3 Reasons for Fund Investors to Celebrate

Scandal Free Few will mourn 2020's passing. However, mutual funds and exchange-traded funds bucked the year's glum trend. While a pandemic raged and a recession struck, the fund industry quietly went about its business, with little fuss and even less cause for complaint. Funds acted as their shareholders would have hoped and expected.

That praise is more than faint. Over the years, the fund industry has suffered notable embarrassments, such overstating returns by mispricing portfolios; holding more low-quality bonds than permitted by prospectuses; and, during the market-timing scandal, favoring some customers over others. Given that checkered history, and considering how Wall Street generally operates, avoiding the headlines rates as a genuine achievement.

This improved behavior owes to several factors. One is the industry's maturity. Funds are no longer the new kids on the block, about which little is known. Quite the contrary. Decades of public scrutiny have chased the bad actors out of the business, either because of SEC actions or because investors voted with their feet. Another reason is that the industry's leaders thoroughly dominate the sales charts, and those firms have so very much to lose. If their CEOs are to err, they would prefer to do so via omission, by being overly dull, rather than to harm their companies' reputations by sinning through commission.

Finally, and perhaps of greatest importance, fund companies now seek to avoid surprises. Once upon a time, aggressive organizations sought to beat the indexes by the largest possible margins, accepting major perils while doing so. Few today take such an approach. The watchword is "risk management"--keeping the fund's performance within sight of a benchmark, either by running index funds explicitly, or by managing their actively run funds with that benchmark very much in mind.

Of course, eliminating swashbucklers reduces the number of funds that will post exceptional performances. If they do record high returns, it will be because their markets carried them along, rather than through the inspiration of their portfolio managers. That seems like an acceptable drawback. Despite indexing's growth, there are more Chartered Financial Analysts than ever before, which makes out-thinking the competition very difficult. Best under such circumstances to scale back one's ambitions.

Lower Costs If funds promise less, they also charge less. Much less. Twenty years ago, the average asset-weighted expense ratio among funds was 0.87%. Today's figure is barely more than half that amount, at 0.45%. Effectively, 42 basis points per year that once were collected by the fund company now flow directly to shareholders. That makes for an extra $420 each year on a $100,000 investment.

This boon owes primarily to shareholder decisions, because the price decline comes primarily from investors switching from active to passive funds, rather than from funds cutting expense ratios within those groups (although that has occurred, particularly in recent years). Also, it must be confessed, some current investors pay higher overall investment costs today that they previously did, owing to changes in how financial advisors bill their customers. But these caveats do not alter the main story: By and large, retail funds now charge wholesale prices.

What's more, their fees have become more uniform. Previously, many funds carried embedded sales charges, in the form of front-end loads, back-end loads, and/or 12b-1 fees. This complicated fund analyses, because the first two items were conditional, one-time events, whereas fund expense ratios cannot be avoided and are ongoing; and because most of those costs left the fund company to compensate its outside distributors. Today, almost all the best-selling funds lack such features. Their costs may readily be compared.

Greater Choice Along with lower expense ratios has come improved choice. By this, I do not mean that shareholders may select from additional investment approaches. Entering this millennium, funds already followed hundreds of strategies, most of which were superfluous and over-engineered. The last thing that shareholders needed was yet another all-too-clever (and usually expensive) fund-company invention. The industry was littered with the corpses of such failures.

Rather, what shareholders required were additional ways to own their funds. Historically, the industry was bifurcated. "No-load" fund companies sold directly to investors, without bundling sales commissions into the price of their funds. For their part, "load" companies sold exclusively through financial advisors, with funds that carried bundled sales commissions. Investors therefore faced two very different paths: 1) Go cheap and forego advice, or 2) pay the full price for full advice. There was no middle ground.

Today, there is. With the price of advice largely stripped out of their costs, funds are now sold in a variety of ways. Not only have financial advisors switched from using only load funds (well, almost only, as there was always a small coterie of fee-based planners) to using the industry's full lineup, but many are evolving their businesses to serve their clients through technology. Another innovation has been the development of "robo-advisors," which straddle the previously unoccupied middle ground, by delivering advice remotely, at a discount to the full price.

The upshot: Whether buying alone or with assistance, investors can now select among the entire fund industry, while enjoying more choice about the nature of the advice that they receive.

Wrapping Up By and large, the fund industry has followed rather than led. Investors flocked toward funds that avoided performance surprises, thereby encouraging fund companies to manage their assets more carefully. Shareholders also embraced cheap funds, which nudged organizations that had not launched low-cost options to consider doing so. And investors and financial advisors together adopted the new advice model, which bypassed funds that contained bundled sales charges.

That's fine; marketplaces consist of a dance between customers and those who serve them. Who drives the decisions is, ultimately, immaterial. What matters is the result. And the result for funds has, quite clearly, been positive. That the fund industry no longer attracts the headlines is a very good thing.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.