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The Financial Industry Is Having Its Napster Moment

Has the music stopped for the financial industry?

Just as record companies in the early 2000s had to deal painfully with the digitization of music courtesy of Napster and Apple Inc.'s iTunes, many asset managers are now facing a similar situation as more investors make the switch from high-priced, actively managed mutual funds to passive, low-cost, exchange-traded funds (ETFs) and index funds. When the dust settles in this sea change, the financial industry may be half of what it once was, simply because its revenues will be half of what they once were.

This trend may be accelerated because of proposed new “fiduciary rules” issued by the Department of Labor, which will require brokers to (gasp) put clients' interest ahead of their own when it comes to customers' retirement investments. In other words, no more putting grandma in a pricey active mutual fund just because you get a commission, or "load" in industry jargon.

The rule, which is set for a vote in 60 days and would be phased in over the next two years, is predicted to be a boon for ETFs and index funds, the vast majority of which already pass the fiduciary rules and are the vehicles of choice for advisers currently abiding by this standard. Rule or no rule, however, the trend toward passively managed investing has been slowly blooming for more than a decade, as seen in the chart below from the Investment Company Institute, which looks at this trend within equity funds.

Accumulative flows into equity funds.

Since the beginning of 2015 alone, about $250 billion has moved out of actively managed mutual funds and into passively managed index funds and ETFs. For investors, this has been a way to save costs and increase returns, but to asset managers—and many of their stakeholders—this represents a direct hit to revenue and a...