Morningstar Magazine - June/July 2017 - 10

Dispatches

What a Tangled Web
We Weave Investors
want simplicity;
fund industry keeps
creating mazes.
PHILLIPS CURVE

Don Phillips

The mutual fund industry spent much of the
past 30 years complicating its offerings. Investors
have spent the past decade seeking simplicity.
The classic virtue of a mutual fund is that
it's an easier choice than assembling a diversified
portfolio of securities yourself. The earliest
funds were balanced funds that combined stocks
and bonds to form an elegant solution for
an investor seeking a simple, one-stop way
to participate in the investment markets. Human
nature being what it is, however, the industry
was not content to let a good solution stand.
Instead, it began to tinker and add more choices,
but also more complexity. Funds that bought
just stocks or just bonds were created.
Sector funds, style-based funds, capitalization-based funds, regional and international funds,
and many other innovations followed. In addition,
many more management firms entered
the business, greatly increasing the number
of choices investors faced.
In the 1980s, this innovation shifted to new ways
to price mutual funds. With the growth of the
industry and the popularity of funds in individual
retirement accounts came a slew of financial
journalism helping guide confused investors. These
publications shared a common mantra: Whatever
you do, insist on buying a no-load fund. Predictably,
this counsel sent millions of Americans to
their brokers requesting to be sold a no-load fund.
Never one to miss a sale, the industry responded
by shifting around charges to create B and
later C share classes that abandoned a front-end

10

Morningstar June/July 2017

load but still offered a similar compensation
level for the advisor. With these new share classes,
and the many that followed, the act of choosing
a fund became even more complex. Now, not
only did the investor have to sort through dozens
of fund flavors from hundreds of sources, but
she also had to claw through a maze of different
pricing options.
To make matters worse still, U.S. mutual fund
investors have been saddled with some
of the most complex taxation rules for their fund
investments anywhere on the planet. In the
vast majority of countries where funds are sold,
investors only pay capital gains taxes when
and if they sell their funds. There's no guesswork
about what hidden taxable events may be
sprung on the investor in late December and
trigger added complexity come the April tax filings.
But in the United States, mutual funds are
forced to make annual taxable capital gains
distributions if net gains are realized internally at
the fund, resulting in tax headaches for shareholders that investors in much of the rest of the
world avoid. And if there's one kind of complexity
investors loathe most of all, it is tax complexity.
From every thesis sprouts an antithesis. Investors
have responded to wave after wave of added
complexity by purposely trying to streamline their
financial lives. They're opting for the investment
simplicity of indexing over choosing active
managers, moving to exchange-traded funds,
which shun the numerous pricing options of
conventional funds, and preferring indexed ETFs
for their internal structuring mechanisms,
which limit capital-gains distributions. In short,
investors still value the core virtue of simplification
that the industry has trampled over. Clean share
classes, without all the cost and noise of
distribution payments, are increasingly the vehicle
of choice. Simple indexes, rather than one
manager's idiosyncratic take on the market, are
the preferred building blocks. And ETFs, available
from any brokerage platform, rather than
funds that had selling agreements with some
platforms but not others, have become the
preferred choice of many investors.
The industry has responded in predictable
fashion-by complicating these new choices.

We've already witnessed scores of new index
launches. In the same way that there are
more funds than stocks, today there are more
indexes-the total is in the millions-than there
are current funds. ETFs have migrated into
ever more esoteric fields, with new investable
indexes created every day. Smart- or strategic-beta
funds offer numerous twists on standard
indexes, offering more choice, which is good for
some, but at the cost of greater complexity, which
intimidates many. Despite investors' demonstrated
preference for simplicity, the machinations
of the mutual fund industry seem able to produce
only one outcome: complexity.
So stands today's fund industry. It offers the
individual investor options that only the most
connected of professionals could have accessed 30
years ago. That's the good news. But in
meeting the ever-more-esoteric needs of the
narrowest niche markets, the industry continues
to put at risk one of its most salient virtues, the
virtue of making it easier for investors to
participate in the power of the markets. Today's
investors are inundated with choice to the extent
of paralysis. The challenge facing the industry
as it moves forward is not to supply investors with
yet more options, but to help them better
navigate the maze they already face. The issue
is better deployment of the tools already given
them, not a need for yet more options. The
solution will call on different skills than those the
industry has showcased to date. K
Don Phillips is a managing director with Morningstar.
He is also a member of the editorial board
of Morningstar magazine.



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