Fund Industry Facing Game-Changing Trends

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Changes in the industry confront asset managers on several fronts. Alternatives have gained in popularity, shunting aside traditional core assets. Regulators seek to broaden their scope, demanding access to more data. And technology spurs industry innovation, providing new investment vehicles and strategies, new ways to promote and distribute products, while also ushering in new security threats.

Michael Rawson, an analyst covering passive strategies on Morningstar's manager research team, shares his expectations on the outcomes these industry shifts will bring, including a lowering of fees, a move away from selling performance and greater focus on suitability for the individual investor.

You said that ETFs can be seen as a technology disruptor. How else will they disrupt the investment world for fund companies and investors?

One major advantage that ETFs have over index mutual funds is the process by which they're created and redeemed. So the redemption process - or in kind redemption process - basically means that when there's an outflow from the fund, a traditional mutual fund will have to sell securities to raise cash to fund that redemption. An ETF, when there are outflows, it happens through an in kind redemption process, where a market maker goes to the ETF provider and says, 'I'm seeing that there's not much demand for this ETF. I want to redeem the ETF. I'm going to give you back shares in the ETF. You give me the underlying stocks on that ETF.' Let's say it's the 500 stocks in the S&P 500. The ETF provider chooses to give that market maker the 500 stocks, the individual securities, with a low cost basis. Because that's an in kind process, he's trading stocks in the S&P 500 for shares of the ETF.

This means a large tax advantage.

A very large tax advantage, particularly when it comes to comparing ETFs to actively managed funds; not so much when you compare index ETFs versus index mutual funds. Index mutual funds also have some techniques, which give them a tax advantage. But by and large, ETFs tend to be more tax efficient than mutual funds. So there's a technology advantage. Another source of an advantage or a disruptive technology is the way in which ETFs versus mutual funds are distributed. Traditionally funds get distributed using wholesalers who call on a financial advisor. With ETFs, they're bought and sold on an exchange, just like a stock is. That is good for the individual investor.

Going forward, what other disruptions do you see over the next two to five years?

The investment world has seen the increasing acceptance of passive management such as capitulator funds like S&P 500 and total stock market funds. Going with an index fund has been an accepted form of asset management. What's gaining acceptance now are these strategic beta type of funds. There's no longer a debate between active and passive. Passive is at the table.

The SEC is developing requirements that asset managers give regulators more data about their portfolio holdings in mutual funds. What impact would this have?

When portfolio managers have to fully disclose their holdings, it changes the nature of the kinds of securities they can invest in. There is some type of bifurcation in the market between very transparent vehicles like mutual funds, and less transparent vehicles like hedge funds. The more highly you regulate mutual funds in terms of disclosing holdings, the deeper that division between mutual funds and hedge funds is going to be. If you over regulate the mutual fund industry, you're essentially going to chase some money into less regulated markets such as hedge funds.

How are providers managing alternatives from an operational perspective?

The alternative fund market is a very small part of the overall assets and mutual funds and ETFs. But that's where the growth is. We've seen that there's very little growth in traditional mutual funds; certainly active equity mutual funds, there's very little growth. But there's tremendous growth in alternatives.

How are fund providers dealing with cyber security?

It's going to become something of increasing importance, especially as people age, to rely on their fund provider for additional financial services. Vanguard recently promoted to chief investment officer someone who came from the Information Group. He was the former chief information officer and he became the chief investment officer. He didn't necessarily have the background in investments, but he had the background in information technology. It was a sign of how important Vanguard views information technology, and how big a part of it is in their business, and how intertwined it is with investments.

How do you see the provider/advisor relationship evolving over the next several years?

You are seeing the number of RIAs or independent investment advisors is growing, while the number of wirehouse advisors over time has been declining. Essentially, the old wirehouse type of advisor's numbers are dwindling, as some of those advisors become RIAs. Now, with more registered investment advisors who are fee based, more concerned about what is the expense ratio of this product, and what other ancillary services can that fund provider give me? The main thing is low cost products, because if you're working for a wirehouse, you have this menu of funds you can sell. Now when you're with an independent, you could sell any product that is in the best interests of your client.

From a product perspective, what are some ways innovation has been successful, as far as changes that have helped firms mold their business models to be more successful?

There has been a focus on providing complete solutions, and I think this is something which is still evolving. Clients are saying, 'I want a complete portfolio solution. I need the entire portfolio, and I need it to be a diversified portfolio that is suitable for my own needs.' There's more focus on a complete portfolio solution.

Looking at the provider segment, what would you say are the three things that are wrong with the industry?

Traditionally Morningstar was completely independent; we didn't have any investment products; we weren't issuing funds. Now, we have our Morningstar Investment Management Group. Morningstar is viewed as an independent voice for the individual investor, and would be critical of the industry in certain areas. The industry has come a long way in terms of disclosure and transparency. What I see, however, is that there's definitely, again, this bifurcation between active and passive management, where passive management is available at a very low fee; active management tends to be more expensive. The active managers have not really cut their expense ratio. At the same time, the passive industry has taken off and gained a tremendous amount of assets that the active industry could have had if they had cut fees. I also want to see firms get away from selling performance. They trot out the funds that have done really well, and publicize those in marketing materials while not showing those funds, which didn't have good performance. They're selling performance instead of selling suitability for the individual investors. So certainly, lowering fees, moving away from selling performance, and more of a focus on suitability for the individual investor, I think are three things, which the industry can improve on.

What is the current passive/active breakdown?

Money market funds in some sense are a little bit more of a banking product - it's about 30% passive, 70% active. That's across all asset classes that would include commodities and bonds. So that's increased essentially from zero back in 1990, and it really started to accelerate in 2000, because even though ETFs came out in 1993, you didn't have them gain wide acceptance until around 2000, and they didn't really start ramping up, in terms of inflows, until the mid-2000s, and that's where the growth really took off. Now, what's interesting lately is that more flows over the past five years have actually been going toward bond categories. Most bond funds tend to be actively managed, just because traditionally, it was hard to set up an index for a bond category, with stocks, it's easy. With bonds, it's a little harder to manage an index, because sometimes, you don't really even know the price. Indexing, in general, hasn't been as popular. There have been strong flows into bonds, but still, passive has gained share.

As the numbers shift, do you think research will show that indexing was not actually the best way to get to the most desirable results, longer term?

There is this rule that is called a fundamental law of active management, which says that for any active manager to outperform, somewhere else there's got to be an active manager who's going to underperform. There are a couple of things that will help active managers.

First, if active managers lower their fees and become more competitive with passive managers that gives active managers a better chance, because the historical evidence shows that active managers only lose to the index by the amount of their fees. If they lower their fees, that improves their chances. As more and more assets become managed passively, that opens up opportunities for active managers to outperform.

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