Part 1 – Funds are Going the Way of Compact Discs
Funds are dying. In the next several years, the entire rationale for investing via funds will dissolve, due largely to changes in technology and cost structures.
Investing will cease to look like going to your provider and cobbling together 3-5 funds. Instead, your advisor will rent software from the cloud, called DCIs (“Dynamic Custom Indices”), which will buy, manage, and transact in real time on your behalf, at the individual security level, based on your goals, situation, and values.
The subsequent decade will result in a land grab as the asset management industry shakes up. Part 1 of this series explains the basics of this paradigm shift, while later posts will explain how the Post-Fund Future impacts different types of financial players.
It’s quite understandable if this all sounds preposterous. If you were a record industry executive in 1998, and I told you CDs were going away, you would have a similar reaction. You’re making money hand-over-fist. You think that your product is the physical album, rather than the music. You’re wearing overalls, rockin’ a backwards cap, and thinking you’re hot stuff.
But it turns out those records and CDs were the barriers to consumption, not the channel. Most people don’t actually want to go into record stores. They don’t want all the songs on the album. And in fact, different people like different songs. Of course, you have little incentive to see this.
You’re about to be the first victim of the digital transformation, and experience 20 years of pain.
In the long run, streaming is saving the record industry and propelling it to unprecedented fortunes. Music has effectively transitioned from a product to a service. Asset management will follow a similar trajectory. So let’s hit fast-forward on that mix-tape…
The Post-Fund Paradigm Shift
One hundred years ago, if you invested in public markets, you would buy stocks in companies. Then, in the early part of the 20th century, mutual funds came along, hailed as a tremendous innovation. Just imagine: the everyday person can now diversify their portfolio, while avoiding the tremendous costs and complexity of holding 1,000 stocks!
In 2016, OpenInvest launches the first Dynamic Custom Indices (“DCIs”) production platform
If mutual funds are vinyl records, then index funds are CDs.
Actively managed mutual funds were further commoditized over the last several decades into passively managed index funds and ETFs. Index funds are taking off due to lower production and management overhead. This is creating tremendous price pressure on traditional (actively managed) mutual funds, as well as themselves. Fidelity even recently announced a zero fee index fund.
Cheap/free is not a victory, but a death song. It’s equivalent to Walmart selling CDs for essentially nothing in the late 90’s. If you can no longer make money, then bait customers through the doors in the hopes they’ll buy other things as well. There are now over 5,000 ETFs – only a handful of which can cover their costs – attempting to differentiate by targeting the endless possible combinations of demand in the market.
The most important thing the active-to-passive shift has brought is not price pressure. It’s the realization that algorithms can replace humans when it comes to diversifying equities exposure. “Bogle’s folly” was laughed out of the room when he launched the first index fund in 1976 and collected meager assets for decades. Yet the “un-American” use of passive trackers now reflects the 40% of the market.
Decreasing Costs, Increasing Opportunity
Fast-forward to today. Transaction costs are going to negligible or zero, and already have at places like Robinhood. We have a whole new set of low-cost APIs, and a proliferation of free and cheap data. So what costs are we still controlling by pooling together into funds? Why would anyone still be in the same cookie-cutter portfolios?
If you work at Facebook, you are highly exposed to Facebook’s financial performance and to the tech sector overall. You should therefore own a different index fund from the next person. But in the old world, no one is going to sell, for example, an S&P500 fund minus Facebook.
That’s just the beginning. Maybe your partner is switching from a career in media to one in healthcare. Maybe you were at the Women’s March, and you want your portfolio companies to respect and promote gender equality. You also care about climate change. And you just got ripped off by Wells Fargo (along with 3 million other people) and want to divest. Plus your account is taxable and you should be harvesting losses. There are infinite combinations that can’t cost-effectively be fulfilled by funds. As a result, nearly all of us are off the efficient frontier.
This all sounds complicated. And it is…for humans. Here’s where technology comes in, which can enable personalization at scale, while ensuring portfolios maintain discipline. The key is the development of Dynamic Custom Indices (DCIs). A DCI is essentially a dynamic separately managed accounts (SMA) engine which is replicating indices by directly purchasing the underlying stocks. The software maps the correlations across the balance sheets of all the tradeable securities in the selected universe. It allows custom changes to be made to the portfolio. It then responds dynamically by breaking apart and rebalancing the portfolio in-real time, ensuring tight tracking of the index. Here is a short video that graphically represents how this works. Finally, a DCI typically has an integrated front-end to allow relationship managers and clients to interact with the software and leverage its capabilities.
This translates into advisors switching from building portfolios with “cinder blocks” (funds) to using “3D printers” (DCI platforms). Meanwhile asset managers, instead of manufacturing 10 funds, will be selling 10 strategies, which will have 10,000 slight variations based on the needs of different clients.
Michael Kitces notably wrote about “Indexing 2.0” in 2014, and how it could disrupt the fund industry and beyond. He was ahead of his time. Yet he and others have focused on tax-loss harvesting as the pull factor. I argue that the growth in Socially Responsible Investing (SRI), or “ESG,” will provide the use cases that more likely move the herd. Here’s why:
- Like it or not, clients are actually more inclined to move money for these emotive issues rather than cost or tax savings.
- ESG has become one of the fastest growing segments in equities management, expanding by 15% CAGR.
- The incumbent product set is high-priced.
- Everyone has different values. Actually tapping that opportunity creates a combinatorial explosion of portfolios, requiring a move to The Post-Fund Future.
- All the growth above is occurring essentially pre- “The Great Wealth Transfer.” This movement of assets from Boomers to Millennials promises to put $40T into the hands of the biggest, most diverse, most transparent, and most socially conscious generation in history.
Why would any provider switch to this approach? The question really is: why not? You can now transact infinitely. Judging by the ubiquitous claims of wealth management shops that they’re about customization, clearly the market values this. It only makes sense to go the last mile to actually personalize portfolios, and capture that value in the form of client acquisition and retention.
Up-Ending the Interface
Let’s first pay tribute to the old world. Here’s the retirement account provider from my old job (remember vinyl?!)…
Building portfolios with the “cinder blocks” of the fund-based paradigm
The best outcome for your current provider, and everyone in their supply chain, is that you launch your account, set up auto-deposits, and then you never come back. This is why their websites suck.
For example, my wife hasn’t known her Vanguard password for 15 years…which is just how they like it. As it happens, I discovered she’s in some expensive mutual funds. I recently attempted to execute a password recovery and get her out of there. I failed. Turns out Vanguard’s snail mail has been bouncing from our old New York address. So they locked the account. Now we have to call, mail in a form, and then send a copy of our marriage certificate. Ridiculous! Many a banker’s house in the Hamptons were bought on the back of these shenanigans.
This will all change. As of 2019, your advisor can whip out an iPad during a meeting. She’ll input her strategic allocation mix, overlay your multiple values, select tax optimization, perhaps add factor tilts and other variables, show you the portfolio, and then hit: “Go.” The software will thereafter manage and trade to reflect the latest data and keep you on track.
Of course, that data is changing all the time. The financial data is typically updating quarterly. But ESG data is proliferating, and update frequency is accelerating. A new woman is elected to a board. Gender pay gap data expands to European mid-caps. A team of scientists publishes the best new data for water risk in Sumatra. Once validated, that data can flow right through the relevant portfolios, ensuring they remain best-in-class.
And then there’s a whole new set of data: client signals. At OpenInvest, for example, we’ve had Facebook divestment sweep our platform in recent months. This is not based on any wonky change in ESG KPIs on the backend. It’s just normal folks acting on personal emotional concerns. They swipe their smartphones, Facebook gets stripped out, and then the whole portfolio instantly breaks apart and re-optimizes to keep them tracking the index. No transaction costs. No distortion. High personalization. High engagement.
Reshaping the Value Chain
The Post-Fund Future is all about vertical integration.
To deliver a post-fund experience, you need clean data end-to-end. But more importantly, there are also whole new ways for relationship managers and consumers to engage with their portfolios in meaningful ways. The UI must be seamlessly integrated with portfolio construction, in turn with trading, and in turn with reporting, to provide that feedback loop in real-time. You may also want your clients, or your client’s kids, to be able to see each other’s actions, or the actions of other shareholders, resulting in explosions of activity. (Building this effectively is non-trivial to say the least.)
When the digital transformation hit music, it collapsed the record player, the record store, and the record label, into one. That’s vertical integration. There are many more rungs in finance (about 16), and they won’t all go away. Yet there will be significant winners and losers. The exact picture remains to be seen of course. But here are some of the dynamics and opportunities that face each rung as I see it:
Financial Advisors – The future is bright. Instead of serving as salesmen for fund families, advisors become “masters of software,” truly customizing for clients with ease.
Asset Managers – The spoils go to those who adapt from a “product” to a “service” mindset. The shift to the Post-Fund Future provides a unique opportunity for those who missed the ETF revolution to leapfrog and sustain margins, while also unlocking new distribution pathways.
Traditional ESG Players – There is a need to adapt. But overall, technology will break down the cost, performance, and distribution barriers that have kept the sector niche for decades. Mainstreaming will generally lift all boats, from data providers to investment managers.
Institutional Asset Owners – Foundations, endowments, and family offices can simply get better and more customized products, at lower cost, with more up-to-date data, transparency, stakeholder engagement, and impact reporting.
Pensions – Pensions have the opportunity to fully democratize, allowing individual choice and engagement while software systematically manages the investment pool to match benchmarks at low cost.
Custodians, Record-Keepers, Index Providers – There exist huge opportunities for these upstream players. But there are incentives and inertia that will keep most from stepping up, opening the door for others to capture value.
(I don’t have a crystal ball. Much of this will be wrong; I only aim to be slightly more right. This analysis is based on what we’ve assessed, developed, and are now seeing in the market, largely behind the scenes. We’ll further explore the impacts to some of these segments in future posts.)
The Valley Beyond
In summary, due to declining transaction costs and other tech developments, we are entering a Post-Fund Future. Instead of buying funds, investors and advisors will rent software-as-a-service, referred to as DCIs (“Direct Custom Indices”), which transact individual securities based on rules. That software will support customization at scale, and drive vertical integration in the industry. There will be winners and losers. Yet it’s early days, and thus TBD who will capture the most terrain in this grand leveling.
Of course, investing isn’t rock n’ roll. Music consumers have strong preferences, and they like to engage. This is why digital transformation hit music before investing, and why the transformation may be slower here, with significant additional drag from our regulatory context. This is again why I stress the ESG/values investing use cases above all.
Ultimately, digital transformation in music is really about media as a whole. Similarly, the transformation of public equities investing is really about finance writ large. Software will ultimately buy, transact, and optimize across all of your accounts, unlocking whole new cross- asset class efficient frontiers. Invested in your friend’s cafe? A corporate borrower changed its exposure to the UK market? The rest of your portfolio can adjust. Exciting as this all is, it’s of course way too early to parse. I’m just happy to see that after 2-3 years of engineering in isolation, the “Post-Fund Future” is now being echoed back to us across Wall Street. We’ll learn a lot more from how some of these integrations play out in 2019, as well as the resulting market dynamics, and then we’ll have something to write about for a future series.
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