Mutual fund supremacy in decline: study

Date: Monday, November 17, 2008
Author: Mark Noble, Advisor.ca

The mutual fund is certainly not going away, but a new study by the Boston-based Financial Research Corporation (FRC) concludes that its share of the retail portfolio is going to be drastically diminished, and replaced with alternative investments classes.

According to the FRC, traditional long-only mutual funds, the bread and butter investment vehicle of retail investors, continues to grow as an industry. But in the last three years its growth has been substantially slower.

In the U.S, large-cap domestic equity doubled its assets between 1997 and 2007. Over the last three years of the period, during mostly favourable market conditions, the asset category, along with all its style subcategories of growth, value and blended, substantially slowed to single digit growth.

The FRC hypothesizes that the traditional mutual fund market is now mature, meaning growth in sales will likely be steady but slow. It points to three major factors for this: more funds in net redemptions than net inflows — a trend that is likely even more pronounced currently; sales are increasingly concentrated among larger firms; and there has been a significant shift in the top-selling asset classes, like large-cap equity, to asset allocation, fixed income and foreign equity funds.

"The combination of these three factors suggests that fewer firms and funds are benefiting from the growth of actively managed funds, and that successful product packagers such as asset allocators and specialty managers have benefited most in recent years," the study's authors write.

There has been a growing stack of supporting literature, such as a 2003 study by Antti Petajisto and Martijn Cremers from the Yale School of Management, which suggests that only about 20% to 30% of mutual funds are truly actively managed. This would suggest the majority of funds have instead moved toward benchmark hugging, and primarily deliver beta returns rather than alpha returns. As a result of studies like these, an unprecedented number of retail investors are seeking alternative investment products.

"Despite the current economic and market uncertainty, we believe that product dynamics in the retail investment market will continue in the same direction, with advisors and investors increasingly separating beta exposure from potential alpha generation," says CFA Kristin Adamonis, the study's editor. "Alpha and beta can be looked at as a spectrum, with passively managed vehicles, like ETFs, on one end providing only beta exposure, and on the other end, market-neutral funds offering only alpha. The emergence of alternative products to more effectively and cost efficiently fill the alpha and beta roles within retail portfolios poses a growing threat to the dominant position of long-only actively managed mutual funds in the retail market."

Likely no other financial product will eat into mutual fund market share more rapidly than ETFs. The study notes that by year-end 2007, ETFs had gathered $608 billion in assets, or a 7.2% market share. Growth is even more pronounced in net sales, with ETFs garnering greater than 20% of annual industry net sales since 2004. In 2007, ETF net sales were beginning to rival actively managed fund net sales.

ETF usage in Canada pales in comparison to the U.S. A survey of more than 300 U.S. advisors found more than 71% have used ETFs for their clients. Two out of every five advisors surveyed (40%) said they are either gradually or rapidly replacing actively managed mutual funds as core portfolio holdings. Still, only 11% have abandoned mutual funds as the core holding for their client portfolios, and the shift is predominantly in the independent and fee-based RIA channel. For advisors affiliated with banks and insurance companies, funds are overwhelmingly the product of choice.

This trend seems to be establishing itself in Canada. For example, Barclays Global Investors, the world's largest ETF provider, says its ETF subsidiary in Canada, iShares, is doing brisk business right now during a period when most traditional fund companies are bleeding a substantial amount of assets.

For the months of September and October combined, iShares funds had net inflows of $2.1 billion. In contrast, mutual funds saw sell-offs of $4.5 billion in September and $8.45 billion in October.

If retail investors are going to pay for beta, they want to buy it as cheaply as possible. The number one reason for transitioning a client's holdings to an emerging asset class was lower costs (43%), according to the survey. Although, for ETFs, which have greatly expanded to cover almost every conceivable asset class,the number one reason for their selection was the level of diversification they provide investors. The number two reason was cost.

"This gets to the heart of why funds are losing market share — a growing number of advisors believe the performance difference between active and passive management doesn't warrant the cost," the study says.

Still, there is a place for active management. The FRC believes that mutual fund share will also be increasingly eroded by alpha-seeking alternative investments, most notably "short-extension" strategies such as the emerging 130/30 asset class of funds.

Although usage of 130/30 strategies in the retail market is extremely low and in its infancy, based on the response of advisors and where the industry has been going, the FRC anticipates a rapid uptake of these strategies as more investors and their advisors look to have alpha returns carved out and transparent. Short-extension strategies are perceived to have more downside protection than other strategies that have come from the hedge fund world.

"Short-extension funds offer the opportunity to generate increased, measurable alpha, but they also have more controls in place compared with long-short and market-neutral funds," the study says. "While advisors and investors want their portfolio managers to have the necessary tools to improve returns, most are unwilling to completely bet the farm on their manager's stock-picking abilities."

It should also be noted that it may be premature to write off long-only mutual fund performance. Active managers have often sold investors on their strategies for their downside protection, rather than upside gains. The latest SPIVA scorecard from Standard & Poors found that in Canada, the majority of Canadian equity managers — almost 60% — were able to outperform their benchmark.

Over the long term, the benchmarks are still handily beating the majority of funds. For instance, in the U.S. SPIVA report released on Thursday, the SPIVA Scorecard shows that for the five-year period through June 30, 2008, the S&P 500 outperformed 68.6% of actively managed large-cap funds. On a yearly basis, nearly 60% of funds in that space are outperforming the benchmark.

In investing, yearly outperformance, let alone quarterly performance, can be considered an aberration, but given the exceptional downturn experienced of late, the ability of fund managers to outperform and preserve investor capital is not something that's being taken too lightly.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com