It is pretty evident to anyone who uses Morningstar or Lipper that choosing a fund in any category is challenging, not so much by the unique features of each fund, but by their profound commoditization.
In the U.S. large-cap fund category alone, Morningstar lists 200 in their database, but this is only partial. It takes full-time analysts to discern what, if anything, separates one from the other over the long term.
So it is no surprise that a mutual fund industry discussion noted that the fund industry suffers from “too much capacity.” That is analyst jargon for too many mutual funds. “We’ve competed away the alpha,” according to Jeff Hopson of Stifel Nicolaus, brokerage firm. “I clearly think that the golden age of the fund industry is behind us, unfortunately.”
Hopson is correct in that manager performance has become more average and it is more difficult for managers to beat the market ( which is what he means by “competed away the alpha.”) Importantly, he also says that the mutual fund industry’s “golden age” may have passed.
But keep in mind that Hopson was speaking on a panel with other financial analysts at a conference sponsored by a mutual fund publication. As a result, their perspective is myopic and comes from the industry’s vantage point.
In reality, the “golden age” of mutual funds clearly benefitted fund companies, sales people and portfolio managers more than shareholders. Under the current fund company structure, shareholders take all the risk, while portfolio managers and fund companies benefit in bull and bear markets by regularly extracting fees and rarely reducing fund expenses, regardless of fund performance.
Clearly, the industry has to address the structural changes it needs to effectively compete in the post-recession, consumer activist environment.
Change the Business Model
But for smaller, boutique fund companies which want to change their business model without making significant changes, there is an alternative: Elevate shareholders to make them partners with their portfolio managers. This could involve fee restructuring, imposing hurdle rates tying fund performance to fees, increased transparency and disclosing and correcting conflicts of interests arising from revenue sharing.
In short, if some boutique fund companies wanted to differentiate themselves from their competitors at little or no cost, they would voluntarily adopt the fiduciary standard, which is currently causing convulsions in the financial industry. The reason why this straightforward standard is shaking large segments of the financial industry is that it challenges the basic business model, which makes shareholders the enemy, not a partner.
Determining Net Flows
The mutual fund panel also predicted greater acquisition activity, possibly from non-U.S. firms. But this will be done at bargain-basement pricing mainly because of fund commoditization. Boutique fund which do not get acquired, the panel said, should see slow growth and a wider valuation gap between fund companies.
While the mutual fund industry’s commoditization has been going on for years, the current recession, the “lost decade” of positive fund performance, the ascent of ETFs, and the demands of Baby Boomers and other future retirees, has placed the spotlight on whether mutual funds are delivering on their implied promises, especially in light of their fees versus their performance.
Stalling and obfuscating proposed new fiduciary regulations in Congress does not eliminate or mask the need for fund reform. More informed and agitated shareholders will demand more. But boutique funds which want to survive can make some modest changes and even prosper in the upcoming new environment. They only have to translate good corporate governance into good marketing.
