This past year was an important period for the investment management industry. Globally, extraordinary stock market appreciation triggered rising flows into pooled investment funds (mutual funds, ETFs, UCITs, CITs, etc.). Such inflows totaled a record of near $2 trillion. Yet, participation in the industry’s organic growth remains highly concentrated, with a very high portion of net inflows captured by a few managers of passive vehicles, as well as by a small number of high-promise actively managed bond and equity funds.
Overall, it is widely accepted that we are in a period of transformative changes for the investment management industry, with a number of mega-trends under way. One such accelerating development, strongly evidenced in the maturing U.S. mutual fund landscape but experienced globally, is the increasing use of asset-allocation “solutions” among wealth managers and mutual fund distributors.
In the United States, for example, asset-allocation solutions—wrapped funds/ETFs; standalone funds with balanced strategies, including target-date funds; and similar investment approaches—now account for 80% to 90% of mutual fund purchases by investors served by financial advisors.
Such increasing adoption of asset allocation impacts mutual fund managers in many ways. Particular points that mutual fund trustees and investment managers should consider include:
- Asset-allocation protocols trigger a rising bar in the selection and retention of actively managed funds.
- Asset allocation use reduces liquidity pressures in times of market duress but also introduces risk of rapid redemptions out of sub-par funds during “normal” markets (especially in discretionary accounts where a small number of “selectors” make choices on behalf of many thousands of investors).
- Asset-allocation platforms are reluctant to add newly launched funds (unless unique, with proven demand); moreover, the marketplace dominance of such platforms leads to more liquidations of sub-scale poorly performing funds.
- With advisor compensation increasingly set as fee-for-service outside the “wrapper,” the shift toward use of very low-fee ETFs and the least-expensive share classes accelerates. (To ponder: Will “clean” share classes dominate the industry in five years? If so, how will distribution platform costs be paid, and by whom?).
Each of these trends drives down investment management firms’ profitability and amplifies competitive trends. Rising global stock markets and the resulting fee revenues in recent years camouflaged such structural profitability attrition; what will happen when stock market gains are reversed?
Making the ‘Select List’
It is more difficult for actively managed funds to raise new assets due to a rising bar of performance excellence for such funds. To provide a wrapped asset-allocation solution, financial advisors (FAs) increasingly are combining actively managed funds (only the excellent, inexpensive ones) together with cap-weighted index funds and ETFs, “smart beta” funds, and more (smart beta ETFs/funds’ 2017 U.S. net inflows exceeded $30 billion and could grow significantly in 2018). Indeed, an increasing number of FAs are becoming product agnostic and consider actively managed funds only if they offer the highest past-performance rankings—such as top decile/quintile trailing returns (three-year returns relative to peers remains a key screen). Once a fund loses its top ratings, FAs and fund selectors are quicker now than ever before to remove it from the recommended “select list”—or to redeem it if used within an existing asset-allocation-based portfolio (especially in discretionary accounts).
Naturally, the marketplace debate about the predictive value of historical rankings continues.
FAs and fund selectors are focusing on mutual fund share classes with the lowest total costs, as evidenced by the fact that low-fee share classes—no 12b-1 fees, some without TA fees—account for an overwhelming share of new purchases (more than 80% of new mutual fund sales by FAs today are of such share classes). In parallel, the race to zero fees among core ETFs accelerated in 2017.
Meanwhile, fee-for-service controls the great majority of FA compensation from mutual fund sales today (likely over 85%), while point-of-sale commissions account for a low single-digit share of new sales for the majority of fund management companies. This proportion continues to decline, with the data showing that in mutual fund distribution, point-of-sale commissions—one of the key rationales for the Department of Labor's fiduciary rule—are now nearly extinct.
DOL Fiduciary Rule
The future of the fiduciary rule is unclear, yet preparations toward rule implementation have influenced the fund industry in ways that are irreversible (in particular the shift toward low-fee fund share classes). It is likely that the industry will continue along the path toward adoption of clean shares.
For fund directors and the advisers with which they work, there are several outstanding issues worth pondering:
- Will the SEC introduce principles-based fiduciary standards? If introduced, this could lower regulatory burdens, whose costs are paid ultimately by investors.
- In a clean share class future, who will pay for distribution platform costs if no cost/revenue-sharing mechanism exists? Would investment firms pay for this out of their profits? How likely is it that powerful, concentrated distribution platforms absorb such significant costs?
- Narrower participation in a “managed architecture” distribution environment would lead to platform maintenance costs paid by fewer participants. How would a new cost-sharing equilibrium be established with a significantly shorter list of fund managers included in distributors’ preferred lists? Will investors ultimately pay for such costs directly through additional platform fees for funds/ETFs administered on this platform? Keep in mind that such payments by investors do not have the cost benefits of mutualization, or rule 12b-1 tax benefits.
Ameliorating Investors’ Euphoria
As global stock markets inch higher, some investors and their advisors are rebalancing, replacing some stock fund allocations with bond fund allocations (this explains the large inflows in 2017 into bond funds, which continue despite expectations of a 1%+ increase in U.S. interest rate within the next 12 to 18 months).
Other implications of spiking stock prices include less interest in alternative mutual funds with lower return/non-correlated risk (many such funds experienced redemptions in 2017 and numerous sub-scale alt funds were liquidated); a greater interest in low-fee index strategies that are not market cap-weighted; and, inversely, a greater understanding of the limitations of index funds biased by the largest-cap, most expensive stocks (already factor/smart beta ETFs/funds attracted near $30 billion inflows in 2017).
The shift to an asset-allocation mindset buffers the tendency for stock market euphoria. In 2017, as in prior years, Investment Company Institute data suggests that each month about two-thirds of new sales of mutual funds—different from net flows, which equal sales minus redemptions—continues to be deposited into active and passive stock mutual funds, while the balance goes to bond funds (ICI’s data on new sales does not include ETFs).
Actively managed funds continue to account for the great majority of the industry’s new sales. ICI’s data shows that in 2016 actively managed funds accounted for 81% of the industry’s aggregated new sales. Proportionally, in 2017 sales of actively managed funds were likely only modestly lower.
Naturally, a relatively small number of high-ranking funds account for the majority of actively managed funds’ new sales. The highest share of industry new sales of active funds was experienced among global equity funds (over 90% in 2016, somewhat lower in 2017), followed by bond funds. Inversely, actively managed large-cap equity funds experience the lowest share of sales due to substitution by core index funds/ETFs within wrapped asset allocations and elsewhere.
The mutual fund industry witnessed slowing introductions of new actively managed funds, selective introductions of ETFs (many factor-based), and faster liquidations of aging or sub-scale young funds. Such acceleration of fund line rationalization/fund closures will continue, as fund management companies and their funds’ boards of directors remain focused on fund line reviews for further closures of small, expensive, and underperforming funds.
Asset Allocation, Liquidity Risk Management
Investors owning an asset-allocation solution observe net asset value changes of the entire portfolio, not a single fund’s NAV decline, during volatile days. As a result, they are less likely to redeem defensively. The SEC recently extended the implementation date for its reporting modernization rule, which includes liquidity reporting and was drafted concurrently with the agency’s liquidity risk management rule. This offers a more realistic timeline for successful, well tested implementation and reporting (requiring staging and including vendor assessment and selection, as well as fund board approvals over two to three meetings). One related concern is that if the industry becomes dependent on one dominant third-party vendor for liquidity-related data, security concentration risk may increase (and liquidity become more challenging during volatile periods) due to the increasing uniformity of security classifications related to liquidity.
A key factor on liquidity risk management and planning is concentration risk, or how diverse or heterogeneous a fund’s shareholders are. A higher concentration of assets from a few, homogenous institutional shareholders or platform “selectors” presumably would yield more harmonized decisions to redeem. Fund managers regularly monitor pockets of higher concentrations (especially in discretionary accounts) and anticipate/plan (at times collaboratively with the platform administrator) for the possibility of rapid liquidations in such positions. Some managers already share such concentration reports—and their liquidity management contingencies—with their fund boards.
I continue to believe that a principles-based rule to guide liquidity risk management is preferable to a prescriptive-based rule. Does the postponement of the data reporting rule implementation date open a small window for further modifications along these lines? (Interestingly, Germany’s securities regulator BaFin just introduced principles-based guidelines for liquidity stress test.) In my view, the SEC liquidity risk management rule is a 99% solution to a 1% problem. Naturally, management companies recognize the necessity of planning for the rare periods of extreme market liquidity stress, but does the rule’s current prescriptions offer a sufficiently reassuring path?
The use of asset-allocation solutions using bond positions to reduce portfolio volatility are broadly adopted today, as the wealth management industry continues its transition from its historical focus on individual securities and high-promise mutual funds. Often such portfolios are mandated to become more and more conservative for older investors.
Yet, I often ponder and envy the courage of my old relative, a New York City schoolteacher now in his mid-80s who, despite his age, keeps his retirement portfolio 100% in stocks and withdraws 4% to 5% annually. He already has benefitted from nearly 20 years of annual withdrawals, yet his retirement savings still equals 10 times his total cumulative lifetime deposits for retirement. Investment courage has worked wonderfully for him, for Warren Buffett and his followers, and for others. There are many paths for wealth management for income-at-retirement beyond the age-triggered conservative rebalancing (especially as expected returns for bonds are modest for the coming years, at best).
Avi Nachmany is an independent consultant to mutual fund boards and investment firms, following 30 years of providing thought leadership to the mutual fund industry as the research director of Strategic Insight. He offers a perspective for fund trustees and executives in the areas of distribution, pricing, and fee trends; product evolution; compliance; and strategy, and he serves on a number of compliance organization advisory boards.