Like books and music, the investment industry is being squeezed
Posted on May 3rd 2014
Article from http://www.economist.com/
SOME of the greatest fortunes in the modern world have been accrued by those who look after other people’s money. Hedge-fund and private-equity managers have become billionaires thanks to their ability to claim a chunk of their funds’ annual return. The irony is that many of these fortunes have been built at a time when investors no longer have to pay high fees to earn the market return for equities or government bonds. “Tracker”, or “passive”, funds do not try to beat the market. They just replicate the components of an asset class, and their fees amount to only a few “basis points”, as a hundredth of a percentage point is called in the lingo.
This distinguishes them from “active” funds where a manager tries to select assets that will do better than average. Such funds have higher costs and, unless they outperform markets over the long term (which the average fund does not), those costs eat into returns. Invest $100,000 for 30 years at 6%, with annual charges of 0.25%, and your portfolio will be worth almost $535,000; if the annual charges are 1.5%, your pot will grow to only $375,000.
Even great investors think that low-cost tracker funds make sense. In his latest letter to Berkshire Hathaway shareholders, Warren Buffett describes what should happen to his personal portfolio after his death. “My advice to the trustee could not be more simple: put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund.”
As investors wake up to the maths, active fund management is starting to face the kind of pressure seen in other industries, like newspapers, record labels and taxi companies, which are losing their role as gatekeepers. A report by the accountants at PwC forecasts that low-cost funds will double their share of the global fund-management industry by 2020 from 11% to 22% (see chart 1).
Earlier generations of investors were prepared to believe that the returns achieved by fund managers were down to skill. Now it has become clear that the returns were the result of factors that can be replicated. Like shoppers on a budget, investors are trading down from expensive brands to white-label goods. That may put many active managers out of a job.
Three factors are driving this commoditisation of fund management. The first is the rise of exchange-traded funds (ETFs)—portfolios of assets that track indices and trade on exchanges. Around $2.45 trillion is now invested in ETFs, up from just $425 billion in 2005, according to ETFGI, a consultancy (see chart 2). That makes this sector almost as big as the hedge-fund industry. The average fees on ETFs are just over 0.25%, but that proportion is inflated by specialist funds. State Street’s huge Spider fund, which tracks the S&P 500 index, charges only 0.09%.
The ETF sector is still small relative to the rival mutual-fund industry, which manages $27 trillion in assets, but it is beginning to close the gap. American ETFs received $895 billion of inflows between 2008 and 2013, compared with only $403 billion for actively managed mutual funds, according to the Investment Company Institute (ICI), an industry body.
One reason for the rise of ETFs is the changing behaviour of financial advisers.
Historically, many earned commissions, paid by the fund-management company whose products they sold and incorporated in the annual management charge. This system created a conflict of interest: the products that were best for advisers to sell were not necessarily the best products for clients to own. Low-cost trackers did not have sufficient fees to reward the advisers, so tended not to be recommended.
The best way to insure advisers’ independence is for them to be paid by the client, not the fund. But few clients wanted to pay an upfront fee when the cost of commission-based advice appeared to be free (because it was subsumed within the cost of the product).
In Britain the introduction of the retail distribution review (RDR) in 2013 abolished commissions and required advisers to explain the true cost of advice to clients. Slowly but steadily this will expand the market for low-cost funds. Other countries are following suit; versions of the RDR have been created in India and Australia, and are being set up in Switzerland, Germany, Italy and South Africa. The PwC report reckons that by 2020 nearly all developed markets will have introduced rules that align the interests of the salesman (or broker) with those of the customer. In addition, some investors have the confidence to buy financial products directly, without the use of an adviser, just as they buy insurance online; the internet and the rise of product forums known as fund supermarkets make it easy for them to do so.
The second trend driving the commoditisation of fund management is the rise of alternative indices, known as “smart beta”. Conventional indices weight assets according to their value: the biggest stock is the one with the highest market capitalisation. This may be the best way of measuring how the overall market is performing, but it is not the best approach to investing, smart-beta enthusiasts argue. Shares that rise rapidly in price, and thus become more expensive, get a bigger weight; shares that fall in price, and look cheap, have a smaller one. Investors who track these indices end up buying high and selling low.
To avoid this problem, smart-beta indices weight companies by their sales, or profits, or even volatility. In a sense, they replicate what active managers try to do, at much lower cost. Although some dismiss this as a fad, around $330 billion is now invested in smart-beta funds. Towers Watson, a consultancy to pension funds, says its clients have doubled their allocation to the sector over the past year.
The third trend behind commoditisation is the steady rise of defined-contribution (DC) corporate pensions. For most of the 20th century employers offered defined-benefit (DB) pensions, which are linked to the final salaries of employees. If the pension scheme had insufficient funds, the employer was required to top it up. This gave employers an incentive to look for high investment returns—and to employ active managers who charged high fees.
But in a DC pension the employer merely makes contributions. The payout is governed by the whims of the market; the employee bears all the investment risk. Most employers offer a default DC fund (which most employees opt for). And these funds usually have a big exposure to low-cost index-trackers: no employer can be blamed for opting for low-cost funds. The average large British company has costs of 0.41% on its DC scheme. That does not leave much scope for active fund managers. More than half of all schemes use trackers exclusively.
In Britain DC pensions are virtually universal for new private-sector employees, and the total size of DC schemes is slowly overtaking the old DB funds (see chart 3). DC assets rose from 38% to 47% of the private pensions sector between 2003 and 2013, according to Towers Watson. In America DC assets are already well ahead in the private sector, with $5.9 trillion as opposed to $3 trillion in DB schemes, according to the ICI, the industry group.
Governments are also pushing pension providers to opt for low-cost funds. In Britain pension charges will be capped at 0.75% a year from April 2015. As part of a plan to nudge people into taking out private pensions, known as auto-enrolment, the British government set up a collective scheme called NEST, with annual fees that equate to just 0.5%. Such measures make it likely that more investments will flow into tracker funds.
Money for old hope
The surprise is that commoditisation of the fund-management industry has not happened sooner. After all, the first low-cost tracking fund, designed to mimic the performance of the S&P 500 index, was created more than 40 years ago. The slow transition is partly a result of how most funds are bought and sold: the commissions for brokers that made it attractive to push managed funds, and the fact that many people buy their investment products through banks. These have little incentive to drive down costs. Indeed, part of the appeal of multi-purpose banking is the ability to sell higher-margin products to customers with deposit accounts.
Other reasons are rooted in psychology. When consumers buy books or songs, they get instant gratification. When they buy a mutual fund, it may be many years before they know whether they have made the right choice. As a result, cost may not be the primary factor in their choice. “Human beings like to feel they can outperform and get the best service,” says Edward Bonham Carter of Jupiter, an active fund-management firm.
Investors may also believe, despite legally required caveats, that past fund performance is a guide to the future riches. They want the best fund, not an average one (which an index tracker is likely to be). This gives active managers a great marketing advantage: hope. Inertia is a factor too. Investors who have placed their money with a big active manager often do not bother to move it. They may not even know whether their holding is outperforming or underperforming.
It is not only commoditisation that is now making life difficult for fund managers. Academics continue to debate whether markets are “efficient”, in the sense that all relevant news is incorporated in the price, giving active managers a hopeless task. But you do not need to accept this hypothesis to believe that it is difficult to beat a stockmarket index. By definition, it represents the performance of the average investor, before costs. Since fund managers incur costs, the performance of the average fund manager is doomed to lag the index.
A good proportion of managers will beat the index in a given period, whether through their own skill or simple luck. But it is hard to see how investors can identify managers like Mr Buffett in advance. Indeed, if such paragons could be easily identified upfront, they would attract all the available funds, driving the hopeless managers out of business.
Institutional investors, too, have gradually become more sophisticated about identifying how fund managers generate returns. A hundred years ago they regarded all returns as evidence of a manager’s skill. Then they began to compare returns with those of other managers or the market. Later, with the help of academics, they realised that fund managers might beat the index by taking more risk; so they started to use risk-adjusted measures. Then they realised that outperformance might be down to fashion: the manager might have had a big exposure to, say, value stocks that had been doing well in recent months; so they began to attribute managers’ performance to factors such as cheapness or exposure to smaller companies.
All this has narrowed the scope for managers to demonstrate skill, rather as Victorians explained more and more natural phenomena in terms of science, rather than divine intervention. Where market returns can be explained by exposure to various factors, those factors can be replicated in the form of ETFs at low cost. And the ETF investor need never worry about the manager losing his mojo or quitting to join another firm.
Nevertheless, active managers are not going to disappear overnight. Hedge-fund managers, for instance, have the ability to “go short” (bet on their prices to fall), something that ETF funds cannot do. This allows them to offer investors a smoother return, that is less dependent on the vagaries of the stockmarket. Private-equity managers, for their part, have the ability to remove companies from the glare of the public stockmarket, restructure them (with the help of a lot of tax-advantaged debt) and then sell them at a profit. Both types of manager take advantage of the “illiquidity premium” that is attached to certain assets, which offer a higher return because they cannot be instantly converted into cash.
Some argue that hedge-fund and private-equity managers capture the bulk of this excess return for themselves in the form of their famed “two-and-twenty” fee structure (2% annual management fee and 20% of the fund’s performance). The average return of hedge funds has lagged a plain-vanilla portfolio of 60% American equities and 40% Treasury bonds in nine of the past ten years.
In the wake of such disappointing returns, fees have come under pressure. What is more, hedge and private-equity funds are hard to fit into a DC framework, where workers are allowed to switch between funds on a regular basis; DC schemes need daily liquidity, which such funds cannot provide.
Still, these are likely to continue to appeal to three groups. The first is sovereign-wealth funds: they do not need regular liquidity and their managers may think active funds can provide excess returns over the long run. The second group comprises DB funds: many are in deficit and may hope that active management will boost returns and allow them to meet their pension promises. The third group is high-net-worth individuals who are looking for excess returns and like the “snob value” of investing with top-rated fund managers. In short, there will be a market for expensive fund managers, just as there is a market for designer clothes or vintage champagne.
Life will be harder for traditional active-fund-management companies. Their market share is being eroded by the ETFs at the bottom and by private-equity and hedge funds at the top. Many are accused of being “closet indexers”—building portfolios that closely resemble benchmarks like the S&P 500—while charging active fees.
Index-hugging makes business sense in the short term: it is serious underperformance that is most likely to get a fund manager sacked. As a result, the share of mutual funds that have portfolios which diverge widely from the index has been falling, down from 50-70% of the market in the 1980s to 20% today. But academic research shows, unsurprisingly, that only managers who do take big bets have a hope of consistently outperforming the index.
The big squeeze
When industries come under pricing pressure, they usually consolidate. That is yet to happen in the active part of the fund-management industry. The largest five equity-fund managers control only 47% of American mutual funds. Again, this may be due to the way the distribution system works: the fund-management arm of a universal bank will attract business no matter how lousy its returns. It may also be a result of the “random” element of active investing. Poor managers can have good years and good managers can have bad ones. The one prevents bad managers from disappearing, the other prevents good managers from getting too big.
The index-tracking business is much more concentrated. Almost 70% of the ETF market is controlled by just three companies: BlackRock (through the iShares brand), State Street and Vanguard. Passive investing lends itself to economies of scale. It costs little more to manage $20 billion than to manage $10 billion. Over time, this allows managers to bring down fees. “Vanguard wasn’t charging seven basis points when it started,” says Rob Arnott of Research Affiliates, a smart-beta manager.
Will the rise of tracker funds make the market less efficient, because investors will just be buying blind? Not in the near future: active funds still control the majority of assets. The dotcom bubble, for instance, was driven by active managers more than by trackers; the number of active technology funds had exploded. In addition, smart-beta funds are not buying the same stocks as most trackers; they act as natural balancers of the market.
The PwC report on the asset-management industry in 2020 begins with describing an imagined young Chinese woman who uses her smartphone app to buy, in a single click, a range of funds that most meet her needs and risk appetite. That hints at a reason why other industries have been commoditised so quickly: it has been easy to eliminate intermediaries. People can buy books from their Kindle or download songs to their iPad without visiting a bookstore or a record shop.
In the financial sector, by contrast, intermediaries are remarkably persistent. The ICI reckons that 80% of American retail investors pay for advice. People are able to buy a range of ETFs directly, but few feel confident about doing so. “Even bankers and lawyers don’t know what to do, they need advice,” says Mark Wiedman of BlackRock. There is no ideal portfolio that suits everyone: equities usually deliver higher returns over the long run, but with more volatility; government bonds offer a steady income but are vulnerable to inflation. Younger investors may be more willing to take risks, because they can afford to ride over the market’s bumps; older investors may need more income.
Good advice is certainly worth something: many American investors in pension plans have devoted a big proportion of their portfolios to cash (a low long-term return) or to their employer’s shares (too risky). The ability to avoid such mistakes is worth a one-off fee. But an investor should not pay 1% to 1.5% a year to an adviser. Nobody has yet shown that they can correctly and consistently time markets.
Companies and governments can look after the best interest of their workers by ensuring their pension schemes have as low costs as possible. To some extent, this is happening already. But if the world is going to look like PwC’s vision in 2020, the average investor will need to be better informed. At the very least, they need to read the personal-finance pages of newspapers, and understand the merits of tracker funds and the impact of low charges. Investors of the world, unite! You have nothing to lose but your fund managers’ fees.
Correction: A previous version of this article stated that the largest five equity-fund managers control 40% of American mutual funds. The correct number is 47%.
Posted on May 3rd 2014
Article from http://www.economist.com/
