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    Civil Wars

    The mutual fund industry fights many battles, but is it losing the war?

    Don Phillips, 10/06/2016

    Load versus no-load, active versus passive, suitability versus a fiduciary standard… the fund community has been enmeshed in a continuous string of battles over the past three decades. It’s comforting that the winning side (no-load, passive, and fiduciary) has regularly been the one that provides greater aggregate value for the investor. That implies a certain nobility to the cause and suggests progress for the industry. But before we get too carried away in our celebrations, it’s worth pausing to ask just how much progress has really been made and if these victories were worth the collateral damage they created.

    Propaganda in all wars starts by dehumanizing and vilifying the opponent. In these mutual fund battles, actively managed load funds sold by brokers were vilified, while no-load, passive funds sold by RIAs were seen as the sainted means of investing. Billions of dollars moved from the former to the newly deified means of investing. While it’s hard not to argue that much of this trend is positive, it’s also preposterous to believe that the change is uniformly for the better.

    Twenty years ago, a small investor looking for guidance might well have wandered into his local Edward Jones office, been sold a load fund from Capital Research and then held that fund for decades. It was likely to have been an extremely successful experience, one that put the investor in a far more secure place in terms of his financial future. Over time, it was also likely to have been a very cost-effective means of investing.

    Today, that same starting investor is apt to hear an RIA on a radio show or at a personal finance seminar touting his fee-based practice using low-cost exchange-traded funds. The investor forks over an annual 2% management fee, declining to 1% as assets rise, to his new advisor to gain access to a thematic ETF trading program. Today’s investor has followed all the conventional wisdom—use a fee-based advisor, shun active funds, favor ETFs— but it’s highly unlikely that his plan will be nearly as successful, or as cost-effective, as the now vilified path followed by our investor of decades past who bought American Funds through a broker.

    Of course, there are many investors who will receive great value from their independent advisor today. And, of course, there were many bad brokers who sold expensive, poorly performing funds in the past. I concede that the aggregate changes have been for the better. But I deny that they are uniformly so. The world isn’t black and white. One path is seldom wholly right and the other wholly wrong. But in times of war, that’s the way we view things. Nuances get lost. Much good behavior gets ignored if it’s on the losing side, and more alarmingly, much bad behavior gets excused if it manages to align itself with the winning cause.

    So, the benefits of these civil wars, while real, are not as uniform as they first appear. Let’s now consider the collateral cost of an industry at war with itself. Over this 30-year period, the public enthusiasm for investing has plummeted. Some of that owes to market cycles, but not all. The U.S. stock market is up 175% over the past seven years, and there’s virtually no enthusiasm for investing. Moreover, diversification proved itself a powerful ally over the financial turbulence of the past decade, yet many investors believe it failed them. Costs have come down considerably, yet many believe investing is a rip-off. How can this be?

    To understand, it’s worth stepping back for perspective. The investment industry faces an uphill challenge even during the best of times. Persuading someone to forsake the immediate gratification of consuming goods today in favor of saving for tomorrow is always a tough proposition. It is made harder by the pervasive campaigns of advertisers that tempt us to consume today or the shortsighted agendas of politicians who prefer spending now to boost the economy during their time in office over saving for the future to provide longer-term benefits. These are powerful, entrenched forces that investment firms must combat every day. And in today’s world of targeted Internet advertising and divisive, sound-bite political discourse, the opposing forces to measured, long-term investment perspective have never been more potent.

    The challenge becomes insurmountable when internal bickering over the preferred means of investing dominates the industry’s rebutting message. The industry itself provides the fodder for the very forces it should combat. Investment gains get called unearned income, rather than the more appropriate twice-earned, twice-taxed income. Investment foes paint a picture of investing as something done solely out of greed and only by the evil 1%. Wily politicians capitalize on this twisted sentiment, as Joe Biden did when he boasted that he owns no stocks or bonds in an effort to make himself seem more of a regular guy.

    That our society treats as tainted the responsible activity of living within your means, saving for the future, and investing in enterprises that create jobs and beneficial products and services is absurd. Yet, that’s precisely what’s happened in recent years. While the industry’s civil wars aren’t the sole reason these ideas have taken root, it’s hard to argue that the financial-services industry has been on its A-game in making its case for more saving, more investment, and more of a long-term view. As the need for this perspective is as great as ever, it’s high time for the investment community to stop fighting among itself and to turn those misspent energies to a truly noble cause, that of widening the pool of investors and doing more to ensure that they meet their long-term goals. At the very least, it’s time to get an opposing view to the short-term, consumption-led thinking that dominates today’s investment dialog and political process.


    Don Phillips is a managing director of Morningstar, Inc.