Are Building-Block Funds on the Scrap Heap?

The world of mutual funds is often divided into competing categories. Typical distinctions include equity vs. bond, active vs. passive, and proprietary vs. third-party distribution.

Building block vs. outcome is another pairing that has come to the fore in recent years. So what are these funds?

  • A “building-block fund” provides one piece of a broader portfolio. It will typically reference a benchmark, focus on a specific universe of securities, and contribute to the goals of the over-arching portfolio.
  • An “outcome fund” seeks to deliver a particular result or solution that serves the needs of the investor, essentially trying to replicate the function of a broader portfolio within the confines of a single fund.

Since the financial crisis, there has been a clear upswing in net flows captured by outcome funds, and many asset managers have launched such products to tap into this demand.

So does this mean that building-block offerings have been consigned to the scrap heap, with their considerable legacy assets doomed to gradual decay?

We need to wind the clock back to before the financial crisis to get some context on how the situation has developed. From 2002 to 2007, equity funds accounted for 38% of Europe’s total net inflows. Roll forward to the period of 2012 to 2017, and the equivalent statistic was just 18%, according to Mackay Williams analysis of Broadridge FundFile data to November 2017.

Can you guess where most of the money has been going instead? That’s right — outcome funds. Of the €2 trillion of total net flows registered during the 10 years since the financial crisis, 60% went into outcome-focused sectors, such as mixed assets in general, income-generating products, absolute return funds, and flexible bond offerings.

There are several compelling reasons for this shift. An aging population prefers certainty to risk in its investments, and memories of the dot-com bust and financial crisis have dissuaded many people from making further equity allocations.

Indeed, for investors with longstanding portfolios, there has been little need to top up their equity exposure. Market performance has done that for them — the emphasis has instead been on balancing rising equity assets by purchasing something else.

Meanwhile, low interest rates have created demand for low-risk alternatives to government bond funds. Regulations have also played their part: The Retail Distribution Review (RDR) in the United Kingdom has spurred many financial advisers to seek out simple one-stop-shop funds for their clients, and the Markets in Financial Instruments Directive (MiFID II) could encourage a similar trend in other European markets.

Many of these conditions are unlikely to change substantially any time soon, bringing us back to the initial question: Are building-block funds on the scrap heap?

The short answer is that it depends on the buyer. Some third-party distribution channels, such as retail banks and financial advisers, undoubtedly have a preference for outcome funds. But other professional fund buyers are expected to custom-build their own solutions, otherwise they are out of a job.

By way of example, fewer than 50% of Europe’s fund-of-funds managers or discretionary portfolio managers use mixed-asset funds, the most common type of outcome fund. Many of these selectors will be skeptical of a solution purporting to suit everyone, given that circumstances and needs are unique to each investor.

Surely then, building-block funds should still be in vogue? The challenge of judging their popularity lies in the disconnect between flows and assets. Building-block funds manage substantially higher assets than outcome products, but these assets are more mature: Redemptions offset new money, dragging down their net sales. (Bear in mind: Equity funds — typical building-block products — continue to manage significantly more assets in aggregate than any other category in Europe, albeit varying from market to market.) The more immature outcome funds, in contrast, have been grabbing the headlines because their chunky inflows are unimpeded by notable withdrawals.

Total net sales can be misleading, as they do not describe the opportunity to attract existing investments away from competitors. A look at positive net sales can help to address this imbalance, by summing the net inflows of those funds in positive territory to highlight the true size of the prize available to “winners” during any given time period. This presents a very different picture from earlier: Positive net sales of equity funds during the 10 years since the financial crisis sum up to €1.4 trillion, of which almost €1 trillion was captured by actively managed funds.

Of course, it is not possible to clearly divide the origin of net flows into new assets and legacy assets when analyzing business at the group and fund level: An outcome fund could well attract existing assets from a building-block product, while a building-block fund investing in a novel theme is likely to welcome new money. The point is that there are still abundant opportunities available to fund groups specialized in building blocks.

The advent of outcome funds has occurred at a time when competition has grown stiffer anyway, as passive options have blossomed. All providers have come under greater pressure to demonstrate value for money. Perhaps even more importantly, they also need to be able to articulate a story for each of their funds. This is fairly straightforward for outcome funds: “We aim to give you a 4% return each year.”

But building blocks need to convey their benefits too: Why should you buy this fund, what is different about it, and how can it fit into your portfolio?

This, in turn, requires some deft marketing skills. Building-block funds are by no means dead, but they do require greater promotional efforts for sales to remain in the black.

This blog first appeared on the CFA Institute’s Enterprising Investor platform on 6 March 2018.