16 May

The Future of Mutual Funds

May 16, 2011

Mutual funds are, by far, the most widely used investment vehicle of choice. There are thousands of them, and considering their use in 401k plans, they are the staple that people build their retirement goals upon. There are a few trends that are worth noting in the mutual fund industry as we look forward.

One of the most important trends is that funds investing primarily in large company stocks and that are actively managed (which means someone is stock-picking) are on the decline. Over the last decade, large-cap active management shrank by half, from approximately 40% to 20% of industry assets. The reason is that advisors and investors have been choosing to buy index (passive) funds as a core large company holding, as well as re-position more of their assets towards international funds and, most recently, fixed income funds. The passively managed (index) funds are relatively inexpensive compared to most active funds and cost is definitely a factor.

There is already a proliferation of target-date funds. We should expect this to keep increasing. Target-date funds are usually “multiple” funds covering broad diversification that are all tucked into one overriding fund – this overriding fund will become more conservative by moving assets around the underlying funds as time progresses. An issue faced by these target date funds is poor fee disclosure (because of the multiple funds inside of funds) that can lead to prohibitively high fees.

We are also seeing an evolution of broad asset allocation funds. These are called balanced-risk or absolute return funds. The idea behind these is somewhat aligned with the target funds mentioned above. The difference is that these funds have a mandate that they can “go anywhere and do anything” which is not only limited to asset classes (i.e. target funds), but can also include commodities and derivatives. The goal with these funds is to provide downside protection that investors seek without giving up too much upside. Obviously, this strategy is in reaction to the extreme market volatility that the market has shown since 2007. Experts are skeptical that they will succeed (a bull market would leave these funds “in the dust”) and again, higher cost rears its head.

Mutual funds are expected to still continue to be dominant over ETFs (exchange traded funds) – even though we should continue to see ETF growth overall. From a pure convenience standpoint, the technological challenge for record-keepers of retirement plans (like 401ks) of consolidating ETFs into statement preparation is a big roadblock.

As I look at the trends mentioned above, I should mention that Savant’s efforts at running broadly diversified portfolios have long since addressed every one of these issues – putting us ahead of the curve.

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