Prognosis: Fund Industry in Critical Condition

The following article was posted at yesterday by Robert Dubois, our Senior Vice-President of Investments….

In 2008, investors yanked $235 billion from non-money market mutual funds while adding $175 billion to exchange-traded funds. Market share of ETFs compared to non-money market mutual funds has doubled roughly every three years and now, it would appear, is poised to further quicken the pace.

While non-money market mutual funds suffered asset declines of 35% last year, ETF assets experienced only a 13% reduction, according to the Investment Company Institute.

With asset levels at many mutual fund companies standing at one-half to one-third of pre-crisis levels, mutual fund company revenue streams have hit a wall, leaving operations bleeding cash.

This fate is also shared by advisers having soft new asset inflows combined with client portfolios heavily weighted in anything other than cash and Treasury-related securities.

Moving To A New Way To Invest

Despite the massive toxic asset triage under way, what we are currently witnessing is the unsystematic, wholesale dismembering and dismantling of the 20th-century wirehouse model combined with an accelerated consolidation and downsizing of the mutual fund distribution segment.

Product and product purveyor are, quite absolutely and quite entirely, broken.

Both of these monumental, investor-driven trends were well under way prior to July 2007, but the financial crisis that has since unfolded has served as a crude yet incredibly powerful catalyst to their forward march.

No wirehouse brokerage firm has managed to avoid serious (and for many, life-threatening) damage over the past 18 months. And those that haven’t been fully extinguished now find themselves squarely on their knees.

Among those still standing (or kneeling), there are bound to be a few that will still exist five years from now-albeit in a brutally humbled and suitably reduced and narrowed operating form. Big bets gone bad in highly leveraged investment banking operations and proprietary trading books have fully succeeded in hastening the killing of the wirehouse wealth management “goose.”

But from there, institutionalized mediocrity (aka “advisor-assisted suicide”)-a consequence of entrenched wirehouse cross-selling priorities and related product mills-will, for many (advisors and clients alike), finish the job.

Investors Learn The Hard Way

Investors are learning, of course, to appreciate the importance of both superior product and superior advice.

But, unfortunately for most, they’re finding out the hard way.

Good advice doesn’t involve picking market tops and bottoms. And good product is low-cost, transparent, tax efficient and consistent in the type of exposure delivered.

Accordingly, among recent lessons learned are that precious little in the way of good advice or good product comes from conflicted, cross-selling advisory machines. And it doesn’t include actively managed mutual funds or focusing on advisors behaving as active mutual fund managers on matters of asset allocation.

How many times have investors heard this from their advisers before: “We seek to preserve and grow wealth”?

While advisers almost universally and sincerely wish to preserve and protect capital, the “preservation” matter has been purely rhetorical in practice. Where are the definitive and meaningful “preservation” elements or protocols in these strategies that happen to be routinely wrapped in a “preservation and growth” marketing message?

Going forward, real and tangible attention to the preservation side of the coin will be demanded by investors. And as the industry’s dead wood is burned away, investors will continue to expand their migration to advisors and product that embrace strategies adopting specific protocols to both preserve and grow capital, while utilizing clean, low-cost and transparent index ETFs as the obvious instruments of choice-instruments that actually complement such strategies.

Straight Talk From Advisers

Looking back, how often have we heard advisers claiming to possess a superior, secret or proprietary method for selecting active fund managers?

And those “superior” active mutual fund managers, of course, would like for us to believe that they possess secret or proprietary methods for selection of “superior” fund holdings. But who’s to know anyway? The specification of those fund holdings is kept secret from shareholders for three-to-six-month stretches (i.e., the body’s already turned cold thanks to arcane mutual fund industry reporting requirements).

Not surprisingly, the industry transition to low-cost, transparent index investing via ETFs is being driven at a grassroots level, by a long-rising tide of determined individual retail and institutional investors and like-minded advisers.

And in spite of the predominant 20th-century wirehouse and active mutual fund advisory service models, the use of ETFs and index investing will continue to gain traction within the adviser and individual investor communities.

So, how will the retail investing world look a decade from now? We can be confident that low-cost, transparent index ETFs will play a significantly larger role as will advisers who incorporate them into strategies that are genuinely suited to the task of “preserving and growing” client wealth.

How will the wirehouse and active mutual fund segments fare?

That’s much more difficult to predict. It’s like trying to figure out where a car might wind up after its accelerator pad remains stuck in a floored position with no brakes. The old guard of investing isn’t a very pretty sight to behold right now.

 And it’s not likely to be anytime in the not-so-distant future.