. The most frequent services are (1) transfer agency, which typically represents about 20% of fund expenses and is the largest fund expense other than investment advisory fees and distribution fees, (2) fund accounting, which may represent about 5% of fund expenses, and (3) administration, which might represent about the same.  A considerable part of the difficulty is that some tasks might be included under any of the three services, thereby making comparisons tricky. Another difficulty is that the contracts, although reported on a fund-by-fund basis, are typically negotiated on a complex-wide basis.

     In helping fund directors accomplish their responsibility we have found that there are two general approaches: “buy-side” and “sell-side”, and that there are two methods of obtaining data for each. The chart shown below differentiates the two approaches.

Approach to Service Provider Evaluation
 Buy-Side
 Sell-Side
Fund Expense
 1.Select Fund
Peers
 2. Select Complex
Peers
 3. Request for
Information
 4. Request for
Proposal
Transfer Agency,
Fund Accounting &
Administration
 Inexpensive
 but short on
 significance
 Rollup required
 across
 complexes
 Indicative
 but not
 comparable
 Expensive
 and
 disruptive

     The first buy-side approach is most simply accomplished during the typical 15(c) contract renewal process by analyzing the cost for each service on a fund-by-fund basis using one of the proprietary databases, such as Lipper, Morningstar, or Strategic Insight. As a general rule MPI selects peers for fund expense comparisons based on four criteria: (1) same distribution type (i.e. no-load compared to no-load), (2) same investment objective (i.e. growth equity to growth equity), (3) investment style (i.e. large cap growth compared to large cap growth) and (4) similar asset size (because economies of scale often exist in the processing and administration of mutual funds).

     The second buy-side approach involves comparing fund families with roughly the same mix of products and roughly the same aggregate assets and number of funds. The most demanding part of this analysis is to roll up the cost of each function for each fund in a fund family. This requires a sophisticated data retrieval process which adds up detail from numerous fund filings with the SEC.

Illustrative Snapshot of Complex-wide Expense Comparisons
Admin
Fund Actg.
TA
 Complex A
0.01%
0.04%
0.11%
 Complex B
0.06%
0.05%
0.08%
 Complex C
0.11%
0.07%
0.04%
 Complex D
0.05%
0.06%
0.10%
 Complex E
0.02%
0.05%
0.18%
       
 Average
 0.05%
 0.05%
 0.10%
Source: MPI Analysis of Current SEC EDGAR Filings

    The sell-side approach looks at the price which a service provider of transfer agency, fund accounting, or administration services would charge if asked to bid on (a) a request for information basis and (b) a request for proposal basis. Sondent Group has developed significant expertise in these services and has developed extensive benchmarks of comparable information upon which fund directors and managers can reliably base their vendor selection.

     The first sell-side approach, a request for information, involves confidentially asking a few qualified service providers to provide double-blind-basis indicative prices and service levels for transfer agency, fund accounting and administration. In this approach an independent third party sets common definitions of the broad tasks that are incorporated in transfer agency, fund accounting, and administration so that as much comparability as possible is maintained in the indicative bids.

     The draw back of this approach is that the service providers are not bound by their indicative prices and, as result, may underbid. This, in turn, causes unnecessary consternation among the fund directors. Furthermore, some service providers are reluctant to participate in a request for information process on the grounds that the manager or fund directors are merely using the information as a negotiating tactic.

     The second sell-side approach, the formal request for proposal, will often utilize an independent third party to set the RFP process, including defining the detailed tasks implicit in transfer agency, fund accounting, and administration, qualifying the vendors requested to bid, and to evaluating the proposals.

     One of the important tasks for the third party is to ensure that the bids are submitted on an "apple to apples" basis. For example, there are many ways to price transfer agency, including an asset based charge, a per-shareholder account charge, and a fixed price per transaction. The third party has to ensure that the bids received can actually be compared.

     A RFP is an effective notification to the market that the services for a fund complex are genuinely in play. As such the RFP process may produce some unintended consequences, principally that the current vendor begins to lose interest and services levels could decline. If a new service provider is selected the transition process will inevitably take many months, during which the good will of the outgoing vendor is needed.

     Our experience is that a well managed RFP process takes as much as six months and can be very costly. As a result, fund directors and management companies are generally reluctant to change vendors. They would rather work with the incumbent provider to improve service or reduce costs in some other way.

***

     In the event that fund directors are concerned about their service provider’s fees or quality of service, they are obliged to take action, and the most likely course of action is to start with the first buy-side approach and move sequentially through the four strategies outlined above. The fact that the fund directors are being proactive may well cure the perceived problem, and if not a change of vendors is the natural result at the end of the request for proposal process.