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.
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. 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.
The industry has responded in predictable fashion—by complicating these new choices. We’ve already witnessed scores of new index launches. 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.
From Funds to Advice－High Tech, Low Touch
Over the past decade, “robo-advisors”—entities that create portfolios via computer programs, rather than through personal meetings—have entered the fray. Now advice is available at a fraction of its traditional price. If the new services do not exactly match those that they seek to replace, well so with funds: Passive management is not the same as active management. Eventually, I believe, many will think the same about robos. After all, robo-advisors enjoy the advantage over their human rivals that Vanguard had over its competitors. Just as Vanguard invested in the same stocks and bonds as did the other fund companies, so do robos buy the same funds as do traditional advisors—and through the same process of strategic asset-allocation. The performance difference comes down to price. On average, over time, robo portfolios will beat those created by human advisors by about 75 basis points per year.
However, unlike when Vanguard came to market in the 1970s, investors now possess a deep appreciation of the logic of investment math. Every cent that leaves a portfolio to pay expenses is a cent that would have improved the portfolio had it stayed. This principle is well known. Also understood is the difficulty of generating “alpha.” Over time, investors will no more believe that the average financial advisor’s portfolio outgains a cheap solution than they will believe that the typical actively run fund beats index funds.
The financial-advisory business will indeed follow funds’ lead – to a point. That point being where investment selection stops and personal advice begins. It’s one thing to construct a generic portfolio that serves Sally as well as Tom. They need no customized solutions. Drop them into a target-date fund, and they will be served just fine. They require diversification, strict cost controls, and the force of time. It’s quite another to take into consideration investment lives that have become messier, with multiple accounts and withdrawal needs. Technology can help to address those issues, but it cannot replace the iterative, back-and-forth learning that comes from extended conversations – and the relationships that come from discussions. Those who possess more financial assets than human capital, and who seek professional help (do-it-yourselfers being another breed altogether), will likely use traditional advisors.
Which is perfectly good news for such advisors, as those clients are the ones with the most money. To be sure, fee pressures will continue to build as the wealthier customers push for steeper volume discounts. But there will be an understanding that as human advisors’ services are not the same as those of the robos, that their charges can and will be higher. Thus, the analogy between what has already happened with funds, and what will happen with financial advisors, is imperfect. Pricier funds carry no special appeal to wealthier investors, while pricier advisory services might. Nevertheless, the parallel is sufficiently strong that I feel confident in predicting that robo-advisors have only just begun. They will not conquer all, but they will expand greatly over the next couple of decades.