Are Funds Still the Future?

What’s in Store for Investing in the Future

Mutual funds became mainstream during the 1990s. They had existed for some 75 years, but before the 1990s they were far from dominant. In 1985, U.S. equity mutual funds controlled 4.5% of the nation’s stock market capitalization. Then came the boom. Today, including the assets held by exchange-traded funds, that figure is 25%. (As many stocks are owned by institutional and/or foreign investors, the retail market share for funds is larger yet.)

Funds triumphed because they were easy: easy to buy, easy to monitor, and, thanks to their high level of diversification, relatively easy to own. They were also supported by a wealth of third-party resources, provided by databases such as Morningstar, journalists at major newspapers and magazines, and various newsletters. Fund investors were less likely to face unpleasant surprises than those who owned other, less public investments.

However, funds possess one major drawback: They are identical for everybody. Within each share class, one investor holds the same portfolio as the next, with the same costs, and receives the same results. This leaves funds vulnerable to attacks from rivals who offer customized services. Some investors genuinely need something different. Others do not, but they seek bragging rights. Either way, funds fail them. For such investors, publicly traded funds are like taking the bus—and they would prefer a personalized ride, thanks much.

Separately Managed Accounts

Until recently, the resources for customized investing have been limited. The most popular service has been separately managed accounts. SMAs hold portfolios that resemble a (relatively concentrated) fund, but possess the securities directly. Consequently, unlike fund shareholders, SMA investors can modify their positions to create portfolios that are solely theirs.

The SMA industry has been moderately successful. According to a report from the research organization Cerulli, SMAs are worth $1.5 trillion in aggregate. That makes SMAs larger than a cottage industry. Nonetheless, they have not offered serious competition for funds, which entered 2021 with $23.7 trillion in assets. To support the latter point, although exchange-traded funds were created after SMAs, ETFs have 4.5 times as many assets. Buses remain more popular than private coaches.

Part of the reason is cost. For those who hire financial advisors, investing with SMAs can be cheaper than owning active mutual funds. But doing so is not cheaper than using advisors to buy ETFs or index mutual funds. And for investors who make their own decisions, SMAs are clearly the pricier choice. For example, the annual fee for Charles Schwab's Managed Account Select program starts at 1% for equity portfolios. The company does offer volume discounts for larger customers, but that program can never approach the price of Schwab's ETFs.

Another reason that SMAs will not catch funds is that they occupy the wrong side of history. Traditionally, SMAs have been offered by active portfolio managers. The pitch has been: 1) Enjoy the benefits of professional management while 2) maintaining control of your portfolio. The latter promise remains attractive, but in this day of indexing, hiring active managers has become distinctly unfashionable.

Two New Players May Threaten the Future of the Mutual Fund Industry

These days, two additional strategies for customizing investments have emerged. Each corrects the key objections to SMAs by slashing costs and eliminating active management. However, the two approaches are otherwise starkly dissimilar.

One has been widely discussed: do-it-yourself stock trading. Per The Economist, the number of retail brokerage accounts in the United States has ballooned to 95 million from 59 million over the past two years, for an increase of 61%. Retail trading activity has followed suit. Over that same period, the percentage of U.S. equity trading volume created by retail investors has grown to 40% from 25%. After gradually conceding ground to professional managers for the past several decades, retail traders have suddenly reasserted themselves.

It is customary to credit commission-free trades and the longer-term bull market for sparking the retail-trading fire. Those explanations are correct, as far as they go. But one must also credit the sense of fun. Target-date funds in 401(k) plans are fine investments, but quite dull. To differentiate themselves, brokerage firms increasingly sell excitement. For today's smartphone entertainment, play an online game, place an NFL wager, or use your brokerage app to buy a stock.

The other customization strategy—direct indexing—is less widely known, although it has been highly touted within the financial-services industry. Effectively, direct indexing is the passively managed version of SMAs. Rather than hire an active manager, direct indexing investors begin with a passively constructed portfolio, then customize. They may harvest capital losses to offset capital gains; adjust their positions to compensate for the risk of owning a big slug of company stock; and/or apply investment screens, such as environmental, social, and governance criteria. Typically, such portfolios are more diversified than those offered by SMAs—and less costly.

As with baby names, direct indexing began with the very wealthy, but it has been moving down the economic ladder. Early versions of direct indexing required large outlays—for example, $5 million. However, thanks to technological and operational improvements, including the development of fractional shares, the cost of establishing positions in several hundred stocks has plummeted, as have investment minimums, which tend to range from $250,000 to $500,000.

(Last month, Vanguard entered the fray by purchasing direct-indexing provider Just Invest. Although the company has initially placed that capability within its Financial Advisor Services division, thereby indicating it will be targeting relatively flush investors, one would expect that Vanguard eventually will make direct indexing available to the mass market.)

What Is the Future of Mutual Funds?

To address the headline's question: Are funds still the future? I think so. No matter how much technology continues to improve the customer experience, both do-it-yourself investing and direct indexing will still require more investor involvement than buying and holding a publicly traded fund. I rarely bet against the power of inertia. Also, because of operational constraints, mutual funds will remain the investment of choice within 401(k) plans for the foreseeable future.

That said, the customized alternatives are a legitimate threat in the longer term. According to a report from the online publication Ignites (the article is paywalled), over the past seven years the percentage of Schwab's self-directed brokerage assets allocated to publicly traded funds has dropped to 50% from 55%. Meanwhile, the percentage in individual stocks rose sharply. Funds remain the investment industry's leader, but the trend has not been their friend.

This column was originally published on Sept. 3, 2021.

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.