Have We Reached Peak Mutual Funds?

Journal of Financial Planning: February 2024

Alexi Maravel joined Federated Hermes in 2019 as a vice president, senior manager, focused on the research and creation of investment management thought leadership. Alexi has more than 25 years of experience and is primarily responsible for developing and executing survey research and other types of analytics on a variety of investment-oriented topics including ESG investing, public policy, retirement, and institutional investing, as well as products and strategies. Alexi received a bachelor’s degree, cum laude, in journalism from Northeastern University.

Have we reached peak mutual fund ownership in the United States? Advisers have more options at their disposal than ever before, and greater customization is now possible through low/non-existent trading commissions, fractional share ownership, and the dawn of the tokenization of assets on the blockchain.

In this paper, we explore the decline of mutual fund holdings in the portfolios advisers construct for clients and identify the implications of this ongoing gradual change on markets, vehicles, and asset classes. Specifically, utilizing the findings of our 2023 Federated Hermes RIA and Independent Advisors’ Study,¹ we analyze advisers’ gradual yet inexorable movement away from funds and how they have steered assets into different vehicles and platforms such as ETFs, model portfolios, retail SMAs, and managed accounts. Finally, we use statistical modeling to project how change at a vehicle level could affect the complexion of the industry in the future.

Mutual Fund Ownership on the Decline

Looking at demographic data, we may already be past the peak in U.S. mutual fund ownership, as evidenced by the change brought on by the large millennial generation now entering their early 40s. Only 40 percent of millennial investors’ portfolio assets were devoted to funds, and that share of portfolios declined by 17 percentage points between 2018 and 2022. Additionally, for U.S. households in general, just 44 percent had more than half of their portfolio assets in actively managed funds in 2022, down from 58 percent in 2018, according to the Broadridge U.S. Investor Study.²

Looking at the adviser data we’ve collected in the Federated Hermes RIA and Independent Advisers’ Study, mutual funds as a portion of the advisers’ client assets continue to fall, down to 30.5 percent of the “typical” adviser’s book today from 38 percent in 2021. Our study also asked advisers if in the next year they expected any changes in the vehicles they utilize with clients: ETFs (currently 21.3 percent of assets), annuities (14.5 percent), and retail SMAs (9.6 percent) had the greatest number of respondents expecting an increase in usage in the next year; however, funds had the most (31 percent) indicating a decrease in usage.

As model portfolios become ubiquitous—nearly nine out of 10 advisers use them—a similar dynamic with mutual-fund-based models is occurring. We found a significant proportional decrease in fund-based models on firms’ platforms: 43.7 percent today compared to 50.9 percent last year. Additionally, ETF-based models now comprise one-third (32.9 percent) of models on advisers’ platforms. Although a majority of advisers expect little change in the next year in the composition of ETFs, SMAs, and alternatives in the models on their platforms, the highest number of respondents (26 percent) expect a decrease in fund-based models, in contrast to the most (37 percent) expecting an increase in ETF-based models.

Toward More Customized Portfolios

ETFs have a well-documented utility when compared to mutual funds. When asked what they see as the most important characteristics of ETFs, 23 percent of advisers indicated ETFs were both the best way to target specific risk factors as well as the most efficient way to express an investment view on an asset class or sector. While strategies such as smart beta mainly apply to passively managed ETFs, assets in active ETFs are rapidly growing from a relatively low base. This growth is particularly found in active ETFs that are “converted” from an actively managed mutual fund: 73 percent of adviser respondents said they are likely to recommend an active ETF that comes from an existing actively managed fund. Additionally, an adviser’s familiarity with the asset manager is key to the vast majority (92 percent) of those likely to recommend active ETFs.

Certainly, from an investment vehicle standpoint, the push for more customized yet scalable strategies continues as advisers meet client needs across different relationship levels. We found a majority (59 percent) of advisers utilized retail SMAs with clients—mainly with HNW relationships larger than $1 million. Advisers, however, are increasingly using SMAs among mass affluent—more than 60 percent of advisers utilized SMAs in relationships between $250 thousand and $1 million.

Separate account strategies within the $10.6 trillion managed account industry have also experienced significant growth. In the past two years through Q2 2023, assets in separate account programs have increased 22.4 percent, according to Cerulli Associates.³ Advisers in our study indicate they value tax optimization (56 percent), total portfolio solutions (54 percent), and volatility management (51 percent) in the SMA/managed account programs they oversee.

Future State

How might the shift from funds to other vehicles and strategies shape the investment management of tomorrow? Using traditional statistical modeling—based on past patterns weighted to the most recent time periods—we project hypothetical growth in different vehicles and asset classes assuming historical trends hold.⁴ (To be sure, past is usually not prologue, but to model assets one must make some heroic assumptions.)

Mutual funds, of course, won’t disappear, but asset growth will slow. We project average total net assets (including flows and market appreciation) in active U.S. equity funds will grow to $13.9 trillion by 2028 from $12.1 trillion in 2023 or a five-year CAGR of 2.18 percent. As a percentage of industry totals, that’s a proportional decline to 17.9 percent of industry assets by 2028 for funds from 19.9 percent this year.

In comparison, passive U.S. equity ETFs and mutual funds combined are estimated to grow average total net assets to $14.6 trillion in 2028 from about $12.2 trillion in 2023 (a five-year CAGR of 3.75 percent). We expect a decided gravitation away from passive equity mutual funds as a percentage of industry assets, with passive open-end funds at 7.8 percent of industry assets in five years’ time (compared to 8.5 percent in 2023) and passive ETF’s share declining slightly from 11.2 percent this year to 10.8 percent in 2028. Conversely, we project assets to grow in alternative asset classes and strategies (e.g., private equity, private debt, real estate, infrastructure) as well as more customizable vehicles such as separately managed accounts. We estimate that five-year CAGRs in alternatives to range between 11 percent and 15 percent.

Implications for Advisory Services

There are broader implications for advisory services with a larger and more complex set of solutions:

• Advisers are increasingly getting pulled away from investment management and are embracing a “holistic approach” to fee-based advisory services, as confirmed in anonymous respondent interviews.
• Client service needs continue, especially in volatile markets—three-quarters (75 percent) of advisers in our survey note volatile markets resulted in more client interaction.
• The amount of advisers’ time spent on investments relative to running their business continues to decline: an average 27.4 percent of time spent on investment needs vs. 31.3 percent in 2021.
• Time spent on investments relative to providing wealth management services (e.g., tax planning, estates, trust, charitable giving) was an average of 30.4 percent, down from 32.7 percent in 2021.

Alternative investments and insurance products are certainly more complex from a tax and liquidity perspective than traditional retail investments. How will advisers—and RIAs in particular—square these new client needs with ongoing client service, business building, practice management, succession planning, and/or firm M&A?

In fact, the advisory industry is seeking scalable business models via M&A and consolidation. Cerulli Associates found that 58 percent of RIAs are open to or actively searching for an acquisition. Additionally, the average affiliate of an RIA consolidator manages more than double the average RIA firm ($1.1 billion versus $494.3 million).⁵ Aside from M&A, however, advisers will likely meet the challenge of this post-peak-mutual-fund world by continuing to better utilize existing adviser technology and to work with a select group of asset management and service provider partners. 

Endnotes

1. The Federated Hermes 2023 RIA and Independent Advisor Survey is a study of 259 financial advisers from across the United States who have input and/or oversight of client investment portfolios. An anonymous, online survey of a respondent panel provided by OpinionRoute, LLC, was fielded between June 28, 2023, and July 17, 2023, of advisers with at least $25 million in client assets under management. The survey had a margin of error of +/- 3 percent at a 95 percent confidence level. Adviser respondents included fee-based registered investment advisers (RIAs), independents, dually registered or hybrid advisers, and private client or wealth management advisers. The survey is augmented by 20 anonymous interviews with survey respondents selected by the vendor. 
2. Broadridge. 2023. “U.S. Advisor-Sold Asset Management: This Time It’s Personal.”
3. Money Management Institute and Cerulli Associates. 2023. Advisory Solutions Quarterly-2Q 2023.
4. Asset projections are based on a weighted-average time-series (ETS-AAA) forecasting model where the two most recent quarterly time periods have more weight than other time periods. The longer the projection from the base period, the greater the statistical error.
5. Cerulli Associates. 2022. “The Cerulli Report: U.S. RIA Marketplace 2022.”