Morningstar Advisor - August/September 2011 - (Page 38)

Spotlight Turning Fund Distribution on Its Head By Scott Burns and Paul Justice ETFs bring managed investment products into the digital age. Goodbye, 1940. We are often asked why passive investing and exchange-traded funds are gaining so much traction these days. The answer we think most folks are looking for is that the investing world—burned by the market turmoil of 2008—has accepted that active managers have a hard time beating the market. While that may be true to some extent, we don’t believe it is the cause for the dramatic shift in fund flows from active to passive investments. (In June alone, about $19 billion flowed out of active mutual funds, while passively managed funds had inflows of nearly $1.1 billion.) After all, the data on active management’s ability or inability to deliver alpha on average has been available for decades. Even with that, money has continued to flow to underperforming and mediocre funds and managers. In an efficient market, this kind of behavior is unlikely, but that is the point—the asset-management world is not an efficient market. At least that was the case until a few years ago. The flows tell the story that asset managers and distribution middlemen themselves don’t want to believe. The times they are a-changin’, and how these groups sell their wares to institutions, advisors, and individuals is being disrupted by very unlikely sources. The first disruptor is advisors’ adoption of fee-based and fiduciary models and standards. The second is the technological advancements of ETFs and the national stock exchanges they trade on. We are in the early rounds of this sea change, but if you believe in efficient markets, as we do, then how this ultimately plays out is academic at this point. Commission’s Last Stand The mutual fund industry is fighting a battle it may be better off surrendering. The SEC is reviewing the structure and transparency of the nefarious 12b-1 fee, and some industry insiders see preserving most of the current elements of this compensation mechanism as critical to their survival. At the heart of all of this regulatory scrutiny is an attack on the primary mechanism for how mutual funds are sold: commissions. Commissions to advisors, wholesalers, platforms, and supermarkets and the value each delivers to the end investor are what this fight is all about. It may come as a surprise to some, but all of this regulatory wrangling over fees and disclosure is ultimately a lot of energy wasted. Progressive advisors did not wait for regulators to decide that all of these commission shenanigans weren’t good for investors. They have adopted fee-based models that don’t leave much room for commissions. By aligning their revenue and compensation streams with the fortunes of their clients, advisors have also removed commissions, a source of market inefficiency. It really shouldn’t come as a surprise how advisors allocate their clients’ money now that it is their own. They keep costs low, they stay diversified, and they do not churn the portfolio. They buy the best-performing funds, not the best-paying. More and more advisors, especially with new clients, are adopting the fee-based model, and this is what is driving the flows into passive and low-cost vehicles at such astounding rates. While this has been happening organically in the U.S. market, the regulators have a chance to speed this process up by accelerating their plans to make the fiduciary standard more broadly applicable. While this is debatable, it is our opinion that fiduciary equals fee-based. Anecdotally, major wirehouses and independent advisor platforms have stated that they are planning for a future under the fiduciary standard as if it were a foregone conclusion. One wirehouse reports that as much as 85% of new client money is going into fee-based advisor programs at many of these intermediaries. 1940s’ Technology in the Digital Age The arguments over which is the better vehicle, ETFs or mutual funds, usually get bogged down in quarrels about active versus passive (which is a different debate), investor behavior, and product proliferation. All of these diversions miss the point. What we are really debating is technology. Both vehicles are 38 Morningstar Advisor August/September 2011

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2011

Morningstar Advisor - August/September 2011
Letter From the Editor
Simplicity and Design Matter
Do You Use ETFs Strategically or Tactically?
The Institutional Way
How to Analyze an ETF
Eyeing ETFs’ Next Chapter
Small-Cap/Large-Cap Flip-Flop?
Four Picks for the Present
Investment Briefs
Morningstar Investment Conference
Pitfalls of Peer Groups
A REIT Recovery, With a Catch
Turning Fund Distribution on Its Head
Here Come ETF Managed Portfolios
Circle These Picks Amid the Crop of New ETFs
ETF Analyst Favorites
Beware, the Accidental Portfolio Manager
It’s the Destination, Not the Vehicle
New Growth, Rooted in Experience
Better Ways to Look at ETFs
How to Better Manage Your Clients’ Future(s)
More Bargain Than Bubble
Cheap, Local, and On a Roll
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
First-Quarter Assets Hit an All-Time High
You Say You Want a Revolution?

Morningstar Advisor - August/September 2011