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Fund Distribution Has Been Turned on Its Head. Now What?

Advisors struggle to define their role in the new model.

Scott Burns, 10/11/2013

This article originally appeared in the October/November 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.  

In the summer of 2011, something puzzling was happening. American Funds Growth Fund of America AGTHX, a 5-star fund, was experiencing staggering outflows of about $3 billion a month. Meanwhile, 3-star exchange-traded funds that tracked large-cap indexes were attracting strong inflows. Granted, Growth Fund of America has subsequently seen its Morningstar rating drop to 3 stars, but at the time, we were witnessing an unprecedented set of investor behavior. Investors were tossing well-established, historically high-performing strategies for, by definition, average-performing index funds.

Here at Morningstar, we started digging into why is this was happening. My article “Turning Fund Distribution on its Head,” which ran in the August/September 2011 issue, was the culmination of some of this research.

The simplest solution tends to be the answer in finance. In this case, the simplest answer— and one espoused by indexing diehards—was that investors had simply tired of paying a premium for active management only to get subpar performance. In that answer, index and exchange-traded funds became the logical beneficiaries of outflows from active-management funds.

We ultimately rejected that theory as the driving force of the sea-change in flows that we were witnessing. That theory might explain why poor or mediocre funds would experience outflows, but it did nothing to explain why active funds that were outperforming indexes were experiencing severe outflows. To explain that, we needed to look at factors driving investor preference beyond what returns and finance papers could explain.

In the end, we proposed that there were two primary drivers causing this shift in flows between vehicles and from active to passive. The first was a switch in advisor-incentive systems from a commission-based model to an assets-under-advisement fee-based model. The second was the launching of new investment technologies, primarily ETFs.

That was our view in 2011. Two years later, how accurate was our hypothesis? Overall, I would say I am happy with the effectiveness of the framework that we presented. I would put the results of the predictions into three camps: spot on; right church, but wrong pew; and a swing and a miss.

The Spot-On Predictions
The prediction that had the most uncertainty associated with it at the time turned out to be our most spot-on call. In the summer of 2011, PIMCO was preparing to launch an active-ETF version of its phenomenally successful open-end fund PIMCO Total Return PTTAX. We predicted that BOND would be a success. Boy, has it ever been.

Scott Burns is the Director of ETF Analysis at Morningstar and editor of Morningstar ETFInvestor. Click here for a free issue.
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