FTFM The US mutual fund industry’s best attempts at innovation have fallen flat in recent years due to a hairy mix of factors ranging from changes in how funds are distributed to the simple fact that many new products have failed to deliver their promised returns.
Compounding the lacklustre output is the industry’s maturity level. With all the major asset classes already chock full of choices, there is little room for more products on shelves that are stocked with 7,044 mutual funds.
“The level of creativity could use a steroid injection,” says Jeff Keil, principal of mutual fund consultancy Keil Fiduciary Strategies. He says the innovation drought has a lot to do with the changing nature of how funds are sold.
A big factor in the innovation stagnation is the fact that so-called gatekeepers at the broker/dealers whose financial advisers sell funds have gained much greater influence over what those advisers sell. These gatekeepers are paid to sort through the thousands of funds available. And they want predictability in the funds they recommend.
Specifically, gatekeepers do not want to see more than 3 per cent tracking error, or deviation from the relevant benchmark funds are supposed to track. It is an attempt to manage risk and avoid negative surprises. Their job is on the line if the funds they recommend do not deliver as promised. Innovative products, by definition, are not going to be predictable.
“Innovation is dead – or at least severely constrained – in a third-party distribution world,” says Harold Bradley, chief investment officer at the Ewing Marion Kauffman Foundation and former chief investment officer of growth equity at American Century Investments.
The safe bet for portfolio managers is to stay close to their benchmark. The rub for investors is they end up paying a higher fee for active management when what they are essentially getting is an index fund.
While creativity may be at a low level, pressure to come out with new products is high. But so far the response has been to launch “me-too” products that provide access to a thin slice of the market.
“There’s a tremendous urge to differentiate for the sake of differentiating without much thought to whether it is a viable product or not,” says Burt Greenwald of BJ Greenwald Associates. “What ultimately creates and maintains market share is performance.”
Investor flows follow the top-performers, so fund firms are under pressure to have their products stand out amid a sea of mediocre returns. At the same time, as with most consumer products, there are people who constantly need to have “new and improved” cachet, says Adam Bold, chief investment officer at The Mutual Fund Store. “Brokers need a story to tell their clients,” Mr Bold says. “So there’s a constant struggle between pure fad and giving investors what they want.”
Yet, there is a disincentive for fund firms to innovate. It’s expensive to roll out new products and it takes three to five years to incubate a fund and develop a track record. Being a first mover also carries a lot of risk, something most firms are unwilling to roll the dice on.
For fund shops, one of the only ways to differentiate their new products is to offer access to a particular niche. The trouble with rolling out narrowly focused funds is their limited appeal.
Further, recent history has not been kind to many fund shops that have launched “hot dot” products when times are good and ill conceived ones when times are bad -- think tech funds in the late 1990s and principal protection funds in 2002.
Principal protection funds were a product of the market crash and promised exposure to stocks without any downside, which turned out to be too good to be true. The funds often sought to protect investors’ principal with insurance or derivatives. And, if investors stuck it out with the fund for the predetermined amount of time, their investment would be protected from dropping in value.
But, these funds have produced dismal returns over their lifespan, a reality that has been reflected in net sales. They have suffered $3.8bn (£1.9bn, €2.5bn) in outflows in the three years ending December 31, 2007, according to Financial Research Corporation.
While still in their infancy, heavily touted 130/30 funds have not delivered either. Long/short equity funds, a proxy for 130/30 funds, have trailed the S&P 500 since the beginning of 2006.
“130/30 funds are not the answer,” says Rob Isbitts, chief investment officer at Emerald Asset Advisors, a registered investment adviser in Weston, Florida. “It’s being sold as the everyman’s hedge fund and it’s got a lot of marketing muscle behind it. But if that’s product innovation, we’ve got to go back to the drawing board.”
Other new funds that have generated a lot of buzz are specialty or sustainable funds that invest in water, energy or infrastructure. While these narrow slices may have some merit for a small group of investors, they do not make for a good core investment.
Of all “new” funds on the scene, lifecycles have been the most heralded, even though some shops, such as Fidelity, have had them in place for 12 years. An estimated 102 new lifecycle funds were launched last year, FRC says.
But much of the set-it-and-forget-it funds’ success may have more to do with changes in legislation than product innovation. The funds have gained prominence with the passage of the Pension Protection Act of 2006 and their subsequent place on the list of qualified default investment options in 401(k) plans.
Kevin Burke is a senior reporter on Ignites, an FT publication
