The current state of the investment industry
The primary vertical this article will refer to are mutual funds, but I believe it applies to other areas of investment management as well.
First, my overarching theme is that investment firms of the future will not be built like the ones in the past.
Today, thanks to the internet, you can reach anyone in the world and let them know about your product(fund). However, to gain distribution for your fund, you have to please two gatekeepers; Morningstar and financial advisors(FAs). They both provide a useful service, I’m not knocking them.
But your customers are not the individuals who benefit from your product. Your customers are the middlemen who have the relationship with the end user.
The way forward, in my view, will be a complete transition away from these middlemen.
The WSJ journal summed it up nicely:
Morningstar’s reach is so pervasive that the ecosystem for buying and selling mutual funds revolves around it. Fund companies heavily advertise their star ratings. Money typically pours into funds after they receive a five-star rating from Morningstar, the Journal found. It flows out if they lose stars.
Important note. Active funds exist for the purpose of earning a better return than a low-cost index(alpha). I am leaving out whether “beating the market” is possible for most funds. That is a whole other discussion.
Here, I am primarily referring to the structure of the industry.
The value chain
Value chains track the flow of money through an industry. Ben Thompson sums it up nicely:
If there is a choice in whom to pay, you usually pay less. If you only have one choice, or if switching costs are high, you pay a lot more.
Let’s break down the value chain for the investment management industry.
These are individuals, pension funds, endowments who pay third parties for investment services and products.
Most Financial Advisors(FAs)/RIAs/brokers fall into this category. They take other companies’ products and put their clients in them. They have the relationship with the end user.
Companies who supply the products(funds) to the distributors. Or companies who provide research, such as Morningstar.
According to Statista, there are over 9,500 mutual funds in the United States. There is one Morningstar(gatekeeper) and they help divide $16 trillion among America’s mutual funds.
See the problem?
Think of Morningstar as Microsoft in the 90’s. Computer manufacturers had no choice but to include it in their product, just as most financial advisors have to use or choose to use Morningstar to help them evaluate funds.
Again from the WSJ:
“It’s a cover-your-ass type of service,” says Samuel Lee, a former strategist at Morningstar. “An adviser can say, ‘I’m going to put you in this fund, it’s a 5-star fund,’ …and if something goes wrong the adviser can shunt blame to Morningstar.”
These two parts of the value chain are connected. They serve one another. If a fund doesn’t perform well(on their time frame), they have thousands of others to choose from. You have no leverage because Morningstar has a monopoly on evaluating funds and the financial advisor has the relationship with the end user.
You are an undifferentiated supplier whose fate hangs in the balance of two gatekeepers.
Read the story of Buffalo Emerging Opportunities Fund in the WSJ article. When they got their 5th star from Morningstar, their assets under management(AUM) quadrupled in five months to above $400 million.
Over the next few years, they trailed 95% of their peers and in short order(2 years) their Morningstar rating fell to two stars and their AUM plunged to less than $100 million.
Now, maybe the returns that gave them the five stars was luck. Maybe not. Maybe their strategy went through a period of underperformance; as all strategies do and they are due for a bounce back.
Does it matter? No! They can’t explain themselves to the end user because that’s not their customer; the middleman is. And when they lost their fifth star, then their fourth, that was a death nail because why would the advisor keep his clients in an underperforming fund? They wouldn’t; because they could get fired!
In order to move forward, fund companies will have to separate themselves from current state and build the one relationship that will matter in the future. And that is with the end user.
The path forward
So, if the path forward is building the relationship with the end user. How do you do that? I don’t have all the answers, but here is how I will do it.
Begin by providing value to the end user. I don’t mean making a commercial about how great your fund has performed and blasting it on social media.
I mean producing content and answering basic questions users have about investing or personal finance. I mean replying to every tweet or comment on Instagram and YouTube.
I mean making videos about things as simple as “what is the purpose of investing” or “what is the difference between an IRA and a Roth IRA”.
Look at Home Depot. They started making “how to videos” to teach millennials simple skills like “how to use a tape measure.”
Did they have to do this? No. They know their customers could go to YouTube and get that information. Why did they do it? To connect, to build a relationship, to provide value to the users of their products.
I mean joining Facebook groups related to investing and answering questions. Not once pitching your product but providing value. Out of a hundred people you help, one might click through to your profile and buy your product. If your product creates value, in their mind, they are likely to tell others.
And this is the fundamental difference the internet provides vs the old world. A way to scale your product or service without spending large amounts of money acquiring customers provided you do the work.
That one customer might mention to a Facebook group with 100k members how good they were treated and how much they enjoyed your product. If 1% of them end up becoming customers, you just got a thousand customers without spending money.
The reverse is also true, probably more so. If a customer has a bad experience with your product, they will share that bad experience with their internet peers and millennials, more than anyone, crowdsource financial advice(see chart below).
Millennials and the great wealth transfer
Over the next few decades, 75 million millennials will inherit ~$30 trillion dollars from baby boomers and many feel disconnected from the financial services industry.
Here are a few highlights from a study Facebook did in January 2016 about millennials and money. Full paper
- Millennials are 1.4x more likely than Gen Xers/Boomers to switch financial institutions.
- 45%(~33 million people) of millennials say they would switch banks, credit cards or brokerage accounts if a better option came along.
- Millennials are 2.5x more likely than Gen Xers/Boomers to trust robo-advisors, putting their faith in algorithms and automated portfolio management.
It’s hard. The majority of the wealth in this country is held by the Gen Xers/Boomers generation. Hence, financial companies are incentivized to keep them happy. That’s how they get paid.
But they won’t always be your customers. Companies must start now to build a relationship with their future customers. Hopefully, some already are.
Morningstar, FAs and the smiling curve.
I like Morningstar and think they provide a useful service. It takes tons of manpower and costs to cover all the things they do. They’re a central cog in a massive $16 trillion dollar machine known as the mutual fund industry.
In fairness, before Morningstar, there was no good information on mutual funds. They brought transparency when there was none.
I’m coming at this as an outsider. I’m trying to figure out my spot on the smiling curve.
The smiling curve
The smiling curve was originally used to illustrate the value-added components for the IT-related manufacturing industry.
I believe it is a useful framework for the investment industry as well.
The premise is, you want to be on either end of the curve, avoiding the bottom at all cost. Acer(computer company) founder Stan Stih came up with the theory.
From Ben Thompson of Stratechery:
What makes this observation particularly ironic is that Acer is the epitomical company at the bottom of the curve. They put PCs together, but it was the critical component makers like Intel and Windows that captured most of the value on the left, and systems integrators and value-added resellers like IBM or Accenture that captured the rest of the value on the right.
Acer and its merry band of 8 OEMs competed themselves to single digit margins and ultimately stagnant growth; there simply isn’t any money in the undifferentiated middle.
Where the comparison makes sense to me is in portfolio assembly. Instead of assembling PCs with OEMs, this cohort assembles client portfolios with other people’s products, a largely undifferentiated skill. Whether it be a human or software.
Because while a robo-service provides value to the customer, the companies themselves do not capture much of the value. The value capture will be on either end of the curve.
Think back to the start of our discussion on value chains. “If you have a choice in who you pay, you pay less”.
And competing on price is a loser’s game; because someone can always go lower. Those entering the space now must have some form of differentiation, besides being low-cost.
Think you’re going to beat Vanguard at low-cost? Doubtful.
Does this mean companies like Wealthfront and Betterment are doomed?
No, but they are at a disadvantage because they are trying to acquire customers profitably, in an area of the curve where not a lot of value is captured(portfolio assembly), unless you are already huge.
As more companies enter the robo-space, a brand will become important as the software itself is largely undifferentiated.
Think of Mailchimp. There are hundreds of companies that help send e-mail. They have carved out a share of mind among a certain set of customers. I believe that opportunity exists in the robo-space. Especially among millennials.
I think incumbents are right to worry about Amazon and other tech companies entering the space; who already have a large customer base and have the chops to build the software.
I am still working on this. I’m not sure I have it right. If you have any thoughts, please let me know.
Sarah Tavel wrote a great piece on how to build an enduring multi-billion dollar business.
From the article:
Create a 10x product + recast incumbent costs structures
Maybe the problem is regulatory and that needs to change. But someone will come along and create a 10x better product/customer experience that incumbents can’t match because the structure of their business is based on how the world was.
Instead of wholesalers pitching their funds to FAs and worrying about Morningstar ratings, I believe companies should focus on building their brand and creating a better user experience. Make it easier for customers to understand and buy your product.
Upgrade your website, add live chat(I realize regulations may prevent this but you get my point). Some websites look like they were built in the 90’s. Be honest and transparent about your fees and performance. Do the little things that don’t appear to be fruitful, but it’s the little things that people remember.
The industry could stay the same.
But there will be little peons like me building relationships with customers who one day will inherit their parent’s wealth.
The great thing about the investment business is that it’s enormous. There is plenty of space for people who are willing to innovate and think differently.