ETFs bring managed investment products into the digital age. Goodbye, 1940.
This article first appeared in the August/September 2011 issue of Morningstar Advisor magazine. Get your free subscription here.
We are often asked why passive investing and exchange-traded funds are gaining so much traction these days. The answer we think most folks are looking for is that the investing world--burned by the market turmoil of 2008--has accepted that active managers have a hard time beating the market. While that may be true to some extent, we don't believe it is the cause for the dramatic shift in fund flows from active to passive investments. (In June alone, about $19 billion flowed out of active mutual funds, while passively managed funds had inflows of nearly $1.1 billion.) After all, the data on active management's ability or inability to deliver alpha on average has been available for decades. Even with that, money has continued to flow to underperforming and mediocre funds and managers. In an efficient market, this kind of behavior is unlikely, but that is the point--the asset-management world is not an efficient market. At least that was the case until a few years ago.
The flows tell the story that asset managers and distribution middlemen themselves don't want to believe. The times they are a-changin', and how these groups sell their wares to institutions, advisors, and individuals is being disrupted by very unlikely sources. The first disruptor is advisors' adoption of fee-based and fiduciary models and standards. The second is the technological advancements of ETFs and the national stock exchanges they trade on. We are in the early rounds of this sea change, but if you believe in efficient markets, as we do, then how this ultimately plays out is academic at this point.
Commission's Last Stand
The mutual fund industry is fighting a battle it may be better off surrendering. The SEC is reviewing the structure and transparency of the nefarious 12b-1 fee, and some industry insiders see preserving most of the current elements of this compensation mechanism as critical to their survival. At the heart of all of this regulatory scrutiny is an attack on the primary mechanism for how mutual funds are sold: commissions. Commissions to advisors, wholesalers, platforms, and supermarkets and the value each delivers to the end investor are what this fight is all about.
It may come as a surprise to some, but all of this regulatory wrangling over fees and disclosure is ultimately a lot of energy wasted. Progressive advisors did not wait for regulators to decide that all of these commission shenanigans weren't good for investors. They have adopted fee-based models that don't leave much room for commissions. By aligning their revenue and compensation streams with the fortunes of their clients, advisors have also removed commissions, a source of market inefficiency. It really shouldn't come as a surprise how advisors allocate their clients' money now that it is their own. They keep costs low, they stay diversified, and they do not churn the portfolio. They buy the best-performing funds, not the best-paying. More and more advisors, especially with new clients, are adopting the fee-based model, and this is what is driving the flows into passive and low-cost vehicles at such astounding rates.
While this has been happening organically in the U.S. market, the regulators have a chance to speed this process up by accelerating their plans to make the fiduciary standard more broadly applicable. While this is debatable, it is our opinion that fiduciary equals fee-based. Anecdotally, major wirehouses and independent advisor platforms have stated that they are planning for a future under the fiduciary standard as if it were a foregone conclusion. One wirehouse reports that as much as 85% of new client money is going into fee-based advisor programs at many of these intermediaries.
1940s' Technology in the Digital Age
The arguments over which is the better vehicle, ETFs or mutual funds, usually get bogged down in quarrels about active versus passive (which is a different debate), investor behavior, and product proliferation. All of these diversions miss the point. What we are really debating is technology. Both vehicles are technologies for gathering a broad group of investors together to combine assets under a single manager. One is Depression-era technology, however, and the other is digital-age technology.
Mutual funds are often referred to as 1940 Act funds, referring to not only the securities act that created them, but also the time period in which they were created. In 1940, the mutual fund was cutting-edge technology. Can you imagine being an asset manager in 1940 and being told that you had to price your fund and clear all trades at the end of the day, each and every day? Remember, this was a paper-trading world where trades were done on the floor of the stock exchange by people flashing funny hand signals at each other. On top of that, you had to communicate your portfolio holdings to all of your investors quarterly in public filings and mail annual reports!