The Death of the Mutual Fund

by JT McGee

Much has been said about the death of mutual funds.

Actively-managed funds are a dying breed, in part because so many people are seeing economic value in passive indexes.

One can simply buy a broad market index fund and enjoy the returns of the entire stock market while paying a paltry fee of only a few basis points each year.

Growing skill gaps

When mutual funds die, or simply make up less of the assets under management, there will be an enormous skill gap.

Right now, a few different types of market participants drive prices:

  1. Active individual investors
  2. Active mutual fund managers
  3. Active hedge fund managers and activist funds

Passive funds piggyback the valuations put in place by these three market participants, so their input on “pricing-in” new information is…well, just about zero.

To be sure, the overwhelming amount of capital is still invested in active funds, particularly actively-managed mutual funds, which are accessible for small time retirement savers and everyday investors. Many do practically nothing for the investor, seeing as they’re really just closet indexers who actively manage only a small part of their portfolio. A much smaller share is managed by hedge funds (accessible only for those who meet requirements for accredited investors.)

Supposing that actively-managed mutual funds make up a much smaller share of assets under management in the future, stock prices will be dictated only by active individual investors (including those who take stock tips from cocktail parties) and active hedge fund managers, who manage funds on behalf of the super-wealthy investor class.

Mispricing galore

Imagine a world in which the retail investor and hedge fund managers are the only investor classes with any real input to a security’s value. Remember, passive funds buy stocks based on an algorithm, usually by market cap, basically hoping to latch on to the collective wisdom of all active participants in the market.

If in the future substantially all market activity is driven by at-home investors and hedge fund managers, who can really only work for the top 5% of income earners or households by net worth, there are only two real outcomes:

  • Stocks become more frequently mispriced, as their market prices are more greatly determined by people who have no idea what they’re doing (retail investors with no background in finance in any way, shape, or form.)
  • A growing wealth gap, as hedge fund managers who can only work for the wealthiest investors enjoy the ability to correct mispricing that comes from retail investors and passive funds
  • .

Where’s the equilibrium?

Suppose that 80% of all investment capital is passively invested and simply chases the 20% that is actively-managed. Said another way, one-fifth of assets will be used to actively seek new values. The remaining 80% will be invested in “me too” funds, funds that follow what everyone else is doing.

Imagine what this reality would look like. Fewer people would have much more input on the valuation of any given security. The power to value companies would be vested entirely in hedge fund managers and, to a lesser extent because they have less capital, retail investors. These valuations set by an elite club of fund managers and retail investors would be indiscriminately accepted by passive funds, which merely want to track the entire market.

I’m not sure where this equilibrium is. Passive funds are finding more and more AUM by the day. In 2011 alone, twice as much new money was invested in ETFs than was invested in actively-managed mutual funds. Eventually, passive funds could make up half or more of all assets under management, squeezing out mutual fund managers on the margin of profitability and vesting more power into the few remaining players – retail and hedge fund/activist investors.

If I had to make a prediction…

Asset allocation isn’t going away any time soon. However, I do think that its advantages will wear out at some point over the next 10 to 20 years.

In that time, we’ll see active funds die and asset allocation take over. And during that period, I think we’ll see ever-growing returns for activists, who will correct public company mispricing with take-private bids.

There’s an inflection point to be found somewhere. You simply cannot have a market that is entirely driven by passive funds. Where that inflection point is, I’m not exactly sure. But we’ll probably overshoot it before we shoot under it. I still think passive funds have trillions of dollars of growth ahead of them before active management makes sense once again. In the meantime, I expect historical outperformance from activist funds only to continue, and the margin for outperformance to grow over the next 10-20 years.

{ 6 comments… read them below or add one }

Value Indexer March 27, 2013 at 15:56

As bad as the returns of index funds might get, it’s still not possible for all actively managed money to outperform the index in the same market. So whether the market is smart or dumb, anyone who sets out to beat it will always have a good chance of doing worse than the index because someone has to.

That leads to another interesting conclusion. There is no such thing as mispricing. Even if our knowledge of the future was perfect, preferences and willingness to pay for them vary over time. I would happily buy a stock at a price such that it loses 15% per year for the next 5 years but has a 15% annual return over the next 20. Active managers would get fired for that, so they might only be willing to pay 25% of what I would. That’s one stock and two prices – which one is correct? And if there isn’t one correct price, how can the current price be wrong?

Ultimately the one thing that is still influential regardless of the level of indexing is the choice of asset allocation. While I can’t pick stocks that will beat the S&P 500, I can decide that I don’t like the valuation of the S&P 500 as a whole and I want to get out. This is the real issue. When there is too much capital chasing returns in a market those returns must fall. When everyone leaves a market, the returns rise.

That sets the general market valuation, and within the market there will always be active investors pushing the prices of various stocks up and down to maintain a relative spread. It doesn’t take a lot of them either. If we someday leave behind today’s hyperactive trading activity that aims to make a profit in 2 milliseconds, I’m sure a reasonable market could be maintained with much less turnover and less active investors since it is only the ones at the margin who are trading today that set prices today. In fact, having 10m people wake up tomorrow and decide to buy Apple at any price would be a bigger threat to market equilibrium than having 80% of the market owned by index funds.

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JT March 28, 2013 at 00:25

First, thanks for the lengthy comment – I can dig the discussion. I should probably have clarified a little more in my article:

* I don’t think all active managers will outperform. That’s mathematically impossible. What I think is more likely is that variance of performance for fund managers will grow. Those that outperform will likely outperform by a wider margin than those that do not.

* I think there’s absolutely some standard for mispricing. There are a multitude of companies trading for less than their net cash despite the fact they are profitable. That just doesn’t make sense any way you slice it. You can call that efficient, but no rational business owner would sell their profitable company to a private owner at a price less than the cash in the bank. It just wouldn’t make sense. You can find many of these on the public markets, though.

*I think it does take a lot of active management for a market to work. The most depressed valuations are found where very few people are doing digging. And so I also think the amount of money actively or passively managed does matter. A share of stock signifies a proxy vote – some input on the business and how it operates/returns cash to shareholders/whether or not it gets bought out or remains public. This is why I think activist funds and hedge funds, which can concentrate heavily and seek to create value with influence will find the best returns because they’ll correct the most mispricing. It happens a lot in the small cap space, where pissed off shareholders voice their concerns for an event to create value – whether its buying back stock, paying a special dividend, or disclosing more information in an annual report so the company can be understood by more people.

* Just as a matter of perspective, I think it’s a whole lot harder to determine whether or not the broad stock market is over/undervalued than it is to tell if a single company is.

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Value Indexer March 28, 2013 at 10:54

Good points – I always like a good challenge to my ideas 🙂

Long-term index investors don’t need a lot of trading, just one trade to buy and one to sell. If they drive a large part of the market, then the only liquidity really necessary to keep the index returns healthy is enough for the few people who want to get in our out at any given time. I’m not sure how many active managers are needed to make that liquidity available but it can’t be anywhere near today’s level where Apple’s entire ownership is turned over every 57 days (and it’s not a small company). If you imagine the stock market as a restaurant that’s like someone ordering a steak for breakfast, walking out 5 seconds later, and coming back in the evening complaining that they’ve been waiting 8 hours for their pancakes.

The strange thing is that with all the active managers currently in the market, they seem to focus on a few stocks where they beat each other up and leave others uncovered. At this point the lower competition on small cap stocks might make it worthwhile to cover more of them in order to find enough opportunities. But active managers seem to take the easy way out. As you point out, they could go a long way to earning their fees by influencing the companies they invest in. A large part of the efficiency of the current market is probably driven by a small number of active managers who don’t get the credit and capital they deserve. The rest could become bus drivers and leave everyone better off. Many active managers are not only closet indexers (driving up the passive market share) but also driven by retail investors they serve who push them to chase momentum aggressively (which is even worse for the market than passive investing).

At the extremes there may be mispricing, but then again it could still be different preferences. Some investors might prefer to have lower but more steady return, rather than a company trading below cash value but facing big risks. A rational owner in that situation might shut down the company and keep the cash, or take it private. If they don’t do that there may be other forces at work. If there are real mispricings it seems like the capacity to invest in them profitably is much smaller than the capacity for index funds.

It’s true that you can’t do in-depth research on 500 companies to determine a market’s value, but at some level you don’t need to do that. If you’re picking one car maker to buy then things like market share are important. If you’re buying all of them you don’t care about their market share because it cancels out. On that basis, the profits and returns of large cap indexes seem much more consistent than they are for most individual stocks. Based on that you can decide if you like the index at the current price or not.

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JT March 28, 2013 at 13:45

I agree with you that we don’t need the liquidity we have today. The idea of buying a company that trades at multiples of FORWARD earnings spanning more than a decade and selling it within days or minutes is something I’ll never understand. Ever.

“A large part of the efficiency of the current market is probably driven by a small number of active managers who don’t get the credit and capital they deserve.”

That’s my whole focus. What will likely happen is that much of the share of actively managed cash in their hands. The amount of funds under active management is dwindling, though, and it will probably continue to do so. There are quite a few active managers out there that I would be willing to pay for given their track records and ability to ignore what the rest of the market is doing while they focus on hardcore value. Tweedy Browne has done an excellent job of this over generations – and they actually invest in their own funds.

Yes, the capacity to invest in other opportunities is smaller. I blame active funds for not getting involved in these opportunities partly because of their incentives. You don’t get paid for outperformance, you get paid for tracking reliably what the financial services industry perceives to be your “benchmark” so there isn’t much room for a go-anywhere fund that digs for the best stuff. Also, the liquidity requirements of your average mutual fund requires you to stick only with super-liquidity securities. Hedge fund managers get their 20% on top of their 2% and have withdrawal restrictions. Mutual fund managers just get a percentage of assets. No reason to rock the boat if you collect the same amount regardless.

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Value Indexer April 3, 2013 at 13:36

I’m not sure if a lot of capital will flow to the best managers. No matter how smart they are, if they serve clients they are affected by those clients’ investment knowledge. And the ones who are just working themselves sometimes seem to get this idea that once they’ve made a few billion that’s enough and they can stop. Let us know when you get there 🙂

101 Centavos April 1, 2013 at 05:45

Equilibrium will eventually reassert itself. In the meantime, more underpriced, unloved small caps will be available for the retail investor.

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