The Age of the Mutual Fund is Over

Posted by Alex Frey (@alexhfrey )

For the past forty years, if you wanted to buy a diversified portfolio for retirement, your search pretty much started and ended with a mutual fund.

From 1975 to 2007, the total assets in mutual funds increased from $37.5 billion to $6.4 trillion, going up 171 times. During that time, the overall market increased in value only 44 times.

Individual investors have been living in the age of the mutual fund, even if they didn't know it.

But that age is now over.

Why Mutual Funds?

The Age of the Mutual Fund had three main drivers.

The first was the rise of the middle-class investor. Rising wealth meant that more Americans had disposable income that they could invest. At the same time, mutual funds offered the promise of "democratizing" investing by giving the man on the street cost-effective access to a diversified portfolio. Buying 100 different stocks on your own would be a huge and costly hassle, but buying a single mutual fund gave you broad exposure to a diversified portfolio with only one purchase.

The second factor was the replacement of traditional pension plans that were managed by an employer with new individually-managed defined-contribution plans like the 401(k). The 401(k) created captive demand for mutual funds because employees are required to invest from a menu of funds approved by their employer. In many cases, they have no choice but to buy a mutual fund of one kind or another. 

The third factor was the emergence of a sales channel through commission-based financial advisors. Brokers had traditionally made money from getting their clients to make stock trades, but with falling trading costs it became a lot more profitable and sensible to sell mutual funds and pocket a huge sales fee (up to 5% of the total size of the investment) from the fund company instead. This also created more or less captive demand, since advisors had to put their clients into commission-paying mutual funds if they themselves wanted to make any money.

The Foundation of the Age of the Mutual Fund is Crumbling

The era of mutual fund growth is now ending because all three of its drivers are either saturated, or starting to go in reverse.

First, the mutual fund is no longer the most practical way for middle-class investors to own a diversified portfolio. It is hard to make that argument when funds (as a group) charge such high fees, when 70% of them fail to beat their benchmarks over every five year period, and when ETFs offer much cheaper and more tax efficient diversification.

Second, the crossover from defined-benefit pensions plans to defined-contribution retirement plans is likely now mostly complete. 401(k) plans will continue to grow, but at lower rates than before. Moreover, eventually even this regulated and slow-moving sector will catch up with the times and introduce ETFs into plans, at which point the share loss of funds will accelerate. 

Third, investors are fed up with paying too much for biased advice. Advisors know this and are rapidly moving away from brokerage firms and to independent RIAs (Registered Investment Advisors) that operate under a fee-based model and have a duty to act in their client's best interests. Because RIAs charge clients directly, they have no incentive to put them into a mutual fund, and are far more likely to use ETFs instead.

Mutual Funds Will Die a Slow Death

Many will argue that it is premature to talk of the "death" of the mutual fund, and they are, of course, correct in a way. Mutual funds are not going to go away entirely anytime soon.

But that doesn't mean that a crucial turning point hasn't been reached. For the first time in thirty years, mutual funds are losing share rather than taking it. They are no longer the default choice - or even the best choice - for individuals looking to rationally invest for retirement. And that is significant. 

Mutual funds will certainly not die off entirely anytime soon, but make no mistake -- the age of the mutual fund is over. Place your bets accordingly.

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By Alex Frey