Nearly a century ago, the first modern, open-ended mutual fund was invented, revolutionizing 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.

Operating models

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 program 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.

Tokenization

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 DLT comes in. Assets can be represented on a distributed ledger as tokens, allowing them to be easily fractionalized – split up into smaller units (Figure 1).

Figure 1. How tokenization can benefit investors

Source: abrdn, October 2023.

In this way, we can take a US$100 million private equity asset, tokenize 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 democratized – 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 fractionalization of their assets, which are likely to come at a premium.

Final thoughts

The adoption of DLT in the mutual fund industry has the potential to revolutionize the way funds are managed and accessed by investors. By streamlining existing operating models and enabling tokenization, DLT can help reduce operational costs, increase efficiency in data processing, and democratize 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 realized, 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 DLT at its disposal, it's poised for even greater innovation and progress in the years to come.

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