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The Best (and Worst) Mutual Fund Innovations

Ideas that have withstood the test of time—and that have failed it.

Illustrative photograph of John Rekenthaler, Vice President of Research for Morningstar.

The Winners

Thanks to the many readers who responded to last month’s ”The 5 Best Financial Innovations—Ever.” Today’s article is a sequel, addressing the history of mutual funds. Mutual funds debuted in the Netherlands during the late 18th century, crossing the Atlantic a century later. (Before Yankee ingenuity came Dutch acumen, as evidenced by the purchase of Manhattan.) Given funds’ relatively brief existence, I cut the “best innovations” list from five to three, but I also added the three worst inventions.

The successes:

1) Open-end funds

The first funds, both in the Netherlands and the United States, were closed-end. Consequently, those who wished to cash in their investments could only do so by selling to other shareholders. That placed them at the marketplace’s mercy. If their funds traded for less than the value of their assets, which often occurred, they were forced either to accept the discount or to postpone the trade.

All that changed with the creation of open-end funds, which required the fund sponsor to redeem shares at their par values. Mutual fund investing was thereby simplified. Closed-end funds retained some appeal, since they possessed the advantage of never being forced by redemptions to sell their securities, but they faded into the background. Investors strongly favored their open-ended siblings.

2) Index funds

You knew this was coming. (In fact, a couple of readers suggested that I place index funds among the three best overall financial innovations, but that strikes me as a step too far.) After a slow start, index funds have revolutionized the business. Although they do not yet account for most U.S. fund assets, they will before long. Without question, they have become the industry standard.

As Jack Bogle himself admitted, the main benefit of index funds is their cost rather than their construction. If reliably managed, by keeping a consistent investment style and not trading manically, active funds can be fully competitive with index funds. But their price must be right, and it rarely is. What makes the leading index funds special is that they are far cheaper than what they replaced.

3) Exchange-traded funds

Bogle was none too fond of the final item on my list, exchange-traded funds. Given that most ETFs index their holdings, while carrying low expenses, his dislike seems illogical. However, Bogle’s concern was not how ETFs were built, but instead how they were perceived. He worried that one of ETFs’ major attractions—that their investors could sell their shares throughout the day—would become their downfall. Investors would abuse that privilege by churning their shares.

That has not transpired. For the most part, when retail investors have purchased ETFs, they have treated them like index mutual funds. In effect, ETFs have become the new version of an index mutual fund, albeit while possessing even greater tax efficiency (thanks to their structure) and being easier to buy (because they are available through all brokerage platforms).

The Losers

Now the failures:

1) The 12b-1 fee

I am delighted to report that, if not already, this term will soon bewilder. These days, almost no new fund shares carry 12b-1 expenses. A quarter century ago, though, such costs were ubiquitous. Developed in 1980, the 12b-1 fee was the mechanism by which funds charged more, so that they would charge less. If that does not make sense to you, congratulations! You have instantly figured out what the previous generation learned only from painful experience.

To resolve the mystery: The 12b-1 fee increases the expense ratio paid by existing shareholders, on the logic that the additional revenue will permit the funds to market themselves more effectively, thereby growing their assets so that they eventually become cheaper than they would be had they not levied the 12b-1 fee. Voila! From higher costs lower costs ensue. Unfortunately, this virtuous circle rarely occurred. Funds with 12b-1 fees simply charged more than they otherwise would have, and that was that. Their shareholders paid more to receive less.

2) Specialty funds

Marketers differentiate their wares, by originating new products and services. Obviously, this is a useful tendency. Without invention, all U.S. mutual funds would be balanced funds—fine investments, to be sure, but not ones that meet all needs. Thanks to the imaginations of marketers, various species of equity and bond funds now exist, along with international-stock funds, target-date funds, and many other fund categories both popular and useful.

However, investors would have been better off had specialty funds—that is, funds that invest solely in a single industry or geographic region—never existed. Specialty funds erode the key benefit provided by mutual funds, that of diversification. Worse, they tempt investors into overtrading. Bogle’s concern that investors would churn ETFs turned out to be overblown, but his principle was sound; he had already watched investors do so with specialty funds.

3) Tactical-allocation funds

This title is a placeholder, representing all fund categories that are brought to market after their investment success. Tactical-allocation funds, for example, are intended to protect against stock bear markets (although whether they deliver on that promise is another matter entirely). They first appeared after Black Monday in 1987. They resurfaced in the wake of the early 2000s’ technology-stock downturn, and again in 2009. (I expect another wave of tactical-allocation funds in 2023.)

Such is the downside investment marketing—the tendency to sell barn doors after the horse has bolted. This habit affects rallies as well as selloffs. For example, fund companies rushed to provide cryptocurrency exposure during bitcoin’s boom (albeit vainly, as the SEC has stalled almost all such filings). For that reason, fund shareholders historically have been best served by ignoring the popular new funds, and instead sticking with the dull but effective veterans.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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