The Outlook for Mutual Funds

After a long period of explosive growth, particularly during the last 25 years where assets invested in mutual funds has grown 15 fold, we’re now starting to see this growth wane. These days, we are seeing the huge amount of money held by mutual funds, after breaking the $30 trillion mark, start to back up, where the funds being taken out of funds now exceed new money.

If we think of this as a market, we’ve had a tremendous bull market in mutual funds for a long time, and although things have at least peaked for now, we wouldn’t want to call this a bear market for mutual funds, at least not yet.

Due to the structure of mutual funds, not requiring any thought or effort on the part of investors, it is set to remain a very popular form of investing. The days where mutual funds had no real competition for the public’s investment dollars are over though, although for most investors, there still isn’t any real competition.

Exchange traded funds are the new bull market, and among those who are comfortable enough making their own decisions about their portfolio and also have the means to buy and sell them through self directed trading accounts, ETFs enjoy several distinct advantages over traditional mutual funds and many investors have moved over to this new form of investing.

Hedge funds have also gained in popularity, and some of the massive failures of some hedge funds in the past have been somewhat forgotten. Hedge funds do tend to have periods where they become very popular and also times where fund failures have tended to scare more people away, but we’re in a bull market again these days.

The resurgence of hedge funds and especially the growing popularity of ETFs have had to have their growth come from somewhere, and a lot of it has come from people choosing them over the traditional mutual funds.

Mutual funds are still king and may remain that way for the foreseeable future, and it’s actually hard to imagine this changing anytime soon. ETFs, hedge funds, managed portfolios, self directed investments, and the like may continue to cut into the massive edge that mutual funds have enjoyed for a long time, but it will take quite a bit for the habits of investors overall to change enough to not have mutual funds the preferred way for people to invest their money long term.

How Mutual Funds Will Stay on Top

ETFs trade like stocks, and the big ones trade right up there with the most heavily traded stocks in the market. SPY for instance, the ETF that tracks the S&P 500, is the behemoth, and currently the second most active security in the world. Several other ETFs trade in the top 10 most active.

What we need to realize though is that in terms of funds under management, trading volume and the amount invested aren’t the same thing. ETFs now hold around $3 billion worth of assets, but that’s only around a tenth of the amount that mutual funds hold. Mutual funds don’t trade, they acquire and hold, and they are still doing lots of holding, even though they may be holding a little less each year.

If investors as a whole were sophisticated enough to realize that investing in an asset like SPY is a little more efficient than investing in a mutual fund tracking the same market, there would be more money in ETFs and they would easily overtake at least the index based mutual funds.

Many investors have not even heard of this approach, or they may not be comfortable executing it, even as a buy and hold strategy. Some may worry that having the power to trade your own portfolio may tempt them to do the wrong thing too much. In many cases, this may be a valid concern, as only a small percentage of investors are capable of making such decisions well.

Paying a shade less in management fees may not be enough to tempt them either, especially when one has to open an account to do so, and a lot of investors do not have self-directed accounts nor are interested in having them even though the number of these accounts has grown tremendously.

You’re on your own with trading ETFs, which is going to take at least some investment savvy, and an interest that goes beyond just meeting with your advisor every few years and shaking hands, which is the extent of the involvement that most investors prefer.

While we may criticize regulators for being so tight, for instance limiting access to hedge funds to those of significant means, the truth is, most investors are like babes in the woods and have enough trouble sticking to a simple strategy such as holding during bear markets, and often will make decisions under duress that end up hurting themselves.

Mutual Funds Cater to the Masses

The major reason by far though that will keep mutual funds on top is that they are proactively sold, in a way that caters to the investment public at large, where other alternatives such as ETFs, hedge funds, and self directed investing are only targeted at more sophisticated investors who are inspired enough to go out and learn how to play a more active role with their investments.

Most investors are not interested in doing so, or at least aren’t currently, and this is unlikely to change that much anytime soon. Most people have their own careers and their own lives and conduct themselves according to their interests, and learning about managing your own investments just isn’t on the list.

The mutual funds industry has done a fabulous job of dissuading investors to look to take an active role with their portfolios, and those who may be considering doing so have to contend with all of the advice to stay well away from this.

More than anything though, the reason why mutual funds are funds for the masses is that they are promoted in a mass and systematic way, where ETFs are not. Mutual funds come to you in a real sense, they are sold to you, this is what you are offered when you seek investment advice. ETFs are self directed, it’s on you to go out and learn about them and open an account and trade them, as it is with any self directed investment plan.

Therefore, simply based upon the machinery in place so to speak to promote mutual funds, this alone will likely ensure that they maintain their lead among the types of funds and the types of investment that most investors engage in.

The Move Toward Index Funds

If most mutual funds do not beat the market, then it’s only natural that people will seek out funds that do not deliver meaningfully worse performance, and this is exactly what is happening.

While mutual funds as a whole has been experiencing a bit of a decline over the past few years, it has been at the expense of actively managed funds, and index funds are experiencing a lot of growth now.

Actively managed funds still hold the majority of funds under management in the mutual funds industry, but this is quickly changing, and it won’t be long before they are surpassed by the passively managed index funds that beat most of them.

This is a trend that will continue, as mutual fund companies push index funds more, and with mutual funds, it’s all about what is being pushed. Most investors aren’t sophisticated enough to be that aware of such things, although some are, and in an effort to win the business of more knowledgeable mutual fund investors, this trend has been created.

Most investors will just accept whatever you put on their plate, and aren’t really interested in the details of the funds they buy, perhaps they get a glimpse of some sales material with a chart and some historical returns, and just end up nodding their heads at the recommendations of their advisors.

Managed funds used to be in vogue, passively managed funds are now in fashion, but this still comes down to an exercise in marketing, and mutual funds simply have most investors well within their grasp. This is a trend which is very likely to continue for some time, similar to supermarkets selling most of the food because that’s where people go to buy it.

The expectation is that we’ll see more and more movement toward index funds, and we may even see a day where managed funds become more of a relic. There will probably always be funds that strive to beat the market, and perhaps some that do this the best will remain, but the ones that don’t will probably be regulated to the sidelines more and more.

As we evolve more and more in the Information Age, with more and more people gaining access to more and more and better information all the time, more and more investors will learn more and more about how to manage their own investments and more and more will make the leap and do so.

The biggest gap we face here is the lack of interest in people doing so. Sure, we can go out and learn about portfolio management and the many benefits of doing so, how we can take the approach that the hedge funds do, looking to both increase returns and reduce risk.

Perhaps people will learn that instead of their index funds they can just buy ETFs on their own, and hold that instead, and enjoy even lower management fees. Not a lot of investors are interested in even this though, and far fewer are up to taking charge of their own investments, and this is what will have to change significantly to ever unseat mutual funds as the most popular way to invest your money.

There’s nothing like a good bear market to dampen people’s enthusiasm about mutual funds, but they did survive the Great Recession relatively unscathed, and after the huge rebound, they now get to crow that their strategy was right all along.

The degree that this is true aside, if that’s the perception, it will take a lot to undo this perception. Mutual funds may be not the greatest of ideas, given that they are at the mercy of market performance so much, but they are certainly here to stay.