April 11, 2017    4 minute read

Will Mutual Funds Disappear?

A Glimpse of the Future

Will Mutual Funds Disappear?

The active asset management industry has been under significant pressure. A recent report by Better Finance showed how several active funds – including renowned asset managers – closely underperformed their benchmark. This is not an entirely new story. Academic research also shows that mutual funds often underperform, and do not deliver risk adjusted returns (so-called alpha).

Besides, the technological developments of the last 30 years are challenging the current business model of the active investment management industry. ETFs are cheap and accessible vehicles that are perfect for unsatisfied investors who are not willing to pay expensive fees for the probability of outperforming indexes.

The Mutual Fund Industry

The mutual fund industry is particularly vulnerable to such developments. In fact, while hedge funds provide sophisticated and tailored active strategies, mutual funds are limited by regulation and their performance is compared to specific indexes, which, in turn, are easily tracked by ETFs. Consequently, the passive industry has been growing dramatically in the last years at the expense of underperforming active investors.

Developments in machine learning and artificial intelligence are opening the asset management industry to robo-advisors – machines able to offer dynamic and customised investment strategies. Accordingly, new mutual funds launches are decreasing, and the industry is consolidating, pursuing M&A operations (see Aberdeen and Standard Life).

Time to Evolve

Even though active investment management looks moribund, the rise of ETFs should be regarded as a wake-up call for the industry. In fact, active funds will likely evolve rather than disappear. Four factors will play a significant role in shaping the future of the industry and help mutual funds survive:

  • The Market Segment

Mutual funds can still target investors that – in terms of risk aversion – lay between passive and hedge fund investors. Such a market segment has a medium-low risk aversion and will probably always be willing to pay extra fees even just for the probability to outperform the benchmark.

  • The Human Factor

Customer relationships matter in every sector, and it is also a key business driver in the wealth and asset management industry. The time that investors will rely on robots to manage all their wealth is probably farther than expected. Not only such a development would need a cultural revolution (which it may already have started), but human advisors can also show unique empathy towards investors, proposing tailored (or at least so perceived) strategies.

  • Innovation

Although mutual funds have stringent regulatory requirements, they can still enhance standard stock picking strategies and improve their performance. For instance, data science has been opening new frontiers that make the best out of the enormous amount of information in the market. Active asset managers may start deviating from plain fundamental research and explore new technology-based strategies.

  • Passive Investing Regulation

As the ETF market grows, its relative weight in the financial system increases, as well as its importance for the financial stability of the economy. However, ETFs regulation is rather outdated compared to other financial instruments. Lawmakers may soon propose more stringent requirements for ETFs and ETPs, particularly regarding their listings procedures, their use of leverage and derivatives, and their trading rules during periods of market stress. A more stringent regulatory framework may hamper ETF growth in favour of active funds.

Conclusion

The outstanding growth of ETFs is significantly challenging underperforming and expensive mutual funds. As a result, there will be an important shift in the active management industry in the upcoming years. While active funds will always be able to count on their ability to connect with investors with a medium-low risk aversion, asset managers will probably have to update their investment strategies and look for different business models to outperform ETFs.

In this regard, data science and technological developments will play a major role in active strategies. Finally, possible tighter regulation of the passive industry may reduce the market pressure on mutual funds.

Get articles like this straight to your inbox each morning with our Breakfast Briefing. Sign up by clicking here!

Log in with your details

or    

Forgot your details?

Create Account

Send this to friend