Advisors to Drop Mutual Funds for Lower-cost, Personalized Products: Report

Amid regulatory pressure and changing investor preferences, advisors are moving away from revenue-sharing products such as mutual funds and toward products such as exchange-traded funds and separately managed accounts, according to a recent study.

Advisors’ use of mutual funds is expected to decrease 13% by 2024, according to research by Cerulli Associates, a Boston-based consultancy. And the percentage decline is consistent for advisors in the wirehouses, national and regional broker-dealers and independent broker-dealers, the research found.

Meanwhile, use of ETFs and SMAs is expected to increase 16% and 20% respectively by 2024, according to the research. In this area, the usage forecast varies significantly by channel. ETF use is expected to increase 12% among wirehouse advisors, 21% among advisors at national and regional broker-dealers, and 22% among advisors at independent broker-dealers, while SMA use is expected to increase 16% among wirehouse advisors, 16% among those at national and regional broker-dealers, and 25% among those at independent broker-dealers, Cerulli found.

The research is “based on findings from Cerulli’s annual survey of several thousand financial advisors, and conversations with hundreds of key executives throughout the asset and wealth management industry,” Matt Belnap, associate director of retail distribution at Cerulli, told FA-IQ in an email.

The changing preferences reflect shifting client demands and an upmarket move by advisors, particularly at wirehouses, where the advisor base tends to focus on more affluent clients, according to Dennis Gallant, associate director at Boston-based analytics firm ISS. Affluent clients tend to expect products that can be personalized, such as separately managed accounts, and capabilities such as direct indexing could bring that personalization down market, Gallant said.

“If you’re doing just basic asset allocation as a financial advisor, you’re going to be under pressure, maybe not so much from the robos but from the hybrid advice. The advisor wants to justify their fee, but fee justification requires a lot of advisors to be more sophisticated in their asset management,” Gallant said.

Direct indexing is “the apogee” of personalization and “implies an unbundling of pooled investments away from mutual funds towards a mix of low-cost ETFs and individual securities,” according to Will Trout, director of wealth management at Javelin Strategy & Research, based in Pleasanton, California.

There are three main reasons why custom portfolios are preferential for advisors, according to Iraklis Kourtidis, co-founder and chief executive officer at Rowboat Advisors, a direct indexing provider based in Menlo Park, California. One is to meet clients’ environmental, social and governance preferences, “which you can’t do within a fund because it’s one-size-fits-all,” he said.

The second reason is tax efficiency, particularly tax-loss harvesting, “which you also can’t do with a big fund where you lump all the money together,” Kourtidis said.

The third, “much less talked about” reason is the concept of “completion portfolios,” according to Kourtidis.

“If someone has a lot of tech exposure through stock with their employer, for example, you can give people a custom portfolio that offsets that,” he said.

Regulatory pressure is also driving the change in advisors’ product preferences, according to Trout.

“In terms of 12b-1 fees and other types of revenue sharing agreements there has been a shift to a more harmonized standard of care for the advisor. Things like Reg BI — that really put an onus on the advisor to provide transparency around charges that will hit the end client’s pocketbook and also appropriateness of investments to the circumstances of the individual client,” Trout said.

Regulation Best Interest, which went into effect June 2020, requires broker-dealers to act in the best interest of clients when making recommendations.

The Securities and Exchange Commission “has looked unfavorably” at marketing and distribution fees for years, with 12b-1 fees “being the most notorious,” according to Trout. ETFs can also have such fees, “but the magnitude of scale is completely different,” Trout noted.

“There’s a huge regulatory impetus around disclosure, transparency, [and] appropriateness to the end client in terms of product fit and these high-cost mutual funds just don’t cut it,” Trout said.

Charging for advice “is the only way forward” for broker-dealers, given the shift away from revenue-sharing products, according to Trout.

“That’s the direction of the industry more broadly and regulation has accelerated that trend by making it the only way forward for historically product-focused broker-dealers to survive and thrive,” he said.

Many firms have been moving away from a reliance on revenue sharing and instead focusing on providing reporting to asset managers, according to Gallant. For example, broker-dealers are constructing “data packs” and selling them to asset managers, he said.

“The data packs become another source of revenue — rather than having revenue tied to a product, they now have a revenue source in these data packs for purchase by asset managers that helps them [asset managers] figure out who’s selling what products, where and how,” Gallant said. The asset manager can use that information at the advisor level to better target their wholesaling, distribution and marketing efforts, according to Gallant.