The death of the fund — and what comes next

As advances in technology make mutual funds and ETFs obsolete, advisers will switch to using software to put together customized portfolios for clients

Jan 28, 2019 @ 3:24 pm

By Joshua Levin

Mutual funds and ETFs are dead.

In the next few years, the entire rationale for investing via funds will dissolve. Advances in technology have transformed industry cost structures. Absent the need to pool assets for volume discounts, advisers and relationship managers can skip the one-size-fits-all cookie-cutter vehicles. Instead, financial advisers will use software to truly customize portfolios, resulting in a more engaged and loyal client base.

When mutual funds first launched in the 1920s, they were hailed as tremendous innovations that allowed everyday investors to diversify their portfolios while avoiding the costs and complexity of holding 1,000 stocks. Over the last decades, actively managed funds have been commoditized into passively managed index funds and exchange-traded funds, creating tremendous price pressure. We've now hit rock bottom with Fidelity's recent launch of a zero-fee index fund.

Price compression isn't the biggest effect of the shift from active to passive. It's the acceptance that algorithms can replace humans when it comes to diversification. Transaction costs have dropped to zero at Robinhood. The industry has a whole new set of low-cost APIs, and a proliferation of free and cheap data. So what's the remaining cost advantage of pooling multiple investors into funds?

Here's what investing won't look like in the future: advisers cobbling together three to five funds for clients. Instead, advisers will rent software from the cloud, called dynamic custom indices, or DCIs. DCIs will buy, manage and transact in real time on behalf of clients at the individual security level, based on their goals, situation and values.

Maybe your client is an active member of her congregation. She values having a portfolio in line with the teachings of her faith. She also cares about climate change, inherited some specific stocks and would benefit from tax-loss harvesting in her taxable accounts. There are infinite combinations that current investment products cannot fulfill. This client, like most, is currently off the efficient frontier, creating an opportunity for the investment community.

The market values this kind of customization. In fact, according to a recent Qualtrics Financial Customer Experience Report, 39% of wealth advisory clients selected their advisers because of their personalized service. Meanwhile, a 2017 Morgan Stanley study found 80% of individual investors are interested in sustainable investments that can be customized to meet their interests and goals. And if your clients haven't asked about tax-loss harvesting or tax-advantaged accounts yet, they will soon.

As this interest climbs, and costs and friction fade, savvy advisers will pivot their offerings toward actually personalizing client portfolios. They will move from the cinder blocks that are funds to the 3D printers that are DCIs. The result is a far more loyal and engaged client base.

Other advisers will follow to match the acquisition and retention rates experienced by early movers. Technology enables this personalization at scale, while ensuring portfolios are managed with discipline. In the future, instead of selling 10 funds, advisers will be offering 10 strategies, each with slight variations based on clients' needs.

They'll use iPads to input their strategic allocation mix, overlay the client's values, select tax optimization, show the client the suggested portfolio, and hit Go. The software will systematically manage accounts, keeping them on track as new data stream in.

In addition to financial and social responsibility data, client signals will become stronger than ever. For example, if one in four Americans have now deleted the Facebook app, why wouldn't they delete it from their portfolios?

News breaks. Your client removes Facebook with a single swipe on her smartphone, and her entire portfolio instantly breaks apart and re-optimizes to keep tracking her benchmarks.

No transaction costs. No distortion. High personalization. High engagement.

As a result of declining transaction costs and other tech developments, equities funds are on their way out. Rather than buy fixed products, investors will rent software-as-a-service, or DCIs. That software will support customization at scale, leading to happier, more engaged clients who can send powerful signals to the market in new ways.

For advisers, this means the future is bright. Instead of being the tip of the spear for a fund family, they become masters of software and provide clients a truly bespoke solution.

The question isn't whether the post-fund future is coming; it's who will be the first to grab market share now that it's here.

Joshua Levin is co-founder and chief strategy officer of OpenInvest, a digital investment adviser for socially responsible investing.


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