Barron's Cover

The Future of Mutual Funds

As the industry’s growth slows, expect the push toward ever-lower expenses to continue, with only the best stockpickers thriving.

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Over the past year, Vanguard took in $224 billion in new money, securing its dominance: More than a fifth of all fund assets are in Vanguard products. Shutter_M/Shutterstock


After a half-century of robust growth, the mutual fund industry seems to have stalled. Overall assets last year dipped 1.4%, to $15.7 trillion, after rising at a 13% average annual pace since 1965, according to the Investment Company Institute.
 
The blame lies not with poor market performance, but with investors pulling their money out of traditional mutual funds in droves—a trend fund-tracker Morningstar has termed “flowmageddon.”
 
Some companies have been hit particularly hard, whether because of high costs or subpar investing results. Among the giants, the biggest losers have been Pimco, with $46 billion in investor withdrawals, leaving it with $301 billion in its funds, and Franklin Templeton Investments, which saw $44 billion leave the firm, giving it $387 billion in fund assets.
 
The biggest gainer, by far, has been Vanguard Group, where assets have climbed 7.2%, to $3.1 trillion, from a year earlier. No other firm comes close to Vanguard’s success, thanks to its combination of low-cost products—both traditional mutual funds and exchange-traded funds.

Over the past year, the firm took in $224 billion in new money, securing its dominance: More than a fifth of all fund assets are in Vanguard products.
 
BlackRock is gaining ground, as well, thanks to its iShares ETFs. The firm took in $83 billion over the past year, all of which went into the ETFs. All told, BlackRock (ticker: BLK) has just over $1 trillion in its retail funds, placing it fourth in terms of industry share. Capital Group’s American Funds, the second-largest fund group, with $1.2 trillion, saw inflows of $5.6 billion, while Fidelity Investments, No. 3, suffered $14.5 billion in outflows. American and Fidelity both have roughly an 8% share of the fund market. (Morningstar provided Barron’s with the industry’s flow data for the 12-month period ending in May.)
 
SPLITTING THE FUND INDUSTRY into active versus passive camps when assessing winners and losers is in vogue. It’s certainly worth noting that Pimco and Franklin have mostly active funds, while Vanguard and BlackRock are best known for their low-cost index funds and ETFs.

In the past 12 months, investors have pulled $308 billion out of actively managed mutual funds and poured $375 billion into passive mutual funds and ETFs.
 
But a more nuanced look at fund flows reveals what should be an obvious truth about the industry: Performance matters. Active management is being challenged, no doubt—on average, active managers underperform their benchmarks—but the top performers are still holding their own while the laggards are losing money hand over fist.
 
Using the Barron’s/Lipper 2016 Fund Family Ranking as a guide, the 10 fund shops with the best performance saw a median outflow of $598 million over the past year. If that sounds bad, consider that the 10 laggards lost a median $3.8 billion.
VANGUARD IS PICKING UP the industry’s pieces—but it isn’t just a passive affair.

Some $28 billion of the firm’s inflows went into actively managed funds. That gives them more than any other active fund shop—DoubleLine Capital is second with $16 billion. Clearly, investors are not eschewing active management for passive. But they are voting for low costs.
Industrywide, equity funds with expense ratios in the lowest quartile attracted $611 billion over the past 15 years, according to Vanguard’s research. All other funds suffered outflows.

This hasn’t been lost on the big money managers. Last month, Fidelity dropped the average price on its passive funds to 1/10th of 1%, undercutting Vanguard, which has been a low-cost evangelist for decades.

“This is something we’ve been talking about for 42 years,” says Vanguard CEO William McNabb. “But when you’re in the 1990s and you’re averaging 15% in equities, people just weren’t that interested in hearing the story.” More investors have bought into Vanguard’s vision now that a balanced portfolio is likely to return 5% a year over the coming decade, McNabb says. “If you’re paying 1% for that, you’re paying 20% of your return,” he notes.
 “Cost becomes so much more important in that kind of environment.”

This may strike some as obvious, but many obvious truths have been obscured by the way the industry has sold its products. Right now, what you pay for a mutual fund often depends on how—and through whom—you purchase the fund. The rampant use of share classes means that the same fund can have vastly different costs—and vastly different performance as a result. Fund companies strike different deals with different distributors— Charles Schwab (SCHW) versus Merrill Lynch, for instance—and the costs that fund companies would incur to be sold via a particular platform instead get passed on to investors.

Institutional share classes are generally the cheapest, intended for buyers investing $500,000 or more. This can include 401(k) plans and advisors who make large fund purchases on behalf of their clients. Everyday investors pay retail.

For example: At its priciest, the $86 billion Pimco Total Return fund (PTTAX) charges annual fees of 0.85% and comes with a 3.75% upfront sales charge, known as a load. The institutional share class of Total Return costs just 0.46%, with no sales charge. The more expensive retail shares have returned 5.9% over the past 10 years, whereas the cheaper institutional shares have returned 6.4%. Fees explain the difference. Over a 10-year period, that amounts to nearly $4,000 on a $50,000 investment.

SHARE CLASSES ALSO ACCOUNT for how much advisors make, but that’s about to change. In April, the Labor Department issued a rule that will require advisors to act as fiduciaries when choosing funds for retirement accounts. That means they must put their clients’ best interests first. Again, that’s something that seems as if it ought to be obvious, yet very often was not.

A fund’s load, as well as a portion of its higher fees in some share classes, is intended to compensate advisors. But commission-laden funds can put an advisor’s interests at odds with the clients’ interests—simply, good returns. Investors have grown wary of the practice, flocking to advisors who charge a flat fee, usually a percentage of assets. If clients’ portfolios are growing, so are the fees the advisor collects—an arrangement that keeps interests aligned and one that is compatible with the fiduciary standard.

At some point, the Securities and Exchange Commission will probably extend the fiduciary rule to cover all investment accounts. But even if it doesn’t, the new DOL rule is likely to become the de facto standard.

“There’s been so much cost put inside [mutual fund] share classes to incent people to sell one product over another,” says Charles Goldman, CEO of AssetMark, a technology and investment platform for independent advisors. “Under the DOL model, that doesn’t work. Advisors should buy the best product for the client.”

In many cases, the best product will be a low-cost, broad-based passive fund tied to an index of stocks or bonds. But this isn’t the death knell for active management. For starters, the latest passive craze—smart beta—is actually a form of active management. While based on an index, smart beta aims to beat the market by screening stocks based on a variety of metrics, such as volatility, price/earnings ratios, or dividends.

“It’s just another form of taking active risk,” says Joel Dickson, Vanguard’s global head of investment research and development. “This discussion of index versus active is much too blunt of a description.” Vanguard offers what some would call smart beta, such as its $22 billion Vanguard Dividend Appreciation    ETF (VIG), but the firm has so far been conservative in its smart-beta offerings.
 
OLD-FASHIONED STOCK-PICKING still has a place, as well. Cohen & Steers(CNS), an asset manager that specializes in real estate and infrastructure funds, saw $1.1 billion in inflows over the past 12 months—an impressive feat given that the firm has just $19 billion in fund assets, per Morningstar. The company’s latest annual report takes a strong stand on the future of active management: “It is time to acknowledge the truth. Long-only active management in its current form is no longer a growth industry.”
 
The firm says it will remain focused on specialty asset classes that are “well suited to active management.”

Even as the core of many investors’ portfolios becomes passive, actively managed funds could be used to provide growth and special opportunities. And here is where smaller firms can shine.
Companies like Harding Loevner, William Blair, and Primecap Management, which offer fewer funds and focus on keeping their stock-picking truly active, all had inflows in the past year. So did J O Hambro Capital Management, a London-based active manager with $4.5 billion in U.S. fund assets. CEO Gavin Rochussen says he sees active management becoming “the new alternative.”
 
But for now, swarms of investors are dumping active management—often to their detriment. Take Fidelity Contrafund (FCNTX), one of the world’s largest active stock funds, with $106 billion in assets. For a quarter of a century, manager Will Danoff has beaten the market by an average of three percentage points a year. But for some investors, logic no longer means much. Over the past year, investors have withdrawn $2.6 billion from Contrafund. Of course, the fact that the fund charges 0.7% despite its massive economies of scale may dissuade some investors. It’s worth noting that the average actively managed stock fund charges 1.2%, according to Morningstar.
 
THE FUND INDUSTRY has spent the past few months fretting about the impact of the Labor Department ruling. But many pros see real benefits. Shortly after the ruling, BlackRock CEO Laurence Fink told investors, “We need to have more investor confidence. If they believe the DOL rules will give them better transparency, better certainty that they’re being treated right, and they invest more money for the long run, it’s better for the country, it’s better for their financial future, and it’s really very good for the entire industry.”
 
Like any regulation, though, there could be unintended consequences. Rob Arnott, CEO of Research Affiliates and a smart-beta innovator, sees lurking problems. He worries that risk-averse advisors, fearful of running afoul of the new rule, will push investors into index funds, smart beta, and other investments that have had recent success. Advisors “can’t get sued for recommending something that has performed beautifully in the past,” Arnott says. And as we all know, past returns don’t mean much when it comes to the future. “So the DOL will be a big impetus to passive investing and performance chasing,” he says.
 
Another downside: As the rule pushes advisors into fee-based models, some clients will be shoved aside. A family or individual with $200,000 in assets won’t be worth the $2,000 in annual fees generated for an advisor. The good news is that technology has arrived in time to pick up the castoffs.
 
FOR THE MASS AFFLUENT, mutual funds, ETFs, and other products will be increasingly distributed via software-driven platforms, also known as robo-advisors. New York–based robo firm Betterment now has $4.9 billion in assets under management. Silicon Valley’s Wealthfront has $3.5 billion, at last count. But this technology-led upheaval isn’t like the ones that upended the music, publishing, and television industries.
 
Instead, Scott Burns, Morningstar’s global head of asset-management solutions, likens the robo movement to the 1990s advent of online banking.
 
“Online banking didn’t rise up and put Wells Fargo and Chase out of business,” Burns says.
“The banks built their own. Online banking was great for the customer. And it was great for the bank because it was superscalable and really lowered their cost.”
 
So who suffered? “It was bad for the bank teller,” he says. In today’s robo world, the bank teller is the advisor. But, Burns notes, in this case the advisors are the ones turning clients away. Established players like Vanguard, BlackRock, Fidelity, and Schwab are happily picking them up with their own low-cost services.
 
One year after its launch, Vanguard’s Personal Advisor Services platform has $41 billion in assets. The service uses a hybrid of technology and human call centers to dole out holistic investment advice. Schwab has about $7 billion in its new Intelligent Portfolios robo platform.
And BlackRock recently acquired robo firm FutureAdvisor to help its banking clients build out their own wealth management platforms.
 
Fidelity has been broadening its platform for years. The firm has $2 trillion in assets under management, and a total of $5 trillion in what it calls “assets under administration.” The larger figure includes money in non-Fidelity products held in Fidelity-managed accounts, like 401(k) plans and brokerage accounts. Fidelity has broadened its passive offerings, for instance, by partnering with BlackRock, whose iShares ETFs are available commission-free at Fidelity.com.
 
Brian Hogan, who runs Fidelity’s equity investment division, has been at the firm for more than two decades. Over that period, Fidelity’s assets under administration have grown faster than its assets under management—“and that’s been a purposeful strategy,” Hogan says.
“We’re able to do that by offering Fidelity and non-Fidelity products. The rationale is not, ‘Do we make more money selling a Fidelity fund or a non-Fidelity fund?’ What we think about is what’s the best possible solution for our shareholders and our customers.”
 
“What’s happened,” he continues, “is we have transformed ourselves from an equity-centric mutual fund complex into a very diversified financial-services company.”
 
Whether it be regulations, technology, or changing investment behavior, disruption is nothing new for the asset-management industry. “Pretty much in every decade there has been a major tectonic shift in the business,” says Vanguard’s Dickson. “Whether it is the money-market mutual fund of the ’70s and early ’80s, or the index-fund adoption in the late ’70s and its takeoff in the ’80s and ’90s, or the growth of ETFs and target-date funds in the most recent 10 to 15 years, there has always been some sort of major thing. When you look back over 10-year cycles, that’s a lot of change. Investors are demanding and using different approaches.”
 
SO WHAT WILL THE INDUSTRY look like 10 years from now?
 
Low costs, high returns, good technology, and big-picture thinking will be the recipe for success. The retail fund world will look more and more like institutional investing, meaning that low-cost passive investments will be complemented by sophisticated stock-picking and alternative assets, all under a fiduciary framework.
 
Vanguard and BlackRock already fit the bill. And don’t count out other players with big scale.
Fidelity can afford to take risks, and it should. Smaller fund shops that put a focus on quality stock-picking will always have a place. And smart-beta firms are carving out a niche that could lead the fund industry forward.
 
TECHNOLOGY WILL BE THE NEXUS of all change. ETFs and smart beta owe their success to tech innovation, but as much as asset managers gloat about technology, they barely scratch the surface of what’s possible. In fact, the industry looks like a dinosaur compared with much of Corporate America. Think about the data that Amazon.com (AMZN) has on its consumers.
Or Alphabet GOOGL ’s (GOOGL) Google. Even Target TGT  (TGT) knows far more about its customers than do financial firms.
 
“Would we build financial products differently if we actually knew about people?” asks Morningstar’s Burns. “It’s really taking big data and putting it to work. It’s one of the huge opportunities for asset managers. They still have investment expertise. And there is a lot of value in knowing when to buy—there’s a lot of alpha just in that skill. But how do you reimagine a world where you get all this data?”

Vanguard’s Dickson says technology can bring high-end customization to the mass-affluent investor, far beyond the fund world’s traditional competency. Asset managers will be able to provide insurance, financial planning, and tax guidance.

“What technology is doing is enabling all of that to come together and be evaluated holistically instead of in these silos,” he says. “The private client of today will be the ‘every client’ of tomorrow.”

Insurance recommendations could be tied to return assumptions, and vice versa. Of course, if the fund companies get into the advice-giving game, they’re going to have to give real advice, and they’re going to have ask better questions than how old are you and when do you want to retire.

Again, technology is the answer. Fund firms could build far better products if they knew about investors’ mortgages, credit-card debt, student loans, and medical bills—all easy to capture with today’s technology. Credit-card statements could be analyzed to create a better risk profile. How large is your balance? When do you pay your bill, and is it in full or at the minimum? Privacy concerns will need to be addressed, but investors could benefit. Asset managers could finally provide Amazon and Netflix-type recommendations.

There’s no reason that high-tech solutions should be limited to shopping and TV. Today’s threats, if handled properly, should become opportunities for both investors and the fund industry.

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