It happened with mobile phones. It happened with the music industry. It happened with information technology and even the internet as a whole. Control of the marketplace moved from the hands of the “producers” into the hands of the “consumers.”
The era of people buying what the producers put on the shelf is over; today producers put on the shelf what people want to buy. This is what I like to call the democratization of the marketplace: where the people consuming have more power than the people producing. Apple (AAPL) products sell like hotcakes only because Apple gave consumers what they wanted – simplicity, visual appeal and ease of use, while other players in the market continued to wait for the market to “adapt” to their product or just assumed that what came before was the best that could be done. An arrangement where “producers” are able to dictate what the “consumers” buy is only sustainable until a new entrant comes in and decides to listen to those consumers for a change.
There are very few industries left where such change has not occurred and revolutionized the market structure – unfortunately, the “market” for investment products has been one such area.
The investment world for a long time has been dominated by mutual funds and still is today to a large extent. According to the Investment Company Institute (ICI), global mutual fund assets stood at $22.4 trillion at the end of Q3 2009, with about $10.8 trillion of that in the US. In comparison, latest figures released by the National Stock Exchange showed US ETF assets at the end of March 2010 standing at about $810 billion. In terms of investment options available for retail investors, there really has been very little variety on the “shelf,” with mutual funds being pretty much the only choice for investors looking to invest in a diversified, actively-managed investment vehicle to gain exposure to the market. As such, the issuers have had significant control of the market so far and have been able to dictate the kind of products that investors put their money in.
That I believe has been changing and the process started with the advent of Index ETFs about a decade ago. Index ETFs provided those investors who were looking to utilize a passive investment strategy with a new option besides index mutual funds. And it proved to be a defining moment for the passively-managed space as Index ETFs attracted investor assets and eventually overtook index mutual funds in 2009. The advantages that Index ETFs brought to investors resulted from the unique characteristics of the ETF structure which brought with it tax efficiency, tradability, lower costs and transparency. These are the features that investors, as “consumers”, have increasingly been looking for in making their investment choices and that are provided by ETFs.
However, even with the innovation of ETFs, the assets gathered by this new breed of products had been restricted mostly to the passively-managed space. This only makes up 10-15% of all assets managed, despite investors moving their money into passive strategies as a result of convincing arguments against the effectiveness of active management. Around 85% of all assets are still actively-managed and as was the case for passive investors before the advent of Index ETFs, for any investor looking for active management, there had been only one product on the shelf – active mutual funds.
But that changed with the arrival of Active ETFs in 2008, when investors, for the first time, could access active management through an ETF structure. Active ETFs brought all the same benefits generally associated with Index ETFs but combined them with the potential for active management. What all this means is that investors finally have a choice of whether they want to invest in mutual funds or ETFs regardless of whether they want to invest passively or actively. Given that the majority of assets are actively-managed, it is Active ETFs that I believe will lead the democratization of the investment space going forward.
However, Active ETFs will quite likely face significant head winds in trying to take market share from the mutual fund industry. This is largely due to how entrenched mutual funds are in investor portfolios and 401(k) plans. The mutual funds also have a strong representing body in ICI. Just one example of what mutual funds are having to deal with are the lawsuits targeted at their fee structures, as highlighted by this WSJ piece.
I may be underestimating the staying power of mutual funds, but I do believe they will be given a run for their money sooner rather than later. And this has been evident from the flood of major mutual fund companies filing to launch Active ETFs. People may ask why the mutual fund players will have any incentive to enter the ETF marketplace, given the high fees that they currently enjoy. My answer is that, soon enough, they won’t have a choice.
Disclosure: No positions in above-mentioned names.
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