index funds

The Next Mutual Fund R(Evolution)?

index funds

Too often financial innovations that affect the mutual fund industry are portrayed in a black and white fashion. They are either viewed as just a curious sideshow, or else they are quickly proclaimed to be a fundamental challenge to the health, viability or even the very existence of the fund industry as we know it. Exciting new ideas are not seen as complementary to an established but evolving industry. Instead they are quickly converted in the headlines into revolutionary Davids poised with slingshot in hand to attack an oversized, lumbering and soon to be extinct mutual fund Goliath.

This has been true most recently with exchange-traded funds, and it seems to be the case once again with customized stock baskets (CSBs - better known as folios). Until just a few months ago, these creative fund-like brokerage products were being downplayed by most observers (though it is true that many of these observers have a vested interest in maintaining the status quo). All of the sudden, certain segments of the financial press (always in need of something new to write about) and at least one prominent wing to the analytical community have together begun to fill the headlines with another round of "death of the fund industry" predictions. This time CSBs are the expected assassins.

Financial Research Corporation (FRC) takes a different view of the process of financial innovation. We see even the largest changes as part of the natural evolution of the industry. The asset management industry and its mutual fund component certainly are giants, but they are nimble giants, capable of embracing the best conceptual and technological changes as they emerge, and then integrating these new ideas into an ever-broadening array of products and services to meet the evolving needs and demands of the investing public.

Pundits and analysts alike may have forgotten too quickly just how revolutionary mutual funds themselves once were and in many ways still are. They have democratized access to a world of financial instruments that once belonged only to a wealthy elite. The benefits of the fund revolution still serve the core investment needs of the vast majority mainstream America, and FRC expects that they will continue to do so for many years to come. The system is not fundamentally broken and therefore is not in need of radical change. It meets many of the needs of most of its potential customers, and so these customers are not clamoring for something to replace it.

While Third World countries may have a revolution every few years, our American revolution is 225 years old and still going strong. No doubt it has needed to be extended, upgraded and enhanced from time to time (abolition of slavery, women's suffrage, civil rights, etc.) These changes were substantial, and even revolutionary in their own right, but they did not overthrow, replace or eliminate the overall structure of our constitution or democratic institutions. Rather, they were embraced by our political system and woven into its fabric, making it even better than it was before.

We believe that a very similar dynamic exists with respect to the asset management industry and mutual fund advisors and distributors. The fund industry, like the U.S. Constitution, needs to be amended from time to time. These amendments should not threaten the industry, but instead, if viewed correctly, can only make it stronger, by aligning it more closely with the current needs of some investor segments.

Exciting new innovations like exchange-traded funds and customized stock baskets are truly beneficial breakthroughs that will add substantial value to part of the portfolios of many investors. They can do some things better than traditional mutual funds, and they can do other things that funds can't do at all. This is good news for investors, and there is no reason why it shouldn't also be good news for financial services providers with an open mind and a focus on the new possibilities these instruments afford, rather than the temporary disruptions they will surely create.

FRC believes that now is the time for taking a balanced view of the undeniably significant changes emerging within the financial services world. These changes will complement the fund industry, not overthrow it. Technology is tremendous. It can change a lot of things, but it cannot change human nature and it takes quite some time to influence deeply ingrained cultural and behavioral preferences.

We believe it is neither constructive nor accurate when certain analysts describe the mutual fund industry as "a relic that fundamentally hasn't changed in 70 years." What we need is more balanced dialogue such as that offered by FOLIOfn founder Steve Wallman when asked in the Mutual Fund Café whether customized on-line portfolios would eventually replace traditional mutual funds:

"I don't think so. Mutual funds are a terrific vehicle for providing a cost-effective, diversified investment for some portion of the population. We provide a complement and in many cases, a far superior alternative to mutual funds for part of the population but by no means for all."