MAKING money yourself from investing other people’s has been a good business for over a century. Asset managers established a key principle early on: they could charge an ad valorem fee on the amount they oversee. So when markets go up, their fees go up.
But as the title of a recent London Business School conference indicated, investment management is “an industry in disruption”. Abhijit Rawal of PwC, a consultancy, described the sector’s problems as the “four Rs”: returns are low; revenues are being squeezed; regulations are being tightened; and the robots are coming to take away business.
Plenty of potential for growth remains, as workers save for retirement. But the industry faces the same sort of cut-throat competition that technology has caused elsewhere. The oldest challenge comes from index trackers, funds that try simply to match the performance of a benchmark like the S&P 500. It took many decades for such “passive” funds to become widely accepted, but they are rapidly gaining market share. Vanguard, a big passive manager, received more than half of all global fund inflows last year.
Big tracker funds can drive down fees through economies of scale. The expense ratio for Vanguard’s S&P tracker is just 0.04% of its assets. The average active American equity fund, which tries to beat the index, charges 0.8%. Such fund managers may claim they can outperform the market but in practice few do so consistently. Over the 15 years to the end of December 2016, less than 8% of American equity funds managed that feat. As an old quip has it, “you make your money working in active management but invest the proceeds passively.”
Some managers think they can beat the market by backing certain types of company: those that look cheap on valuation measures such as asset value or dividend yield, say. But even here technology is eroding the case for active management. Computer programs can select stocks on the basis of such criteria at low cost. These “smart beta” funds are gaining ground. The result is that average fees are being dragged down across the industry. According to the Investment Company Institute, a group that represents fund managers, the average expense ratio of American equity mutual funds, weighted by assets, fell from 0.99% in 2000 to 0.68% in 2015.
One reason why high-cost funds have survived for so long is the way that savings products are sold. Many retail investors rely on brokers to advise them; these brokers are often paid commissions or fees by fund managers. These are then passed on to clients in the form of higher management fees. Passive funds do not offer such inducements, so they used not to get recommended. But regulators have been cracking down on such arrangements: Britain stopped these payments in 2013. Trackers have made strong gains since then.
A new disruptive element is the arrival of “robo-advisers”, which offer investors low-cost, diversified portfolios based on their aims and risk profiles. These are popular with younger investors, who are used to buying products online.
Another challenge for fund managers is a change in the corporate-pensions market. Fewer companies are offering defined-benefit (DB) pensions, which are linked to a worker’s salary; new employees now have a defined-contribution (DC) pension, the benefits of which are not guaranteed. Employers offering DB pensions need to generate a high return to keep contributions down, so many tend to use specialised “boutique” managers. But DC plans often offer a default fund, chosen by most employees; these usually employ a more limited range of fund managers. The market tends to be concentrated in the hands of big fund-management groups and insurance companies, which can handle the administration of the scheme as well as the investing.
The result is that the industry seems bound to consolidate. A spate of recent mergers of big fund managers has included one between Henderson, an Anglo-Australian firm, and Janus, an American one. There is plenty of scope for the sector to thrive, if it adapts. It seems likely that retiring baby-boomers will rely more on their own resources, and less on the state, and those assets will need managing. Many investors will opt for multi-asset funds, which own equities and bonds; these are less vulnerable to index-tracking because there is no obvious benchmark. And plenty of people will want the reassurance of speaking to a human being, rather than rely on robo-advice. The challenge for fund managers will be to provide it all at a reasonable cost.