Disintermedation of the Mutual Fund Foretold by Nobel Winner

By: Alpha Male 

In the 1930’s, a commerce student at the London School of Economics named Ronald Coase traveled throughout the United States conducting research for a research paper he called The Nature of Firm.  In 1991, he won the Nobel Prize for Economics for this and similar studies.  In his seminal paper, he tackled the audacious question, Why does the firm exist?  His answer was simple and eloquent.  The firm exists because transaction costs require them to.  In other words, the task of coordinating resources was so complex; it needed to be centrally managed by a head office.  Companies could not rely on the free market to provide the resources they needed because the costs of transacting business with outside firms was simply too high. 

As processes and technology improved during the 20th century, it became possible to outsource commodity functions to outside businesses and still be able to have a reliable supply chain.  More recently, the Internet has made transaction costs even cheaper and corporations have outsourced more and more of their non-core functions.  In a sense, the “gravity” holding the corporation together is weakening and functions are drifting off into space.  Companies have become virtual as previously in-house functions become part of a loose federation of businesses that some commentators have called Business Webs (e.g. Futurist and author Don Tapscott).  An obvious example of this phenomenon is the proliferation of on-line travel websites such as Expedia or Travelocity.   New technologies (the Internet) now allows travelers to bypass the traditional aggragator (the travel agent) and pick from a menu of options to assemble a customized vacation. 

But what does this have to do with mutual funds?  In much the same way that disruptive technologies forced GM to sell off its rubber plantations, parts factories, and financing companies to focus on designing and marketing cars, analogous disruptive technologies will soon force mutual funds to divest themselves of their non-core (commodity) functions – like investing in ETFs and cash.

While mutual fund companies do not literally integrate ETFs and cash into their offerings, they provide essentially the same thing.  ETFs are embedded in the return histories of most mutual funds by virtue of their index-hugging nature.  Recent research (posted here) suggests that mutual fund index-hugging has grown significantly over tha past 20 years.  Ergo, the amount of “embedded ETF” in mutual funds continued to grow.  If the (pure) passive element of a mutual fund can be represented as an ETF, then the remaining (pure) active portion can be represented by a market neutral hedge fund.  And overall, a lower-than-market volatility of a mutual fund can be represented by a cash holding. 

Until now, monolithic mutual fund companies have existed because it was too complicated to invest separately in ETFs and hedge funds.  It was too difficult to perform research, it was too difficult to compare products, and above all, it was too difficult to synthetically create the required products.  For this reason only sophisticated institutions could realize the benefits of disintermediating traditional active management.   

But today, the transaction costs of investing separately in ETFs and hedge funds has decreased dramatically.  Active investors will eventually want to receive each element seperately and as a result, mutual fund companies will migrate toward being suppliers of hedge funds, ETFs, and GICs  (Barclay’s Global Investors is a harbinger of this trend).   Online tools allow investors to perform the necessary comparisons and analysis and purchase both ETF and hedge funds from a world of different suppliers.  New ways to gain market exposure such as CFDs and ETFs and the retailization of “high-alpha” products such as hedge funds mean that investors will soon be able to assemble their own mutual fund by selecting “off-the-shelf” components in a way that is not too dissimilar to assembling a customized vacation at an on-line travel website.

– Alpha Male

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