Nearly a century ago, the first ‘modern’ open-ended mutual fund was invented, revolutionising the world of finance. It made investing in a variety of securities simple – benefiting both individuals and institutions.
Since then, however, not a great deal has changed in the structure of the humble mutual fund. It has undergone fairly limited innovation, despite greater governance and oversight, more processes and paperwork. This has meant increased operational friction and costs to the end investor.
Furthermore, while the range of investment opportunities is vastly larger today, there’s a significant difference in the opportunities that are available to the largest investors and those available to the smallest.
Distributed ledger technology (DLT) has the potential to change things.
The typical fund operating model requires many third-party service providers to function – administrators, custodians, auditors, transfer agents and depositaries.
Even when some of these services may be performed by the same company (e.g., administration and custody), they are typically run by separate businesses, and therefore each entity maintains its own private ledger.
Multiple private ledgers make compatibility more challenging, meaning human intervention is often needed to allow for the necessary reconciliation across these ledgers.
Because ledger operators – the fund service providers – have their own way of recording data, that reconciliation process takes more time, and it can be even longer if there is a discrepancy in the records.
This results in longer data-processing times, which means things like publishing fund prices and audited financial statements takes longer. The more work required to perform these services, the higher the cost to the fund (and, ultimately, the investor).
However, all these operating models could, instead, exist on a single ledger. Administrator, custodian and depository data could be stored as transaction records relating to ‘tokens’ of fund units.
The auditor’s role in reconciling records at the custodian and depository could be replaced by a smart contract – a computer programme that executes a transaction when specified criteria have been met. The financial data the administrator needs to produce audited financial statements could be collected in another smart contract, in real time.
All this potentially reduces data processing time, resulting in fund prices and reporting being published much quicker. Because a great deal of operational burden has been removed, operating expenses will come down.
While the universe of investable assets has expanded rapidly in recent decades, there has also been a widening gap between what is available to the largest investors with what’s available to the smallest.
The largest are typically able to look at investment opportunities that require bigger investments and have less liquidity, such as private markets. These types of alternative investments can produce a differentiated investment return to public markets, while providing diversification for a portfolio.
That said, smaller investors, including smaller institutional investors, are often not able to access the same opportunities. The result is a less well-diversified portfolio that is more highly correlated with global equities and bonds.
This is where distributed ledger technology (DLT) comes in. Assets can be represented on a distributed ledger as tokens, allowing them to be easily fractionalised – split up into smaller units (see Chart 1).
Chart 1: How tokenisation can benefit investors
Source: abrdn, October 2023
In this way, we can take a US$100 million private equity asset, ‘tokenise’ it, and turn it into 100 million US$1 tokens. These tokens can then be listed on a regulated digital securities exchange to trade on a secondary market.
By doing this, the minimum investment is now affordable to the smallest investor, while the secondary market creates liquidity.
This process can be replicated with fund vehicles, bonds, equities and any other asset that can be held in custody, including niche alternative assets, such as wine and art.
Thus, the investment landscape becomes truly democratised – giving the smallest investors the same opportunities as the largest.
Additionally, the largest investors who are the original asset owners, get the benefit of increased liquidity in their portfolios, allowing them to think differently about the liquidity profile of their asset mix. They also have the potential to create additional value through the fractionalisation of their assets, which are likely to come at a premium.
The adoption of DLT in the mutual fund industry has the potential to revolutionise the way funds are managed and accessed by investors.
By streamlining existing operating models and enabling tokenisation, DLT can help reduce operational costs, increase efficiency in data processing, and democratise the investment landscape by providing access to a wider range of assets for all investors, regardless of their size.
As we look towards the future, it's crucial for industry stakeholders to collaborate and embrace these technological advancements, while addressing any regulatory and implementation challenges that may arise.
By doing so, they can help to ensure that the benefits of DLT are fully realised, ultimately creating a more inclusive and efficient investment ecosystem that serves the needs of all investors.
The mutual fund industry has come a long way since its inception nearly a century ago, and with the power of distributed ledger technology at its disposal, it's poised for even greater innovation and progress in the years to come.