The Next Generation of Fund Investing

The Engine That Did

Ask and ye shall receive.

On June 14, I discussed a reader's claim that, in time, an index fund's voting practices will become part of what it offers to the marketplace. Eight days later, the activist investor Engine No. 1 announced that it would launch just such a fund. The company vows that its Transform 500 Fund will make a "positive impact through voting and active ownership." Its ticker will be… drum roll… VOTE.

That was quick! However, although I appreciate the fund’s timing, today’s column is not actually about Transform 500. My subject instead is the fund’s attributes. Transform 500 was designed for younger investors, and therefore provides insight into where the fund industry is headed. The fund itself might not survive the test of time--but the features that it has identified certainly will.

Those features are: 1) passive selection, 2) active ownership, 3) exchange-traded fund structure, and 4) relationship with digital advice.

(Note: Transform 500 invests in securities held by a Morningstar MORN index. When I wrote my June 14 article, I was unaware of both that arrangement and--as I previously indicated--of Engine No. 1’s plans to enter the fund marketplace.)

Passive Selection

Index investing was a sound idea. Per William Sharpe's zero-sum argument, index funds can be expected to match the average returns of their actively managed rivals before they pay their expenses, and exceed them after costs (unless the index fund is egregiously priced). Funds that reliably exceed the averages, if even modestly, are attractive. It was no surprise, therefore, to see index funds steadily gaining market share in the 1980s, the 1990s, and into the New Millennium.

However, I did not foresee that index funds would become the norm. I believed that they would remain a minority taste, controlling perhaps 30% of the industry. Wrong. Index funds now command more than half of U.S. equity-fund assets, and they are gaining market share among international stocks and taxable bonds. The index-fund revolution will continue yet for decades.

In that light, Engine No. 1’s decision to offer an index fund makes sense. It seems counterintuitive for an activist manager to select its stocks passively. But bucking the headwind that favors index investing is a daunting task. Given that reality, Engine No. 1 chose wisely. Better to redefine how activists operate than to debut with an outdated investment model.

Active Ownership

Ironically, even as investors have adopted index funds, they have become more interested in governance. The environmental, social, and governance, or ESG, campaign founded in 2006 as a global platform that was promoted by the United Nations, has since expanded to U.S. retail shores. It appeals particularly to younger buyers, who are likelier to regard climate change as a serious matter.

Although most millennials have not (yet) incorporated their personal views into their investment decisions, sales of ESG-related funds are ballooning, albeit from a small base. Everyday investors are also policing other types of institutions. Thus, the much-noted GameStop GME trade--largely financed by younger investors--arose not only from the desire to profit, but also to harm hedge funds that had shorted the company’s stock. (Social movements don’t always dangle carrots.)

How the twin desires of passive selection and active ownership will be reconciled remains to be seen. Engine No. 1 Transform 500 takes one approach, by attaching its governance policies to its investments. But there are other possibilities. For example, index funds could poll their shareholders for guidance on how they should vote with corporate initiatives. Whatever the mechanism, it seems likely that fund investors will become more active, even as their funds become less so.

ETF Structure

Transform 500 is an ETF, not a traditional mutual fund. This, too, is where the future lies. There’s no investment reason why Transform 500 couldn’t have been designed as a mutual fund. Quite the contrary; the fund will buy and hold a diversified basket of securities, ostensibly for the long term (activist efforts don’t affect day traders), which is the task for which mutual funds were created. But why signal “yesterday” when your goal is tomorrow?

For appealing to the next generation, ETFs are clearly the correct choice. When Charles Schwab surveyed its ETF shareholders in 2018, 55% regarded ETFs as being their "primary investment type." That answer, however, was highly correlated with age, as 79% of millennials responded that way, but only 14% of "mature" investors aged from 73 to 75 did so. The trend is ETFs' friend.

Digital Advice

Not, in this case, that Engine No. 1 had much of a choice. Unusually, Transform 500's launch was accompanied by the news that the fund would immediately become part of a digital-advice platform, offered by Betterment. ("Digital advice" is what sophisticates call the services that are provided by robo-advisors.) As Betterment only invests in ETFs, Engine No. 1 was forced into the structure by its distribution arrangement.

My guess is that Engine No. 1 would have opted for an ETF anyway. At any rate, the Engine No. 1/Betterment partnership reveals yet another industry change. Whereas fund companies traditionally have lined up sales agreements with brokerage firms, which is where the money resides, some will opt instead for Engine No. 1’s strategy by making deals with digital advisors instead.

To be sure, this path is decidedly experimental, as digital advisors collectively hold a modest $500 billion in assets, of which Vanguard accounts for half. While I confidently expect further growth for index investing, retail investor activism to increase, and ETF assets to overtake those of mutual funds, I will hazard no prediction about the fate of digital advisors. They may prove to be an evolutionary cul-de-sac.

Wrapping Up

The fund industry is a supertanker. Its turns are almost imperceptible. This sluggishness occurs not only because the industry is mature, such that existing assets dwarf the amount of annual sales, but also because old habits die hard. In general, retirees reared on active mutual funds won’t care for index ETFs that meddle in corporate affairs. Nor are they the main audience for digital advice.

Eventually, though, the future will arrive, with millennials taking the place currently occupied by baby boomers, just as the boomers displaced their predecessors. And when that happens, the leading funds will look rather different than today’s.

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.