Mutual Funds

The mutual fund industry faces a variety of challenges as a result the evolving threat of cybercrime, globalization, the growth of robo-advisors, and many other developments. The most noteworthy ones worth watching include a shift of investor preference from actively-managed funds to passively-managed ones, changing demographic trends, the embrace of data analytics by the industry, the introduction of new products and investing strategies, and the challenges and benefits of new technology.

From Active to Passive

Over the past decade, investors have steadily shifted their money from actively managed mutual funds to passively managed funds as a result of weak returns from some actively managed funds and an interest in paying lower management and other fees. In 2021, passively managed funds comprised 42.9 percent of mutual fund/exchange traded fund assets under management (AUM), as compared to 23 percent of AUM in September 2015 and 9 percent of AUM in December 2005, according to Bloomberg. It estimates that the percentage of funds that are passively managed could surpass actively managed funds by 2026, which could cause profits to decline. “The rising demand for passive products has already intensified competition among all asset managers—those who pursue active and passive, alternative, and traditional long-only strategies,” according to PwC. “To stay competitive, active managers are evaluating performance-based fee models (such as outcome-based fees, volume discounts, ‘early bird discounts’). Some managers are promising zero or minimal fees on select funds to acquire new clients. They are also cross-selling other alpha-focused products and ancillary services. These fee models are helping to reshape the passive landscape.”

The trend toward passive investing—which is reducing earnings at many companies—is prompting many firms to cut operating costs. PwC has identified the following cost-reduction trends at mutual fund firms:

• Outsourcing certain functions to save money. It predicts that outsourcing will increase in the following areas: legal compliance, accounting, data management, pre-trade compliance, investment research, information technology services, and custody and asset servicing.
• Eliminating underperforming and costly funds. PwC predicts that the number of mutual funds and ETFs will decrease by 14 percent by 2025.
• Large and mid-size companies will merge to achieve a competitive edge. Smaller companies will have to innovate, as well as offer new products, in order to survive. PwC estimates that 20 percent of the firms currently in existence will close or be acquired by 2025.
• Technology will continue to be introduced to help companies save time and money.

Demographic Shifts—From Old to Young

EY reports that “Generation X and Y investors will accumulate close to $46 trillion in assets by the end of the decade, including $18 trillion in inherited assets from Baby Boomer parents.” Many members of these younger generations are interested in more conservative investing strategies (i.e., passively managed index funds). They have also embraced social media and technology, and some want their portfolio managers to post on Facebook and blogs, to tweet on Twitter, and otherwise have a strong social-media presence. Ninety-eight percent of investors ages 21 to 29 reported that they used their smartphones to interact with financial institutions, according to a financial services consumer survey by Deloitte. Additionally, 53 percent of respondents of all ages said that they would welcome a video call with their investment adviser.

“To ensure that the fund industry remains on track to accelerate growth over the long-term, managers need to begin actively targeting the younger generation today,” according to Deloitte’s Mutual Fund Outlook: Accelerating the Quest for Growth. “As millennials age, their rising incomes are likely to provide some of the fuel to keep the industry growing after Baby Boomers start drawing down their assets.” While it’s important to develop good relationships with younger investors, portfolio managers must also work to retain older investors. Look for more firms to create multi-generational teams of portfolio professionals to build strong relationships with both young and older investors.

The Rise of Data Analytics

Fund managers, especially those at large mutual fund companies, are increasingly using data and predictive analytics software to make investment and operational decisions, as well as to better understand the needs of existing clients and market to new ones. Deloitte reports that some firms are exploring the creation of centralized data hubs that blend four types of data: transaction, sales, interaction, and market-related. They are upgrading their customer relationship management systems to be cloud-based, which allows for enhanced interactive and data collection and analytic abilities. Predictive analytics tools are already in use in product analysis and wholesaling, but Deloitte says that they may be increasingly used to track competitor products under stress, anticipate net redemptions, and plan approaches to seizing asset-gathering opportunities. These tools will also continue to be used to identify high-producing geographies and territories and locate new target markets (e.g., a product that is highly successful in the Boston suburbs might also be successful in a geographic area across the country with similar demographics). “A greater use of data and predictive analytics will ultimately bring investment managers up to the level of banks and insurers,” predicts Deloitte. But it also cautions that “though data is the driver, human touch will still remain significant. People are still very much a part of the fund sales process, and wholesaling will remain a people business. So accurate calibration of the digital/personal mix is imperative to capture the best of both worlds.”

Emerging Technology Tools

Technology has been used at mutual fund companies for decades to save time and money, but different IT systems have often been used in the middle and back offices, and there has been no coherent company-wide approach to technology at many firms. That’s changing as companies realize that technology can help them save time and money, better compete with other firms, and provide a better customer service experience. “Transforming technology infrastructure will be critical to the success of U.S. mutual fund firms in the coming years,” according to Mutual Fund Outlook from PwC. “Firms that leverage technology and high-quality data effectively can reduce costs, bolster risk analysis, make better investment decisions—and potentially deliver higher returns to investors and profit margins.” In addition to increasing the use of technology in the back and middle offices, mutual fund companies are also using technology (especially artificial intelligence, distributed ledger technology, and blockchain technology) in the front office.

Artificial Intelligence

Artificial intelligence (AI) can be defined as technology that can be programmed to make decisions which normally require human thought and act independently of humans. “The applications of AI in asset management can and will impact the entire value chain,” according to Broadridge, which offers digital and mutualized solutions to the financial services industry. “Starting with the optimization of sales and marketing interactions, predictive market modeling, and portfolio management based on instant processing of petabytes of data, to the use of AI bots for transaction processing across the entire middle and back office.”

Generative artificial intelligence (AI) is one of the newest technologies being used in the investment industry. It is a form of machine learning algorithms (including large language models) that can be used to create new content (including text, simulations, videos, images, audio, and computer code), as well as analyze and organize vast amounts of data and other information. One of the best-known examples of generative AI is ChatGPT, which was released in late 2022 by the San Francisco-based company OpenAI. “Firms that want to maintain or gain a competitive edge can integrate AI to improve the client experience and streamline their operations,” according to Laserfiche, a software-as-a-service provider of intelligent content management and business process automation. “With the right AI tools in place, wealth managers can maximize the efficiency of their existing staff and serve clients more effectively. By freeing advisors and administrators from time-consuming back-office tasks, process and workflow automation can help firms attract and retain clients, reduce operating expenses, minimize regulatory risks and improve the bottom line.”

Generative AI is still in the early stages of use and development, and companies are still trying to address the include ethical issues, security risks, and operational challenges of using this technology. One thing is certain. Generative AI will eliminate or reduce the need for many low-level jobs. Workers in lower-level positions should prepare for this by learning how to use AI-based processes and develop other skills and knowledge bases that allow them to earn higher salaries and reduce the chance that their jobs will be automated. On the other hand, the use of generative AI will create the need for many new occupations. These include generative AI utilization directors, implementation specialists, product and adoption managers, quality controllers, editors, engineers and software architects, and output auditors.

Distributed Ledger Technology and Blockchain

Another emerging technology is distributed ledger technology (DLT), which is a decentralized database used and managed by various participants. Transactions are synchronized and shared so that all users can view the most recent information on the database. Mutual fund firms and other financial companies are using DLT to improve data security, risk management practices, and fraud detection; create more-trusted recordkeeping for use with customers and for regulatory compliance; more easily share data between various entities (this is especially useful as financial transactions become more complex); and reduce costs. “Distributed ledger technology could fundamentally change the financial sector, making it more efficient, resilient and reliable,” according to the World Bank. The phrase DLT is sometimes used interchangeably with the phrase blockchain technology. Blockchain technology maintains a continuously-growing list of records that cannot be altered, except after agreement by all parties in the chain. Each entry is time-stamped and linked to the previous entry. Each digital transaction or record is called a block in the chain of records, hence the blockchain moniker. Blockchain can either be an open system, where anyone can add information, or a controlled one, where only users with permission can access the system. “A DLT can be considered a first step towards a blockchain, but importantly it won’t necessarily construct a chain of blocks,” according to TheNextWeb.com. “Rather, the ledger in question will be stored across many servers, which then communicate to ensure the most accurate and up to date record of transactions is maintained… That said, DLT is technologically decentralized and relies on similar principles of consensus to blockchain.” The mutual fund giant Vanguard is now using blockchain technology to manage data for some of its financial products, including its largest fund, the Total Stock Market Index Fund.

Despite its promise, some business executives have a less positive view of blockchain technology. Nearly 21 percent of business executives surveyed for GlobalData’s Q2 2022 Emerging Technology Trends Survey said that blockchain technology was “all hype and no substance.” Approximately 37 percent believed that the "technology was hyped, but I can see a use for it,” and 20.7 percent said that they didn’t know if the technology was overhyped or not—suggesting that the potential uses and benefits of blockchain remain poorly defined or misunderstood. Only 21.8 percent of respondents believed that blockchain “will live up to all its promises.” Another factor that has affected adoption is the fact that many people have a negative or skeptical perception of blockchain because of its association with volatile cryptocurrency assets although it has potential for use in many other sectors.

Metaverse

The metaverse is an emerging 3–D-enabled digital space that uses converging technologies (e.g., artificial intelligence, augmented and virtual reality, digital twins, blockchain technology, cloud computing, social platforms, e-commerce, Internet of Things) to create a lifelike experience online. It can be used to engage in commerce, meet business and other goals, have fun playing games and interacting with others, and utilized for other purposes. The metaverse is in the early stages of development, and skeptics do not believe that it will ever generate enough interest and/or revenue to be a viable digital space. Despite the challenges of building the metaverse (and getting the public and businesses to embrace it), 89 percent of 3,200 executives surveyed by Accenture in 2022 believed that the metaverse would play an important role in their organization’s future growth. (Survey respondents represented nearly 20 industries from companies that generated $500 million or more in annual revenue.) “At this juncture, [the metaverse] is much like the internet of the early 1990s or the smartphone of the early 2000s,” according to Reid Menge, co-portfolio manager of the BlackRock Technology Opportunities Fund. “We expect it is going to be big, and very likely change people's daily lives. But we don't yet know exactly how, or how big the shift will be.”

The metaverse has some current and many possible applications in the mutual funds industry. For example, investment funds already have been created that include companies that create or market metaverse-related products. In the future, the metaverse may be used to interact with customers and employees in improved and different ways, as well as for staff training. Although the future is uncertain regarding the metaverse, job-seekers should be aware of the field both as a potential investment expertise area and as a career option (e.g., AI specialists, metaverse designers, software developers).

New Products Are Emerging

In response to investor demand and growing competition for investor funds, mutual fund companies are beginning to utilize alternative investment strategies as they manage their funds. “Mutual fund firms are partnering with hedge funds—either through outright acquisitions or by bringing them on as sub-advisers—to give investors access to more flexible investment strategies implemented by hedge fund managers,” Cary Stier, vice chairman and Global Investment Management Sector leader for Deloitte LLP, told The Wall Street Journal in an interview about the trend. Additionally, some fund managers are incorporating new or lesser-known investments such as business development companies, catastrophe bonds, master limited partnerships, and AI- and metaverse-focused stocks into their funds.

Exchange-traded funds (ETFs) are a fast-growing competitor to mutual funds. These investment pools are similar to a mutual fund, but ETF shares are adjusted to current market values throughout the day, unlike mutual funds. “U.S.-listed ETFs, the overwhelming majority of them passive, have seen their assets rise fivefold to $7.2 billion since 2012, according to a 2022 article in the Financial Times. “Overall, 88 per cent of ETF ranges saw positive net inflows last year…compared to just 48 per cent of mutual fund ranges, continuing a pattern witnessed over the past decade.” ETF investors are typically younger and wealthier than mutual fund investors, which suggests that these funds will continue to increase in popularity.

Another emerging area is environmental, social, and governance (ESG), which is an umbrella phrase used to discuss how a business or other organization interacts with society and the environment. ESG issues are becoming increasingly important to companies and other organizations. They include climate change and wider sustainability; environmental compliance and liability management; diversity and inclusion; employee development and retention; customer welfare; community relations; and business ethics and governance, among others. “The fund industry is responding to increased investor interest in ESG investing by, among other things, creating new funds that explicitly tailor their investments to specific ESG criteria,” according to the Investment Company Institute. The institute reports that the number of investment funds that invest according to ESG criteria increased from 185 in 2019 to 430 in 2022. These funds have a broad ESG focus.