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Don Phillips: Over the past two decades, the fortunes of major financial-services firms have changed considerably.

Don Phillips, 06/10/2010

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Large financial-services firms strive to convey a sense of stability and permanence, but leadership positions in this dynamic market aren't set in stone. Over the past two decades, fortunes of major firms have changed considerably. Once-dominant shops like Dean Witter and Pru-Bache have disappeared, while upstarts like Vanguard and PIMCO now loom large. Success in this industry must be won every day. Change is a constant. But closer study shows that change is anything but random.

10 Largest Firms in '86
1. Merrill Lynch
2. Fidelity
3. Federated
4. Dreyfus
5. Franklin
6. Dean Witter
7. Kemper
8. Putnam
9. Pru-Bache
10. EF Hutton

 10 Largest Firms in '09
1. Vanguard
2. Fidelity
3. American Funds
4. JP Morgan
5. Barclays Global Inv.
7. Federated
8. Franklin Templeton
9. T. Rowe Price
10. BlackRock

First, let's address the amount of change. Only four firms appear in some form on the largest-10 lists of both 1986 and 2009. Federated has remained a major player because of its continued strength in money market funds, but it has been less successful in its efforts to become a dominant player in the stock- and bond-fund categories. Merrill Lynch hangs on as part of BlackRock, which ended 2009 at number 10 and will move up as a result of its iShares acquisition. As a stand-alone entity, however, Merrill would not make the list.

The other two firms, Fidelity and Franklin, succeeded in large part from their willingness to reinvent themselves. Fidelity in the 1980s was an equity-oriented shop that sold directly to the public. The firm didn't have the strong fixed-income reputation, the advisor business, or the dominant place in the retirement market that mark its current strengths. Franklin in the 1980s was largely a fixed-income shop. Through shrewd acquisitions, the firm picked up the international (Templeton) and domestic (Mutual Series) stock skills that kept it relevant during the stock bull markets of the 1990s. Clearly, firms can't stand still and hope to continue to succeed in this business.

Now, let's dig into the characteristics of firms that fell from the list and those that joined it. Among those that fell were firms known for selling flawed funds that stretched for yield or otherwise disappointed. Dean Witter's High Yield and Convertible funds were notoriously bad players in the late 1980s. Putnam's Option-Income and Government Plus funds stretched for yield while eroding capital. Its OTC Emerging Growth fund declined 85% peak to trough during the tech bubble collapse. Kemper had an option-income fund whose manager assigned successful trades to a partnership for Kemper executives while dumping losing trades into the public mutual fund. E.F. Hutton's funds were costly and poor performers. There's a reason these firms fell from grace. They focused more on what was easy to sell, rather than on what investors would be wise to purchase.

If the losing firms catered to the whims of their salesforce, the winners focused on stewardship and doing what's right for investors. Vanguard, American Funds, and T. Rowe Price thought long-term in a business that often thinks only of the next quarter. PIMCO and J.P. Morgan brought an institutional mind-set to the retail space and treated advisors like clients, rather than as a mere distribution channel. Barclays, through its iShares unit, reinvented the mutual fund concept in a lower-cost, more tax-efficient way.

The results show that the U.S. fund industry has been a meritocracy. Thanks to the highest level of transparency in any global fund market and a growing army of investor advocates-- regulators, financial media, independent financial advisors, fund directors, 401(k) plan trustees, gatekeepers at brokerages and insurance companies, and independent-minded researchers like Morningstar--investor assets increasingly flow to lower-cost, more-shareholder- friendly fund organizations. No longer can a fund firm hope to woo assets with a sales contest or by writing a big check to a platform. Assets flow increasingly on the basis of merit, not muscle.

The correlation between asset flows and costs is overwhelming. Funds with expense ratios 20% below their category average have had on average more than $200 million apiece in net inflows over the past six years. Those within 20% of their category average have been essentially flat, while those with expenses 20% greater than their category have been in net redemptions. The notion that fund companies need to raise their fees to encourage sales is pure folly. Even more extreme is the correlation between Morningstar's Stewardship Grades and fund flows. During the period from 2004 to the end of 2009, funds that receive A grades have taken in almost $900 million apiece in new assets, B's have had inflows of more than $400 million, C's roughly $50 million, while D's and F's have experienced net outflows of $130 million and $199 million, respectively.

Clearly, investors have spoken with their assets. Advisors and investors care about stewardship and costs. They don't want the shortsighted sales tactics of the past. There can be no clearer or more valuable message for fund executives to hear. Treat shareholders with respect, or they will find someone who will.

Don Phillips is Morningstar's managing director, corporate strategy, research, and communications.

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Don Phillips is a managing director of Morningstar, Inc.

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