How to save active management
Posted by Robin Powell on January 5, 2017
Assuming you have at least a passing interest in investing and you haven’t been living on Planet Zog, it can’t have escaped your notice that active fund management is having a tough time.
Last year’s financial news was dominated, in the US at least, by the closure of once-mighty hedge funds and by “Flowmageddon” — record outflows of assets from active to passive funds; there was even a crisis summit in New York in November at which some of the world’s biggest fund houses discussed this “seismic shift”; and in his latest quarterly report, Vanguard CEO Bill McNabb, says that people are starting to ask him whether active funds are “dead”.
Now I know this will come as a disappointment to those many TEBI readers who would no doubt welcome such an outcome, but, as Mark Twain might have said, reports that active management has finally croaked have been greatly exaggerated. The fund industry is far too powerful, and its PR and advertising budgets far too large, for that to happen. Add to that our basic human nature, our fundamental optimism and our love of a good story, and it’s very hard to imagine an investing industry completely dominated by low-cost index funds.
That said, the active fund industry does need to face some difficult questions. In recent weeks, I’ve seen several ideas mooted as to how to breathe new life into it. Fund houses should do more, it’s been argued, to educate investors about managing their behaviour; they should focus on providing niche products that genuinely offer something different to the countless identikit products already out there; and they should encourage managers to be genuinely active, to act on conviction and not simply hug a benchmark when it suits them. I agree on each of those.
There is, however, one blindingly obvious solution that would be more effective than all of those things put together — and that is to reduce the cost. To quote Bill McNabb: “Active management can survive.. only if it’s offered at much lower expense. Otherwise, active management is dead, and rightly so.”
I recently wrote about some research by Morningstar, which found that around 70% of US equity funds are effectively priced to fail. The study revealed that pre-fee excess returns have fallen in recent years, and yet fees and charges have not fallen to the same extent. Consequently, any value added by the fund manager is wiped out by the costs that investors incur.
Ultimately, to survive, companies need to offer value. For too long the fund industry has prospered hugely while extracting value. But it’s been found out. Investors, both retail and institutional, are more aware than ever before that managers are consistently failing to outperform, and calls for a fairer, more transparent, more consumer-focused investing industry will only grow louder.
Morningstar’s Global Director of Manager Research Jeffrey Ptak hit the proverbial nail on the head when he said:
“Fund companies should face reality, seek scale, cut costs, or fold.”
So, where should those cost savings come from? Allow me to make a few suggestions:
Increasingly we’re seeing consolidation in the asset management sector and I expect this trend to continue. Fund houses also need to look at sharing resources with other firms, at closing and merging funds, and at other ways of rationalising their operating costs.
Fund manager pay
Remuneration for fund managers has been out of control for years. There is huge scope for cost savings through salary reductions, and scrapping bonuses will have the added benefit of reducing short-termism.
Fund managers spend a fortune on external research; in 2012, for example, UK fund houses spent an estimated £1.5 billion on it. And yet, in the words of Daniel Godfrey, former head of the Investment Association, much of it is “valueless” and “90% of it is never read by anybody”.
Staffing is the fund industry’s biggest overhead by far. Dr Christopher Sier from Newcastle University has estimated that the average staff salary at a UK fund house is a mind-blowing £225,000 a year — and that includes marketing staff, administrators, receptionists, secretaries and so on. Do firms really need so many people and to pay them quite so much?
The FCA’s interim report on UK asset management stated that, even after salaries and bonuses, fund houses have consistently made profits in the region of 35%. That makes them, by any standards, extremely lucrative. Shareholders have greatly benefited from the profits that fund houses have enjoyed over the years; accepting smaller dividends now is a fair price to pay for ensuring that those companies have a viable future.
By saving money in all of those areas, fund management companies should be able to reduce their fees and charges substantially and relatively easily.
More than that, they should also be in a position to be able to absorb their own transaction costs, which are a huge drag on investors’ net returns. Managers continue to turn their portfolios over at an alarming rate (typically around 100%, according to the FCA). Making fund managers liable for the cost of trading will make them think twice before buying or selling and, consequently, it should improve their long-term performance as well.
Active managers, it’s over to you. Cut your fees and charges, and you might just give yourselves a fighting chance of actually adding value.