Up until General Motors (GM) went bankrupt in 2009, their business practices created a beautiful juxtaposition for the business practices of Toyota. GM had been able to rely on their size, market share, and Japan's non-existence to remain profitable for many years. This fostered an environment of complacency in their ability to perform their core activity...creating vehicles. In 2006, GM's profitability was mostly derived from financing the sale of their vehicles while they lost an average of $2,300 on each sale; their core activity had become financing while they were still stuck with making cars. They were using inefficient manufacturing techniques to create a wide array of uncompetitive vehicles.
In contrast, it's no secret that Japanese automotive manufacturers have absorbed the market share that GM was slowly giving up; in 1960 GM held 50% of the North American market, while they only held 19% in 2009. There were some very clear factors that contributed to this shift in the market, and, strangely enough, I believe that the same principles can be applied to the current state of the mutual fund industry. The principles are very basic; efficient manufacturing practices, and competitive products.
Efficient manufacturing practices were revolutionized by the Japanese with Just-in-Time manufacturing (JIT). American manufacturing methods employed economies of scale to keep the cost of machine hours down; they would have a large production run of a single part and then change the machinery to produce the next part. The problem with this was that the time and cost associated with changing the machinery was cumbersome. In the event that a manager suddenly needed a small run of rear doors when the machines were set up for front doors, they would be paying a premium for those machine hours. JIT made the manufacturing process flexible by implementing production machinery and a labour force that was interchangeable; managers no longer had to pay a premium for unexpected production runs because multiple machines could be quickly set up for a small production run of any part. These interchangeable parts in the manufacturing process eliminated the high fixed costs of any single production run. Parallels can be drawn between JIT in auto manufacturing and the trading done within a mutual fund.
Active fund managers will conclude through research that it is the right time to purchase a certain amount of a given security. When they fill this order, they will be paying a premium to obtain the specific amount of securities at a specific time due to the nature of bid-ask spreads; at a given time spreads will vary, and filling the kind of large market order that an active mutual fund would place will result in paying varying prices for different available lots. In contrast, a portfolio designed with holding diversified across asset classes and geographies would not need to accept an undesirable bid-ask on any individual security because they would not be looking to purchase any particular security at any exact time. A mandate may require a certain weighting of domestic small cap stocks, but the individual securities could be anything fitting that description. This approach lowers overall trading costs; trading costs are not something to be overlooked either. It would not be unusual to see an actively managed small cap fund with a trading expense ratio as high as 1%.
Lowering the costs associated with producing either a car or a mutual fund is beneficial to both the customer and the manufacturer, but if the product is not competitive, the cost savings do not drive any value. In 2006, consumer surveys about vehicle value showed that people perceived Toyota vehicles as being better designed and built, costing less to own, and lasting longer than GM vehicles. This higher perceived value combined with lower manufacturing costs allowed Toyota to grow its margins while GM’s margins became negative. GM boasted a massive portfolio of brands and vehicles, each one with a wide array of available features. This lack of focus and internal competition made it very difficult for GM to produce any single excellent product; in contrast, Toyota has only two brands (Toyota and Lexus), and the vehicles that each brand produces have fewer options. Toyota’s focused approach to the continuous development of excellent products combined with their low costs allowed them to surpass GM as the number 1 auto manufacturer in the world. As GM’s margins were squeezed by high manufacturing costs and competition with Toyota’s low prices, the quality of their products continued to suffer. Near the end, and since their re-birth, GM has eliminated or sold many of the brands in their portfolio.
In the context of mutual funds, the industry is in a similar state as GM was before they went bankrupt. Current funds in general are not of a high quality, they are costly to produce and costly to own. Much like GM, fund companies are managing massive amounts of mutual funds. On average, mutual fund companies manage 117 funds, a huge contrast to the average of 1.7 funds managed in 1951. Just as GM had to eliminate many of their brands to pursue a more focused effort, mutual fund companies have been going through the same kind of consolidation. Between 2001 and 2012 there was a 7% per year failure rate for mutual funds; failing funds would be absorbed into funds with strong records to mitigate the evidence of their poor performance. If a mutual fund company were to take the same approach to their product portfolio that Toyota has taken in manufacturing vehicles, it would produce a few high quality, engineered, and focused products.
So, I have drawn a comparison between the automotive industry and the mutual fund industry. Why do we care? We care because those who cannot learn from history are doomed to repeat it. If I went back in time and had a choice between investing in GM and investing in Toyota, I think it’s obvious where my money is going. If I wanted to use this analogy to decide where to put my money today? Dimensional Fund Advisors would be my Toyota.