Is the Open-End Fund Industry Shrinking?

On this episode of The Long View, Dave Nadig, financial futurist at VettaFi, discusses indexing, future investing, and ESG.

Here are a few excerpts from Nadig’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

What is going to happen to the open-end fund industry?

Ptak: I wanted to shift and talk about indexing. I don’t think a conversation would be complete with you, Dave, if we didn’t talk about indexing, a subject to which you’ve devoted much, much analysis and a lot of your career and writings. Years ago, and I suppose this is a form of futurism, you correctly foresaw that ETFs would take market share from funds. What do you think ultimately happens to the traditional open-end fund industry? Will it shrink into oblivion? Or are there some things that you think open-end funds intrinsically do better than ETFs that will sustain the industry?

Nadig: I think it’s very much a horses-for-courses kind of situation, and I think it’s important to remember that all of these wrappers--ETFs, variable annuities, mutual funds, direct indexing--all of these things are just regulatory hacks. None of them is in any way a purest form of investing. Even the way we think about the U.S. stock market, that is itself a regulatory construct. And there are other ways of doing that. And, in fact, other companies and countries have other ways of doing that kind of common ownership. So, I think we get trapped with this idea that somehow these regulatory structures are manifest destiny. What’s manifest destiny to me is that we will inevitably disintermediate, we will inevitably simplify, and we will inevitably reduce costs wherever possible. Those seem inexorable to me. It’s sort of Mark Twain’s death and taxes. Nothing in financial history has ever gotten in the way of that movement, right? Mutual funds go back to the 1400s, and they’ve pretty much been getting cheaper and simpler and easier to access ever since.

So, the traditional mutual fund structure right now has a couple of regulatory advantages that I don’t see going away, not the least of which is fractional share ownership, which makes things like 401(k)s doable and easy, and 12b-1 fees, which allow you to fund things like recordkeeping. I think that as long as those are still real needs in the body corpus of American investors, then mutual funds are going to be just fine. I think there’s $15 trillion in them sitting right now. There will be more than that next year just based on market movement, most likely just because money is going to go into the defined-contribution business. But I do think that mutual funds become more and more of a niche vehicle for retirement savings and ETFs become the--if they haven’t already--become the default vehicle for any other kind of non-tax-deferred exposure. That could change, of course, with the stroke of a pen. You could change the way the IRS taxes things. You could change the way ERISA works. There’s lots of what-ifs you could do. But I don’t really see much impetus for any of that to change much in the next five to 10 years. So, I think, as far as I can tell, mutual funds will remain the default case for 401(k)s.

Will open-end funds be converted to ETFs?

Benz: Do you think a lot of fund companies will convert their open-end funds to ETFs? It seems like to this point they’ve been selective about what they will opt to convert.

Nadig: It’s a question of what they can. I’m just going to pull something out of a hat--but if you’re Gabelli, and you’ve got some giant mutual fund that’s well-situated in 150 large 401(k) plans, and it’s got five or six different share classes based on which versions being taken places. That’s a nightmare to convert into an ETF because somehow you have to deal with all of those existing holders who aren’t necessarily ready to take whole shares instead of fractional shares. So, you got to solve that problem. And certainly, those are solvable problems. Lawyers make a lot of money solving those problems. But there’s not a lot of reason to do it, which is why I think you’ve seen the path of the middle way here, if you will, which is that easy-to-convert funds, those that are not in tax-deferred plans, which often means funds that are tax-managed, which is, for instance, the DFA funds that converted. Those were actually tax-aware funds. They were designed for taxable investors. That makes a ton of sense to convert and that’s what we’ve seen most of the conversions in is those more tax-aware-type strategies.

I don’t really see a huge need for a Fidelity Magellan to convert when they can simply want to clone strategy and that’s what we’ve seen with most of those name-above-the-title, active management strategies from the mutual fund business. So, I think we’re probably on the course we’re going to see for a while. There will definitely be acceleration. We’re already seeing that this year. Dozens and dozens of funds have already converted this year. Most of them have done pretty well in terms of either gaining or holding some assets. But at the end of the day, people still have to want to buy it, and that’s not always the case that the ETF investor is a natural buyer of a mutual fund that just happened to convert.

Let’s talk about direct indexing.

Ptak: Let’s shift and talk about direct indexing, which you referenced earlier. I suppose we could view direct indexing in a sense as a threat to traditional indexing, in the same way that ETFs posed a threat, which was realized to mutual funds, traditional mutual funds. We’ve talked about direct indexing previously on the podcast. I think that we’ve gotten some positive, some negatives. I think that more recently there have been questions about whether it is overhyped. It seems like you concur to a degree. But to what degree, do you think, direct indexing could take share from ETFs in the same way ETFs took share from mutual funds?

Nadig: I think it’s going to be pretty much around the edges. The way I like to think about this is that where are the real value propositions in this investment management ecosystem? And the difference between whether you’re getting your, say, S&P 500 exposure through a direct index, or through SPY, or through a mutual fund, or through an annuity product, or whatever is largely just one of convenience and regulatory arbitrage. So, the value is actually the S&P 500, the intellectual property that goes into that collection of securities. It has some value. It’s been adopted in many formats. It’s a fungible exposure. It’s traded as options and leverage with futures exposures. So, that makes it valuable. That intellectual property has value. So, whether that IP ends up expressed in an index through a direct indexing product, or it gets expressed through an active manager who is simply referencing that as a benchmark, the intellectual property still has the value.

People may migrate between vehicles based on what their specific needs are, but I don’t think that that obviates the value of intellectual property. And I think that’s true whether you’re an active bond manager or whether you’re a big index, I think that that intellectual property is what has value. The thing that’s exciting about direct indexing is that it really strips everything down to the value of that IP. If I’ve got a direct indexing platform--let’s say I’m with Canvas over at Franklin--and I’ve done my tweaked ESG strategy or I’ve done my tweaked factor-based strategy there, the value to me is not the fact that it’s direct index, it’s the intellectual property under the hood and then some things that I can get away within indirect indexing I can’t elsewhere like single-stock tax-loss harvesting.

I think there will be some eating around the edges, but that doesn’t make me concerned for the “asset management industry,” because ultimately the asset management industry needs to be about intellectual property and convenience, and if it’s not solving either one of those things, then your business doesn’t have a reason to exist.

What are the key advantages of direct indexing?

Benz: Can you discuss what you see is the key imperatives for direct indexing, the key advantages? Is it personalization and tax optimization? Anything else?

Nadig: It’s interesting. When I first started really digging into the direct indexing space about a decade ago, it was still pretty nascent. People were like parametric, which were doing what I would call slightly tweaked big indexes. It wasn’t so much that they were making giant bets. They were just allowing you to invest, say, in the S&P 500 with some tweaks here and there. And at the time, when I would talk to the bigger advisor groups or some of the institutions that were using that product, you would hear things around tax-loss harvesting, of course, here and there; you’d hear about specific tweaks that perhaps an endowment had a no-fossil-fuels mandate or something like that, and that indirect indexing made it fairly trivial to implement those things. And I assume that that would be the case as this hit the more rank-and-file advisor.

What’s actually the case, which I’ve learned really in the last couple of years as I’ve gotten to talk to advisors who have really leaned in on some of the advisor-forward direct indexing products, is the number-one big use case is actually single-position management. It’s the executive who has 25% of their net worth tied up in Google stock. And they’ve got to manage that down over time. And so, they work with their advisor to create a selling plan. They work with an advisor to create offsetting exposures so that they’re not hyperexposed to tech or hyperexposed to ad services or whichever part of that business they may have career connection to as well. And it turns out that seems to be the killer app for a lot of advisors, that position management piece of it. The fact that you also get some tax benefits because of the single-stock tax-loss harvesting makes that even better. But often it seems to be that big, concentrated, unsellable position that needs to be managed where DI is just an absolute silver bullet.