Putting investors first made the industry great.
This year marks the 75th anniversary of the 1940 Investment Company Act, a landmark piece of legislation that set the U.S. fund industry on the path to success. Importantly, the 1940 act places stewardship at the forefront of the industry. It protects investors by creating safeguards and checks on the management of their money, not the least of which is the choice to make these entities investment companies, not investment contracts. There’s no stewardship in the writing of a contract. One party writes it, and the other chooses whether or not to sign. In contrast, stewardship is front and center in the corporate model where the asset manager works for shareholders and an independent board is tasked with representing and protecting shareholder rights.
While the 1940 Act brilliantly lays out the letter of the laws by which the U.S. fund industry operates, its spirit slowly faded as fund companies chose to downplay the corporate nature of funds and the notion of funds as consumer products took root. The situation deteriorated so much that by the time I joined Morningstar in the mid- 1980s, it was common to go to fund industry events and be told that “mutual funds are sold, not bought,” reflecting the belief that investors were sheep to be fleeced, rather than owners to be served. The prevailing attitude was that it was a seller’s market and investors’ rights or protections need not be top of mind.
This mindset prompted asset managers to try to “own distribution.” It was widely felt that the biggest asset managers of the future would be banks and brokerage firms that already had large client bases through which they could force product sales. The quality of the product was a secondary concern—so long as it wasn’t dreadful, investors could be kept complacent, blindly paying fat fees for mediocre performance. The competitive landscape of the time reflected this view. Giant brokerage firms were among the largest, most dominant asset managers. Noload firms like Dodge and Cox, Vanguard, and Acorn were fringe players at best—curiosities for those in the know, but not power players in the industry. Distribution power towered over investment merit in the perceived hierarchy of the day.
Today, the opposite is true. The investor is no longer marginalized and has instead returned to the top position on the ladder, as the 1940 act described. Today, it’s difficult to peddle a mediocre fund and darn near impossible to sell one with a scarred performance record. That doesn’t mean that bad ideas don’t get rushed to market and that every fund is good, but by and large, assets flow to better-proven, lower-cost funds. Once-niche players like Dodge and Cox have become leaders. Low-cost shops like Vanguard dominate, and the once-mocked index fund has become the default investment option for many investors.
The asset-management industry did not choose this path, but to its credit, it did respond to market forces and evolve in response to client demands. To my mind, the major catalyst for these changes was the rise of the independent financial planning movement, men and women who put their clients’ interests ahead of any parent firm’s interests. These advisors demanded better results, lower fees, more transparency, and better service. The move to a market where funds are bought, rather than sold, didn’t come about because every individual investor suddenly became an informed player. Rather it was that buyers’ representatives, in the form of independent advisors, 401(k) committees, financial columnists, and other advocates, insisted on better treatment for their clients or readers. In short, these buyers’ representatives embraced stewardship and forced the industry back to the spirit that guided the 1940 act. As these parties became engaged stewards, they raised the bar on the stewardship of the asset managers that they selected. They opted not to recommend firms that touted the latest investment fad or ones whose pricing made their funds a poor price/value proposition. Asset managers who responded to these concerns won market share. Those who tried to perpetuate the old model lost.
As Morningstar dug deeper into stewardship at the asset-manager level, we learned that fund companies define themselves by the products they offer and the way they bring them to market. Sales-oriented cultures tend to ask if a fund will be easy to sell. Stewardship-oriented ones ask what type of client experience they are likely to create. While asset managers do not have complete control over the investment experience, that doesn’t mean that they can’t exercise any degree of control. High fees in a low-return market are unlikely to create a good investor experience. Funds launched into bubbles are doomed to disappoint. Fund names that disguise risks are also likely to create bad investor outcomes. Recall the “North American Government Bond” funds that managed to get scores of investors into Mexican debt just in time for the peso crisis.
Our stewardship work is an attempt to create an institutional memory of the past actions of asset managers, so that investors have the facts on who’s been tempted by the quick buck and which firms consistently put investor interests first. The slippage of the U.S. fund industry back in the 1980s and 1990s from the spirit of stewardship embedded in the 1940 Act should serve as a stark reminder that unless shareholders, advocates, and regulators remain vigilant in demanding good stewardship, this industry may lose the very virtue that makes it great. There are pockets of the exchange-traded-fund and alternatives space that likely are slipping today. There are still many markets outside of the United States that fall short in terms of investor rights. Stewardship is not a one-time thing, but something that needs to be embedded in the industry’s DNA, if investors are to be well-served. Asset management must always remain an industry where excellence is measured not by quarters or years, but by decades.