Remutualising Funds

According to Lipper, European equity mutual funds have now seen outflows for three years in five, suggesting growing investor disillusionment with this type of savings vehicle.

(See our blog from last week for more details of the Lipper survey)

Though there may also be economic and demographic trends at work, an increasing perception of the poor value of fund management services is undoubtedly causing such large-scale investor withdrawals. With stagnant or falling returns from equity markets over the last decade, the share of those returns being absorbed by costs has gone up sharply.  This is a topic that’s unsurprisingly attracted a great deal of mainstream press attention in recent months.

“3.2 percent in fees are being siphoned off each year from pension plans,” yesterday’s Daily Mail reported.  Investment industry insiders may quibble about some of the measurements used, and many of those attacking fund costs have their own commercial interests to promote, but you can’t dispute the frightening effect of compounding percentage charges in a low-return world.

But it’s not just high-cost active managers who are under fire. Even though ETFs have continued to record net positive sales, the passive funds industry can’t be complacent, either. 2011 was the year in which one of the leading ETF issuers in Europe, Deutsche Bank, admitted in a research article that providers make as much on the side from “ancillary” activities like stock lending, trading and derivatives provision as they do from fund fees.

Other observers have added weight to arguments that you can’t take passive funds’ headline expense claims at face value.  For example, the Bank of England suggested in its summer Financial Stability Report that notionally lower fees on synthetic ETFs may disguise higher and unadvertised risks.

It’s worthwhile remembering the original aim of mutual funds—of which index funds and ETFs are one type. First developed on a large scale in the 1920s in the US, such investment vehicles were designed to offer easy and diversified equity and bond market access to the masses. Open-ended mutual funds became popular after the 1929 Wall Street Crash discredited the previously popular (closed-ended) investment trusts, many of which had become highly leveraged pyramid schemes that ended up losing all their investors’ money.

Reinforced by better post-crash regulation, the US mutual funds industry took off in the 1950s and 1960s, while indexed funds added a formidable new strand to the business from the 1970s, one that continues to gain market share.  The move towards defined-contribution pensions in several Western economies greatly reinforced the demand for such pooled savings vehicles.

Mutual funds haven’t stayed immune from the conflicts of interest that beset the broader financial services industry, though.  Some of the leading names in the business—Strong, Putnam, Invesco, Prudential—were caught up in the 2003 late trading and market timing scandals in the US.  The increasing use by mutual funds of “heads I win, tails you lose” hedge fund-like performance fees is another, more recent cause for concern.

And now, as we have seen, there’s ever more attention to costs and the extent to which the guardians of investors’ money are really working on their clients’ behalf. An increasing number of observers are asking a simple question: why have average fund expense ratios gone up during a decade of poor returns and when computerised trading has greatly decreased the costs of accessing those funds’ underlying investments?

Perhaps a new bull market is around the corner, something that would probably divert attention from nagging questions about fund expenses.  Until then, the extent to which the interests of management companies, fund directors and investors are truly aligned will be the standard by which fund viability should be measured.

Unless the asset management business can address the conflicts of interest to which it seems prone, expect ever more investors to ditch funds altogether and buy equities and bonds directly. Let’s hope that, helped by sensible changes in regulation, 2012 will be a year in which steps can be taken to restore pooled fund investing’s original goal of mutuality.

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