Description

Thesis:

• Over the past few decades, passive management has gained a large amount of market share in the asset management industry, to the point where indexing has an almost dogmatic, cult-like following

• The active management mutual fund industry is facing an inflection point as the DOL fiduciary rule is implemented and fees continue to face dramatic pressure – most actively managed mutual funds struggle to outperform their benchmark indices; in light of this, the DOL fiduciary rule will make it increasingly difficult to justify the sale of actively managed mutual funds and will elevate redemption rates

• It is worth noting that in light of the recent election of Donald Trump, the market has decreased the perceived odds of the DOL being implemented, due to an offhand comment Anthony Scaramucci made that Trump would repeal the rule – I think this has provided an even more attractive opportunity to execute this short

• Given Trump’s populist platform and mandate, it seems likely he would be inclined to support the precepts underlying the DOL rule

• The prediction markets imply that the current undersecretary of Labor, Phyllis Borzi, would be the favorite in a Trump cabinet, and she architected the rule

• Trump will be very busy during his first 100 days and it seems unlikely he would turn his focus to a relatively obscure financial regulation like DOL

• The entire debate around DOL and the steps many financial services firms have already taken to comply may make the actual implementation largely irrelevant; essentially, there already is increased awareness that advisers currently are not fiduciaries, and fees have already been brought into the spotlight and scrutinized

• Given the language around the steps being taken by wealth management firms / banks / etc. to comply with DOL, it would be very difficult to undo those steps and justify those actions as being customer-friendly

• A large portion of actively managed assets will likely shift toward lower-fee index funds and roboadvisors, for better or worse

• It seems likely that roboadvisors will be able to replicate much of the performance of mutual funds using factor based models, and with substantially lower fees

• Waddell and Reed’s poor fund performance, focus on equity funds, and particularly at-risk distribution strategy in the context of DOL make it an attractive short given the broader industry paradigm shift

• The market / sell-side is viewing the situation too linearly: this is illustrated by consensus EPS of $1.89, $1.86, and $1.67 for 2016, 2017, and 2018, respectively, and several analysts estimating fund AUM levels will normalize over the next few years (e.g., MS estimates have only a moderate decline in average AUM from ~$88BN in 2016 to ~$74BN in 2017 and 2018)

• Essentially, the market / sell-side is anticipating that modest AUM outflows will be largely offset by cost reductions

• I view WDR as facing an existential threat whereby large portions of the business can potentially disappear; additionally, I think any potential cost savings are likely going to be muted by increased regulatory and compliance costs due to the DOL rule

• View it as likely that outflows will only accelerate for WDR in the next few quarters and that if performance doesn’t improve, WDR will likely be forced to cut fee rates in an effort to stem the tide of outflows

• As WDR faces continued outflows, expect that the business will face substantial, negative operating leverage; it has become increasingly diversified a larger number of funds, which will make it more difficult to cut costs as AUM declines

Business Summary:

• Waddell and Reed is an active investment manager and proprietor of the Ivy Funds platform. It focuses on a range of actively managed mutual funds, with a majority of its AUM focused in equity funds

• WDR has historically had respectable performance across its fund platform, but post-recession its funds have performed relatively poorly

• Approximately 70% of WDR’s AUM is in equity-focused funds, with the balance in fixed income funds and a small portion in money market funds

• The table below illustrates Waddell and Reed’s fund rankings from several distinct time points:

• WDR has three main channels for distributing its products: 1) Retail wholesale – WDR’s wholesalers work with independent broker-dealers and wealth management firms 2) WDR Advisor Network – WDR’s captive distribution arm of advisors that sell WDR products 3) institutional channel – WDR offers its products to institutional clients, including through subadvisory agreements

• As WDR’s performance has struggled of late, several key fund managers have departed, raising additional concerns about the firm’s ability to turn performance around and maintain / attract key talent

• The table below illustrates a summary of WDR’s fund flows in 2Q16:

Key Trends in Asset Management:

• Over the past few decades, passive investing through indexing has gained traction and become increasingly popular – though it was once seen as ill-advised, it is now seen as an attractive option for investors given the relatively low fees and close tracking of indices

• The trend of investors switching to index funds from actively managed mutual funds has accelerated post-financial crisis given many actively managed funds underperformed the market in the crisis and during the post-crisis market rally

• The increasingly consensus view is that most retail investors should focus on minimizing fees and trading costs – the easiest way to do this is to invest passively

• Recently, a crop of roboadvisor platforms have gained traction – these platforms largely follow simple algorithms aimed at optimizing passive investment strategies by implementing tax loss harvesting, rebalancing, etc., for a relatively low annual fee (BlackRock’s recent purchase of roboadvisor FutureAdvisor  indicates this trend is likely going to continue and larger players in the asset management industry will get involved by either buying or building their own roboadvisor platforms)

• Recent A.T. Kearney report estimated roboadvisors could manage ~5% of assets in 2020

Source: Visual Capitalist

DOL Fiduciary Rule / Potential Impact to Active Management:

• The Department of Labor recently approved the final version of the long-anticipated and somewhat fractious fiduciary rule (much of how the rule will actually be implemented and play out remains to be seen)

• In its essence, the fiduciary rule will impose a much stricter fiduciary standard on financial advisors, as opposed to the previous suitability standard

• Whereas previously an advisor simply had to sell a product that could reasonably be considered to be suitable for the client, a fiduciary standard necessitates that the advisor act solely in the best interest of the client (i.e., under the suitability standard it was sufficient that the product wasn’t grossly unsuitable for the client or opposed to the client’s goals / wishes, the fiduciary standard implies that the advisor must seek out the best possible option for the client to the extent possible)

• In the aftermath of the recent Presidential election, the implied market probability of DOL being implemented decreased; this is largely driven by comments Anthony Scaramucci, a Trump adviser, made regarding DOL that stated that DOL would not be enacted under a Trump presidency

• Given the rule is already final and is scheduled to be enacted in April 2017, I believe it will likely go into effect as written, with the possibility of some further changes later on

• Given Trump will likely be focused on a number of more significant issues during his first 100 days in office, it seems unlikely he would turn his attention to the relatively arcane DOL rule

• Given Trump’s populist platform and mandate, it seems like he would actually be inclined to support the framework of DOL given it is aimed at helping average Americans and actually is a negative for Wall Street

• The prediction markets imply that the current undersecretary of the DOL, Phyllis Borzi, is the favorite to be nominated to be the Secretary of Labor; given she architected the rule, this would make it very likely the rule goes into effect as written

• The rule creates a private cause of action for clients who feel that their advisors provided improper advice

• There are numerous exemptions and exceptions to the rule, many of which were lobbied for by the insurance and asset management industries

• The industry lobbying groups have challenged the law, but I view the legal arguments being promulgated as largely weak and unlikely to succeed, especially in light of the initial decisions

• The rule is only applicable to covered retirement accounts (e.g., IRA’s, 401(k)’s, etc.)

• Nevertheless, many expect the rule will ultimately impact non-retirement accounts as well given it would be difficult for both advisors and advisory firms to bifurcate between being fiduciaries and not being fiduciaries – it is thus likely that the stricter standard will be the binding constraint

• Illustration of the potential impact of the DOL on wealth management firms can be seen by Merrill Lynch’s recent decision to move retirement accounts to a fee-only model and thereby eliminating commissions on those accounts – while this suggests that they are attempting to maintain the non-fiduciary standard for non-retirement assets, it seems unlikely they will be able to maintain this split for long given the obvious questions this would raise from clients

• Merrill is planning on introducing a roboadvisor platform with a fixed 0.45% annual fee and offering factor based, asset allocation in lieu of traditional actively managed funds

• Edward Jones’s recent decision to stop selling mutual funds to commission based retirement accounts is another sign that wealth managers may be hesitant to sell mutual funds to retirement accounts

• While it is often difficult to objectively assess the merits of various financial products given uncertainties around market and asset class performance, inflation, interest rates, and client expectations and life circumstances, among other factors, it seems likely that in the lens of the fiduciary standard, advisors will have a heightened focus on reducing fees as much as possible (i.e., fees are known with almost 100% certainty and will always be a drag on performance, whereas other factors are not known with a high degree of certainty)

• For products with direct indices that they are aiming to outperform or track, fees will be especially important – this will particularly impact actively managed, equity mutual funds given they are aimed at outperforming the market and charge relatively high fees

• Given how easy it is to compare performance to the S&P 500 and other indices, there will be increased pressure to justify the sale of active managed, equity mutual funds

• The importance of fees in the post-DOL environment is highlighted by BlackRock’s recent decision to lower fees on certain of its ETF’s

• Bond funds may be somewhat less impacted given bond market indices are less closely followed by retail investors

WDR’s Captive Advisor Channel:

• Approximately 50% of WDR’s AUM is from its captive advisor network

• Historically redemption rates in this channel have been fairly muted, especially in the context of industry average redemption rates (redemption rates are roughly half that of the industry average)

• This is likely to shift dramatically in a post-DOL environment – view it as unlikely that WDR’s captive channel can maintain muted redemption rate levels in the context of continued underperformance and pressure to focus on reducing the level of fees clients pay

• Interesting case studies can be seen from both Metlife and AIG disposing of their retail captive distribution channels in light of the DOL rule

• WDR has elected to focus on tinkering the advisory platform and offering new fee-based advisory approaches (i.e., paying a fixed fee and receiving allocations to several different WDR funds)

• It seems likely that WDR may ultimately be forced to dispose of its captive distribution arm once DOL is implemented – compliance with the rule is very difficult for advisory channels focus on selling one brand’s products

• Additionally, if this happens, new sales from the channel will decline dramatically and redemption rates for this channel could spike dramatically

• WDR’s elevated exposure to its captive distribution arm makes it particularly vulnerable to the DOL rule

Fund Performance and Expense Levels:

• Historically WDR has demonstrated respectable performance across its fund complex, especially in context of industry norms; however, its performance in the post-recession period has been poor, and shows no signs of improving any time soon

• As has been seen with several notable investment management firms shutting down in the past few years, some investment strategies that have historically worked seem to no longer be working in today’s low interest rate and central bank driven market environment

• This may be the case for WDR because its investment process seems to be unable to produce adequate returns

• The pattern of poor performance may cause a feedback loop whereby poor performance drives fund outflows in conjunction with a flight of top investment talent, which further accelerate performance declines and fund outflows, etc.

• Relative to industry norms, some of WDR’s funds have relatively high expense levels

• In the context of the weak performance, it seems that it would be hard to justify the sale of many WDR products in the lens of the DOL rule

Catalysts:

• Continued fund performance issues and fund outflows

• Potential dividend cut – management team indicated that they will not maintain the dividend at current levels if it is not supported by earnings – given the current high dividend yield and appeal to retail investors, the stock could re-rate if the dividend gets cut

• Potential market correction – many are beginning to sound alarms that the market is fully valued and may correct in the near-term; AUM flow data for WDR indicates that retail investors are particularly flighty in turbulent markets – this dynamic would combine with negative performance to materially decrease WDR’s AUM

• Disposition of captive distribution arm – would decrease sales in the channel and elevate redemption rates in the channel

• Earnings misses as street realizes earnings will decline much more quickly than current expectations

• WDR uses cash to execute an ill-advised acquisition in an effort to stave-off potential impact of the coming industry paradigm shift

Risks:

• It seems likely the asset management industry will consolidate in response to pressure on fund flows and fees – will aim to gain scale with respect to overhead and expenses – that would make certain asset managers acquisition candidates

•  View it as unlikely that someone would seek to acquire WDR given it is one of the worst-positioned asset managers in the context of DOL; if WDR continues to face challenges with its fund complex it seems unlikely someone would want to acquire the franchise; the premium offered would likely be very modest (e.g., recent Janus merger which was a defensive move aimed at consolidation and involved only a modest premium)

• DOL rule scaled back or reversed by Republicans / industry lobbyists – though there are definitely going to be issues and complexities with the rule, it appears the overarching framework is here to stay

• Fund outflows / increase in redemption rates takes longer than expected to materialize – retail investors can be somewhat sleepy so it may take longer than expected for these trends to play out

• Dividend yield is fairly high (~10%) so if the thesis takes substantially longer than expected to materialize than the short can begin to grow expensive; that being said, if the dividend is cut due to weak earnings, this will be somewhat mitigated

Financial Data:

Catalyst

• Continued fund performance issues and fund outflows

• Potential dividend cut – management team indicated that they will not maintain the dividend at current levels if it is not supported by earnings – given the current high dividend yield and appeal to retail investors, the stock could re-rate if the dividend gets cut

• Potential market correction – many are beginning to sound alarms that the market is fully valued and may correct in the near-term; AUM flow data for WDR indicates that retail investors are particularly flighty in turbulent markets – this dynamic would combine with negative performance to materially decrease WDR’s AUM

• Disposition of captive distribution arm – would decrease sales in the channel and elevate redemption rates in the channel

• Earnings misses as street realizes earnings will decline much more quickly than current expectations

• WDR uses cash to execute an ill-advised acquisition in an effort to stave-off potential impact of the coming industry paradigm shift