Actively Managed Open End Funds 1980-present. What should investors bear?

Much is being written and debated about long term, actively managed mutual funds (“AMMF”) and regulators are currently considering increasing the operational and compliance requirements of sponsoring these products. There is a good deal of discussion around money market funds and the issues being raised, and regulations proposed, are different from those of AMMFs.  This article will focus on non-money fund AMMFs. 

This post will explore a brief history, evolution, and current state of the AMMF business from my decades of perspective advocating for fund shareholders. AMMFs have operated with the same core structural concepts for decades.  As you will see, AMMFs position within the range of investor choices has shifted as markets have expanded and evolved. Fund boards and managers throughout the industry are working to find ways to address the complex issues facing AMMFs.

The AMMF products are at a turning point. They are increasingly over regulated, have expanding cost structures and are competitively challenged by the availability of lower cost alternatives. For the retail investor, they are just one vehicle to access professional investment management and exploring if they are still structured to provide maximum benefit to investors is important to millions of shareholders. 

AMMFs have gone through a full product lifecycle since 1980. Examining that evolution is important to the retail investor as they seek to provide a secure financial foundation for themselves and their families. The lifecycle has evolved from a product originally designed as a tool for investors to aggregate their assets and gain access to professional management at a reasonable cost to a product that has layered in significant regulatory and distribution costs on top of management and operational fees. There is a benefit to third party service providers that has emerged as the size of the industry asset base has accelerated. In fact, the investor emphasis has, arguably by some, become secondary to the economics supporting these entities, with a disproportionate cost to investors. AMMFs still offer the ability to access diversification and professional management at a relatively low absolute cost, but are investors interests weighted appropriately? AMMFs inability to lower costs is what has driven the explosion of new types of product structures such as ETF’s, collective trusts, and separately managed accounts, where more favorable fee structures and tax consequences, arguably, benefit investors more directly.

The AMMF, while conceived in the Investment Company Act of 1940, truly became a mainstream product when the stock market began its steady climb starting in 1982. Companies like Fidelity, Vanguard and T Rowe Price launched hundreds of AMMFs that were sold directly to consumers, the “no load” fund. Publications such as the Wall Street Journal, Money Magazine, Forbes and others became megaphones to, and research tools for, the retail investor (pre-internet). The no load fee structure was relatively simple and easy to understand, and positive investment performance became the driver of asset growth. The markets had not yet become divided into “style boxes” like growth and value, giving portfolio managers had latitude to invest in the companies they believed had the greatest return potential without constraints. Legendary investors became synonymous with their companies, who competed for assets based on significantly differentiated performance.

Every mutual fund company “owned” their investors, as exchanging between fund companies was not yet possible (an early 90s development by Schwab). Product expansion was accelerating as companies sought to increase their “share of wallet” by offering more AMMF products to their investors. International funds, sector funds, expanded income products and specialized products emerged and product creativity was rewarded. While the broker/intermediary channel was important to a smaller segment of the AMMF market, most investors shied away from paying the sales load/commission charged when they could buy the same product without the charges directly from fund companies. AMMF returns generated by strong performance primarilybenefited the investor and not the sponsoring company or the broker’s firm. Fund companies became profitable through size and scale as investors poured billions, then trillions, of assets into the expanding product line, in turn fueling the stock market growth trajectory. 

The primary form of investor communication in the 80s was the telephone and the large companies saw volumes of calls grow into the hundreds of thousands PER DAY as the decade aged. Investors, both small and large, banded together to drive fund assets to levels where all could benefit from professional management at a reasonable cost. The co-mingling of large and small investor accounts (before the high net worth and institutional investors got segmented or carved out) produced economic scale and investment performance.

As with any growing business, more service providers became attracted to the space because of its financial success. The 90s saw some significant market shifts that would begin to change the AMMF business. Sector funds (an industry targeted version of an active fund that was priced to investors hourly versus once a day) had become the precursor to today’s ETF’s. The market shifted from a mostly “value” based market to one that added the “growth” segment. The difference being a stock no longer had to show financial success as the driver of their share price, they could have a “good story” about the intrinsic value of their idea, with a vision of future profitability, and be rewarded with hefty market valuations. In the 90s many of the tech companies attracted significant attention even though few would show profitability for many years (which led to the tech bubble in 1999/2000). AMMFs followed this shift and built products to collect assets and invest in these companies so retail investors could have access to this emerging segment. At the same time, globalization began to emerge as more countries developed market structures and AMMFs expanded their reach to emerging and international segments, allowing retail investors to access these markets. To support that growth, expansion of custodian, servicing and trading platforms was needed, and additional costs of these services were borne by the fund’s investors.

At the same time, one of the industry’s leading voices, Jack Bogle, was strongly advocating for low cost, passive indexing options as a more beneficial way for investors to participate in market growth. His underlying message was that higher fees were increasingly detracting from retail investor’s return and, that active management was not consistently outperforming general market indices. While his perspective was viewed negatively in parts of the AMMF world, the facts behind his assertions supported his viewpoint. Active fund management adapted by beginning to measure performance relative to an ever-expanding set of benchmarks versus absolute return. The rationale was that as funds became more specialized (style boxes, market segments, etc.) their performance must be measured against a comparable index rather than the general market. This was, and is, a confusing concept for investors.  If a fund beat its benchmark, even if returns were negative for retail investors or below passive product returns, managers would be paid at a fee level relative to peers in the same product type. Many wondered then, and still ask, whether this approach is best for investors.

At the same time, the distribution model for AMMFs was shifting significantly. “No load” funds were rapidly being displaced by funds sold by an intermediary, adding costs to investors, and reducing their returns. New product types emerged to offer an alternative to the AMMF for retail investors, initially based on passive index strategies, Exchange Traded Funds or ETFs. ETFs solved many of the structural issues active funds had and added more direct financial benefit to the investor. Benefits included constant versus once-a-day pricing, immediate liquidity when markets were trading, greater tax efficiency and much lower fees as payments to many “third parties” were not needed. 

As global investing became more mature and markets around the globe operated throughout the day and night, the challenges of “striking” a price once a day at 4 pm EST became disconnected to the investing reality. To this day a 4 pm EST market close is the standard practice for AMMFs by regulation, even though it doesn’t align with the trading schedule of underlying securities in many products while requiring more complex pricing practices. The best illustration of the challenge this problem created emerged in the early 2000’s, a “market timing scandal”. A large investor realized that price movements could be accurately predicted as foreign markets closed hours before the 4 pm EST deadline. He convinced several large fund companies to allow him to trade as frequently as daily at 4pm or shortly thereafter, investing large sums of money in international funds where he already knew whether the daily price would move up or down. While that loophole has been closed and companies were fined and individuals sanctioned, it illustrates that AMMFs have structural issues their growing competitive products do not. The costs to address those types of regulatory issues is borne by investors in AMMFs. 

As trillions of assets poured into the investment space, more types of money managers emerged developing more sophisticated instruments to take advantage of market anomalies, many of which benefitted from market or stock declines in addition to market growth. These instruments are broadly known as “derivatives”. 

The expansion of global trading and market derivatives opened new avenues to produce investment results while adding, at times, significant risk to the world of investments. Building up to 2008, concepts using derivatives produced “leverage”, which basically increased the level of risk in pursuit of higher returns, many times using the riskier segments of the markets. AMMFs were not immune to the use of derivatives and use some types to enhance the possibility of greater returns and to mitigate downside risks in other cases. With a growing number of investors and hedge funds investing in both positive and negative market swings, volatility of markets, and resulting investment returns, varied widely. At the peak of the markets prior to 2008, companies that catered to the growing wealth management segment were creating derivatives for investing and, at the same time, “shorting” the same investments arguing that they were catering to different investor types – those who thought the investments were good and those who believed they would collapse. While there is an argument by these companies that being neutral and meeting investor demand was their goal, the unwillingness to have an opinion hurt the retail investor and benefitted some institutional and high new worth clients when the market collapsed.

Over the course of these events, and others, some of the fundamental structure of the AMMF has remained unchanged as the markets have changed around them. 

·      They are priced daily at 4 pm EST 

·      They accrue capital gains in their share price and distribute it once a year as a taxable event to investors, except in retirement accounts.

·      They are subjected to excessive regulation that competitive products are not- creating a fee structure that is significantly higher than those products. 

Distribution of AMMFs has shifted dramatically as well. Investments directly from retail investors, for most fund managers, has almost disappeared. AMMFs today are primarily sold by intermediary brokers as part of a large retirement plan or as a “sleeve” in an investment portfolio. In exchange for offering an AMMF on a distribution platform, brokerage firms are requiring escalating, and unregulated, payments from fund managers, without regard to the ultimate cost impact to the retail investor. The aggregate dollars many of these intermediaries collect runs into the tens of millions and is a material negative number in a fund managers’ profitability. The challenge here is balancing the fiduciary need to place assets in the best vehicle for investors versus the distributors’ desire to find ways to increase their revenue. Regulators have not adequately focused on this issue yet and such an evaluation would likely produce positive results for AMMF investors.

The cost structure of the AMMF has not kept up competitively with the newer types of investment products. The burden AMMFs, and their investors, bear from the larger costs makes it more probable they will underperform products that are not actively managed in the same segment. When coupled with the narrowing of the investment universe that an active manager must conform to as they manage within their benchmark, the ability of AMMFs to significantly outperform with a reasonable risk profile is greatly diminished and very cyclical.

In summary, the challenges AMMFs face is extensive in the investing world today. A few include;

·      AMMFs tax accrual and yearly distribution requirement is not investor friendly except in a retirement plan.

·      Regulation continues to be layered into AMMFs, and money market funds, disproportionately to other product types. Much of the regulation is unnecessary and addressed by the operating structure of the product.

·      A greater share of an investor’s return in AMMFs is needed to support these regulatory requirements as well as servicing costs, compliance support and governance. 

·      Accelerating distribution costs are requiring higher costs in AMMFs, challenging fund managers as they cannot include many of those costs in their AMMF contract negotiations.

·      The pricing requirements of AMMFs are disconnected from today’s markets, adding complexity costs to the investor.

·      AMMFs benefit to retail investors has decreased since the 80s, disproportionately negative when measured to competitive products.

The question becomes what does the AMMF industry need to do to adapt and succeed in the investing world today? How does the retail investor use this product to best position themselves for investment success? What does the future of the AMMF look like and what has to change to make the product more competitive?

These issues will be explored in greater detail with my next post, Future Possibilities for Actively Managed Mutual Funds, which will be posted in the coming weeks. Ideas explored will include;

·       The impact of AI on AMMFs

·       Alternative structures to current AMMF use of 40 Act

·       Where costs in the AMMF world need to be reduced

·       Emerging services to work around structural problems, such as reflow tools.

·       How should the governance model change?

Undoubtably in today’s world, comments will point out alternate viewpoints and arguments on these topics, adding to the important discussion to have on the future of AMMFs.

Experience shaping my viewpoints. 

Over portions of the last five decades, I’ve had a front row seat in the mutual fund arena. Turbulent markets that have produced, at times, joy, angst, profit, and loss for retail investors. This post is written from the perspective of someone who has spent their career supporting the retail mutual fund investor. Beginning my career in 1980 at a then small fund company, answering 200-300 investor calls a day, and then spending the next four decades directly serving fund investors, my viewpoint is shaped by what I learned about investors’ collective concerns and goals for their money. As my career progressed through many roles, including as CEO & President of numerous fund families, and eventually chairing a large fund Board, I participated in, and at times led, shaping the product and cost structures as the AMMF business evolved, while never losing sight of the impact on the retail investor.