Morningstar Advisor - October/November 2013 - (Page 36)

Spotlight Fund Distribution Has Been Turned on Its Head. Now What? By Scott Burns Advisors struggle to define their role in the new model. In the summer of 2011, something puzzling was happening. American Funds Growth Fund of America AGTHX, a 5-star fund, was experiencing staggering outflows of about $3 billion a month. Meanwhile, 3-star exchange-traded funds that tracked large-cap indexes were attracting strong inflows. Granted, Growth Fund of America has subsequently seen its Morningstar rating drop to 3 stars, but at the time, we were witnessing an unprecedented set of investor behavior. Investors were tossing well-established, historically high-performing strategies for, by definition, average-performing index funds. Here at Morningstar, we started digging into why is this was happening. My article “Turning Fund Distribution on its Head,” which ran in the August/September 2011 issue, was the culmination of some of this research. The simplest solution tends to be the answer in finance. In this case, the simplest answer— and one espoused by indexing diehards—was that investors had simply tired of paying a premium for active management only to get subpar performance. In that answer, index and exchange-traded funds became the logical beneficiaries of outflows from active-management funds. We ultimately rejected that theory as the driving force of the sea-change in flows that 36 Morningstar Advisor October/November 2013 we were witnessing. That theory might explain why poor or mediocre funds would experience outflows, but it did nothing to explain why active funds that were outperforming indexes were experiencing severe outflows. To explain that, we needed to look at factors driving investor preference beyond what returns and finance papers could explain. In the end, we proposed that there were two primary drivers causing this shift in flows between vehicles and from active to passive. The first was a switch in advisor-incentive systems from a commission-based model to an assets-under-advisement fee-based model. The second was the launching of new investment technologies, primarily ETFs. That was our view in 2011. Two years later, how accurate was our hypothesis? Overall, I would say I am happy with the effectiveness of the framework that we presented. I would put the results of the predictions into three camps: spot on; right church, but wrong pew; and a swing and a miss. The Spot-On Predictions The prediction that had the most uncertainty associated with it at the time turned out to be our most spot-on call. In the summer of 2011, PIMCO was preparing to launch an active-ETF version of its phenomenally successful open-end fund PIMCO Total Return PTTAX. We predicted that BOND would be a success. Boy, has it ever been. Launching out of the gate with a large initial seeding, the fund raced to having billions in assets within several months of its launch in early 2012. BOND trails only the ubiquitous PowerShares QQQ QQQ in the history ledger in terms of being the fastest-growing ETF of all time. That is, not just the fastest-growing active ETF, but the fastest-growing ETF, period. In addition to stellar asset gathering, BOND also outperformed not only the benchmark, but also the cheaper institutional shares of its sister mutual fund by hundreds of basis points. All and all, it was quite a successful launch. Also in the spot-on camp is our prediction that fee-based advisor schemes would continue to overtake commission programs. While it is difficult for us to get our hands on accurate data on this front, I don’t think there is anyone out there who would question that the switch to fee-based advice is happening across the board. Most likely there will remain some small amount of commission-based advice where it makes sense. But it is becoming pretty clear that when new clients come in the door, advisors whether captive or independent are likely to provide them with a fee-based program. We think conversion of existing clients to fee-based programs is beginning to accelerate as well.

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2013

Morningstar Advisor - October/November 2013
Letter From the Editor
How to Make Social Media Work for You
Do Mutual Funds Still Have a Role?
More Personal Than Finance
How to Handle Your TIPS Positions
A Real Estate Veteran Starts From Scratch
Investments á la Carte
Investment Briefs
When to Say No
Take a Guarded Approach to Homebuilders
Fund Distribution Has Been Turned on Its Head. Now What?
Winning the Distribution Battle
Active ETFs Wait for Their Heyday
A Fund Firm Defies Indexing Trend
Piloting New Channels
A Good Fit
The Predictive Power of Fair Value Estimates
Does Being Prudent Pay Off?
Utilizing Utilities’ Total Return
Stuck in the Middle Is Not a Bad Place to Be
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
The Good Guys Win

Morningstar Advisor - October/November 2013