— Paul Amery's Blog

Mutual funds look obsolete

On the face of it, mutual funds are a huge global success story.

Assets in collective investment schemes have grown seven-fold in two decades and now top $30 trillion.

Growth in global mutual fund assets

mutual fund assets

Source: Investment Company Institute

Yet the mutual fund structure contains weaknesses.

First, funds need to apportion correctly the costs associated with investors entering and departing the fund, a tricky job. So-called dilution levies (also called entry fees or front-end loads) and exit fees are there to make sure that the costs of any purchases (or sales) of securities incurred on behalf of an entering (exiting) investor are borne by that investor, rather than by the rest of the fund holders.

Unfortunately, many fund managers have historically set entry/exit fees too high and used them as a disguised source of revenue.

A more important drawback of funds is that they may carry liquidity risk.

If a fund invests in less liquid assets but promises immediate liquidity to its investors, the fund manager may cope with a sudden withdrawal of investors’ funds by selling the most liquid of the underlying assets. This would disadvantage those remaining in the fund by leaving them with a rump of less liquid securities. As a result, investors are incentivised to “run” from a fund in stressed market conditions.

Given the increasingly large size of many mutual funds (including ETFs) and the potential liquidity problems in certain asset classes (like corporate debt) it’s not surprising that regulators have been focusing on fund liquidity as a potential source of broader, systemic risk.

In most jurisdictions, the managers of mutual funds have the little-advertised ability to “gate” (ration) redemptions—a right that, if invoked, could contribute to a panic.

Mutual funds have historically been expensive, too. ETFs are a welcome recent exception to the trend of overcharging, but fund fees pay for hefty salaries at asset management firms, as well as for the services of a whole range of middlemen: lawyers, accountants, custodians and transfer agents.

The world’s largest investors don’t use mutual funds: they insist on their own, flexible managed accounts. What if smaller investors could follow suit?

It turns out that they now can.

Firms like US-based Motif Investing allow you to buy a diversified, thematic portfolio of stocks in one transaction. Motif charges $9.95 for a trade in up to 30 stocks, much cheaper than online brokers’ rates for buying or selling 30 individual securities. You can customise your own portfolio (called a motif) or copy someone else’s.

You end up with an investment that’s very similar to an index fund, but with significant advantages: no annual fees, no administrative overheads, no worries about how costs are mutualised and no concerns over gating. Unlike some funds, a stock basket doesn’t lend shares, use derivatives or incur collateral risks.

Under this model you own the stocks in your motif, with full entitlement to dividends. You retain voting rights, rather than delegating them to an anonymous fund manager, who may not even use them (except, potentially, if the small size of your basket means you own fractional, rather than whole units of shares).

Mutual funds first came into being as a way of spreading risk. Reducing company-specific exposure via a shared portfolio seemed an attractive prospect for European investors recently scarred by Tulipmania and the South Sea Bubble.

But that technological advance came nearly three centuries ago. Now we can see the prospects for another significant shift in the savings market. The emergence of cheap, tradeable thematic baskets of stocks threatens to render funds obsolete.