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  • Home>Research & Insights>Phillips Curve>What a Tangled Web We Weave

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    What a Tangled Web We Weave

    Investors want simplicity; fund industry keeps creating mazes.

    Don Phillips, 06/02/2017

    The mutual fund industry spent much of the past 30 years complicating its offerings. Investors have spent the past decade seeking simplicity.

    The classic virtue of a mutual fund is that it’s an easier choice than assembling a diversified portfolio of securities yourself. The earliest funds were balanced funds that combined stocks and bonds to form an elegant solution for an investor seeking a simple, one-stop way to participate in the investment markets. Human nature being what it is, however, the industry was not content to let a good solution stand. Instead, it began to tinker and add more choices, but also more complexity. Funds that bought just stocks or just bonds were created. Sector funds, style-based funds, capitalization- based funds, regional and international funds, and many other innovations followed. In addition, many more management firms entered the business, greatly increasing the number of choices investors faced.

    In the 1980s, this innovation shifted to new ways to price mutual funds. With the growth of the industry and the popularity of funds in individual retirement accounts came a slew of financial journalism helping guide confused investors. These publications shared a common mantra: Whatever you do, insist on buying a no-load fund. Predictably, this counsel sent millions of Americans to their brokers requesting to be sold a no-load fund. Never one to miss a sale, the industry responded by shifting around charges to create B and later C share classes that abandoned a front-end load but still offered a similar compensation level for the advisor. With these new share classes, and the many that followed, the act of choosing a fund became even more complex. Now, not only did the investor have to sort through dozens of fund flavors from hundreds of sources, but she also had to claw through a maze of different pricing options.

    To make matters worse still, U.S. mutual fund investors have been saddled with some of the most complex taxation rules for their fund investments anywhere on the planet. In the vast majority of countries where funds are sold, investors only pay capital gains taxes when and if they sell their funds. There’s no guesswork about what hidden taxable events may be sprung on the investor in late December and trigger added complexity come the April tax filings. But in the United States, mutual funds are forced to make annual taxable capital gains distributions if net gains are realized internally at the fund, resulting in tax headaches for shareholders that investors in much of the rest of the world avoid. And if there’s one kind of complexity investors loathe most of all, it is tax complexity.

    From every thesis sprouts an antithesis. Investors have responded to wave after wave of added complexity by purposely trying to streamline their financial lives. They’re opting for the investment simplicity of indexing over choosing active managers, moving to exchange-traded funds, which shun the numerous pricing options of conventional funds, and preferring indexed ETFs for their internal structuring mechanisms, which limit capital-gains distributions. In short, investors still value the core virtue of simplification that the industry has trampled over. Clean share classes, without all the cost and noise of distribution payments, are increasingly the vehicle of choice. Simple indexes, rather than one manager’s idiosyncratic take on the market, are the preferred building blocks. And ETFs, available from any brokerage platform, rather than funds that had selling agreements with some platforms but not others, have become the preferred choice of many investors.

    The industry has responded in predictable fashion—by complicating these new choices. We’ve already witnessed scores of new index launches. In the same way that there are more funds than stocks, today there are more indexes—the total is in the millions—than there are current funds. ETFs have migrated into ever more esoteric fields, with new investable indexes created every day. Smart- or strategic-beta funds offer numerous twists on standard indexes, offering more choice, which is good for some, but at the cost of greater complexity, which intimidates many. Despite investors’ demonstrated preference for simplicity, the machinations of the mutual fund industry seem able to produce only one outcome: complexity.

    So stands today’s fund industry. It offers the individual investor options that only the most connected of professionals could have accessed 30 years ago. That’s the good news. But in meeting the ever-more-esoteric needs of the narrowest niche markets, the industry continues to put at risk one of its most salient virtues, the virtue of making it easier for investors to participate in the power of the markets. Today’s investors are inundated with choice to the extent of paralysis. The challenge facing the industry as it moves forward is not to supply investors with yet more options, but to help them better navigate the maze they already face. The issue is better deployment of the tools already given them, not a need for yet more options. The solution will call on different skills than those the industry has showcased to date.

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    Don Phillips is a managing director of Morningstar, Inc.