The rise of passive funds as investors opt for lower costs poses a growing threat to active fund management. How well-equipped is the industry to fight back? Will Jackson investigates.
A brief stroll down the typical British high street shows how consumers’ priorities have changed over the past couple of years. Bargain stores and 99p shops fill the gaps where big-name retailers once stood, and even Waitrose – the high church of middle-class food shopping – has introduced an “essentials” range. According to John Lewis Partnership’s interim results, published earlier this month, the strategy was the main driver behind the supermarket’s strong performance in the first half of 2009.
Value for money is increasingly the mantra for investors too. The shift towards lower-cost passive products continues to gather pace, and nowhere is this more noticeable than in the growing use of exchange-traded funds (ETFs). The funds – open-ended investment companies whose units are traded on a regulated exchange – have proved hugely popular in recent years. Barclays Global Investors data reveals that global ETF assets hit a record $891 billion (£548 billion) at the end of August.
Index tracking strategies in traditional fund structures also look set to gain greater prominence. In June, Vanguard, which manages over $1 trillion in passive funds for American investors, announced its intention to crack the British market by unveiling a range of Oeics. HSBC Global Asset Management, which cut the annual management charge (AMC) on its trackers in the same month, expects that 95% of British advisers will increase their exposure to passive funds over the next three years.
The rise of passive investing has been well-documented – in Fund Strategy and elsewhere – but it raises equally important questions about the future of active fund management. To what extent will traditional mutual funds come under pressure from their lower-cost cousins? Will wider access to passive strategies influence which sectors active managers operate in, and the types of products they offer? In short: how well-equipped is the industry to cope with the battle, and how can it fight back?
In the near term, passive funds appear to pose the greatest threat to active managers investing in efficient, liquid markets such as the FTSE 100 and S&P 500. Such indices are notoriously tricky to beat through active stock selection – a view reinforced by the latest Standard & Poor’s (S&P) Indices Versus Active Funds Scorecard. The twice-yearly report assesses how well active American equity and bond managers have performed, relative to their benchmark indices.
According to S&P, most equity funds were beaten by the S&P Composite 1500 index over one, three and five years to June 30. Active large-cap, mid-cap, small-cap and multi-cap growth funds fared particularly badly, while just two sectors – large-cap value and real estate – outperformed their benchmarks over all three time-frames. The story was similar for fixed income, where more than three-quarters of funds underperformed over five years, in all categories except emerging market debt.
S&P does not produce a similar scorecard for British funds, but a quick glance at the Investment Management Association’s (IMA) largest sector – UK All Companies – indicates a similar trend. Financial Express data shows that most funds in the peer group generated a total return lower than that of the FTSE All-Share in each calendar year from 2001 to 2008, after a small majority outperformed in 2000. The pattern looks set to continue in 2009 – just 147 out of 323 portfolios (45.5%) were ahead of the index on September 15.
David Chellew, HSBC Global Asset Management’s head of UK wholesale market position and global funds marketing, says passive products will gain market share from underperforming active managers. HSBC reduced the AMCs on its seven-fund tracker range from 0.5-1% to a flat rate of 0.25%, cutting expected total expense ratios (TERs) to between 0.27% and 0.37%. The announcement came just days after Vanguard’s official British launch, but Chellew says passive providers are more interested in gaining market share from active funds than fighting each other.
“The press has focused on competition between indexing companies but that is a red herring,” he explains. “The real competition is between trackers and those core equity funds which might outperform by 1% but which charge 1.5%. Underperforming active managers must be feeling the pressure.” Data from Morningstar shows that American equity index funds have an average TER of 0.78%, compared with 1.43% for active products. The difference is even clearer in fixed income, where active bond managers command a TER almost three times as high as their passive rivals.
Chellew expects investors to shift increasingly towards the “core-satellite” method of portfolio construction – using a core of low-cost trackers in areas where managers struggle to outperform, and satellite active funds for exposure to less efficient markets. Accordingly, HSBC plans to focus its active fund marketing efforts on its emerging markets range in future, where the firm’s managers have a greater chance of adding value. “It is not a debate between active and passive,” adds Chellew. “Most people will use both.”
Simon Elliott, the head of research at Wins Investment Trusts, expects a similar trend to emerge in the closed-ended fund world. The Wins monthly report for September examines the threat posed by ETFs to investment trusts. ETFs offer several advantages to institutional and retail investors over traditional closed-ended funds, the report says, including greater liquidity and lower discount volatility. Despite this, Elliott expects ETFs to act as complementary holdings alongside trusts, rather than as direct competitors, while core open-ended funds may come under greater pressure.
“It is not enough for investment trusts to offer beta – they need to generate alpha and outperformance,” says Elliott. “But this is an argument that trusts faced a few years ago in relation to open-ended funds, and trusts have already moved away from institutional benchmark plus 1-2% mandates.”
Alliance Trust, the largest generalist investment trust on the London Stock Exchange, is typical of the shift away from benchmark investing. According to the Financial Times last week, the fund has halved its stocklist since 2007 in a move to differentiate itself from the index.
Core open-ended funds intent on protecting their assets under management may decide to follow suit. Richard Ramyar, the head of research, UK and Ireland, at Lipper, agrees that active managers will have to move away from their benchmarks to maintain market share. However, he is sceptical that retail fund groups will simply switch to running more concentrated “high alpha” long-only products.
Such funds already exist, including Martin Currie’s 25-stock North American Alpha Oeic, but Ramyar says the approach is unlikely to win widespread support from investors.
“Active management, on average, tends to be similar to the benchmark,” says Ramyar. “That raises two issues. First, investors ask why they should take on the risk of using an active fund for a benchmark return. And second, it means that active managers have to deliver more. Passive funds will become bigger at the expense of long-only, and really active managers will take some of the pie. But concentrated funds will remain niche products – the variation of returns between different funds would go up, and that would not be tenable from a political or regulatory standpoint.”
Ramyar notes that investors are not using passive funds only for broad beta but also for “alpha-inspired bets” in specialist areas such as commodities, nuclear energy and water. This trend is also likely to support active managers who operate in similar niche sectors, a view echoed by Elliott, who points to the rise of “more esoteric” investment trusts. As an example, Elliott highlights this month’s launch of the Impax Asian Environmental trust. Impax, which specialises in environmental investing, runs about $1.8 billion across a range of segregated accounts and funds.
Away from long-only portfolios, Ramyar says the trend towards unconstrained active management is most likely to bolster demand for absolute return. The sector has expanded dramatically over the past year following retail fund launches from a range of companies including Cazenove, Gartmore, Ignis and SVM. British investors reacted with enthusiasm, boosting assets in the onshore IMA Absolute Return peer group from £2.3 billion in July 2008, to £5.4 billion in just 12 months.
Hedge fund operators are likely to widen the range of options further, as long/short managers increasingly turn to regulated Ucits III structures. As Fund Strategy reported earlier this month, Man Investments is set to enter the retail market in October with the launch of its Man AHL Diversity portfolio. The fund, which aims to generate uncorrelated returns using futures, is aimed at “sophisticated” British investors but has a minimum investment level of only £100.
Artemis has also found plenty of demand for the cash-benchmarked Strategic Assets portfolio it unveiled for William Littlewood in May. While the fund does not sit in the IMA Absolute Return sector, it has the flexibility to use several hedge fund-like techniques, including taking long and short positions in equities, bonds, commodities and currencies. The portfolio, which took £145m at launch and has grown to £220m in assets under management, began shorting government bonds in August.
Toby Hogbin, the global head of product development at Martin Currie, is upbeat on the sector. “The future looks bright for actively managed funds that offer the potential for alpha generation,” he says. “We see opportunities for absolute return strategies as investors recognise that a real return is more attractive than a relative return and buyers look for their absolute returns within a regulated package.”
Martin Currie runs nine single-strategy hedge funds, but Hogbin says that the firm does not plan to launch a retail absolute return product in the near term.
Developments in America, where Vanguard launched its 500 Index fund in 1976, also point to a shift towards absolute return investing. Bradley Kay, a Chicago-based ETF analyst at Morningstar, says active managers are increasingly seeking to maximise the flexibility of their products.
“Managers want to be able to move to cash, or go overseas if they see better opportunities,” says Kay. “They are saying, ‘I will take better care of your money than the market’. The number of absolute return funds is still relatively small [in America] but they are gaining a higher profile.”
Kay is less convinced that other active products that use shorting, such as 130/30 funds, will see much retail demand. The portfolios, which fund additional long exposure from the proceeds of short selling, offer managers the freedom to implement high- conviction long and short ideas. Providers claimed that such products offered investors the best of the hedge fund and mainstream fund worlds, prompting Merrill Lynch in March, 2007 to publish a research paper entitled “130/30 portfolios – here comes the wave”. Firms responded to the call with a flurry of launches.
The burst of new issuance has since petered out in America. “Not many managers can run this type of product, so this has limited their growth,” says Kay. “We have also seen very mixed results – some managers have been very good while others have made a hash of it.”
Launches have also become few and far between in Britain, but Ramyar is more upbeat on the long-term future of the sector. “All products have to go through the test of time,” he says.
“Conversations around absolute return and 130/30 funds in five years’ time will be interesting – I don’t see them going away.”
Active managers seeking to maintain market share in the face of a growing passive industry may also face pressure to modify the charging structures on their existing long-only products. Performance fees, designed to encourage managers to beat their benchmarks, are commonplace on hedge funds and retail absolute return funds – BlackRock’s £1.6 billion UK Absolute Alpha unit trust charges a fee for returns above the three-month London interbank offered rate (Libor), for example. If used in conjunction with lower AMCs, such fees may convince investors that actively managed products represent good value compared to index funds.
Some retail groups, such as JO Hambro Capital Management, already use this structure across their long-only funds, but the approach has yet to catch on. This, however, may be about to change, according to research from Skandia Investment Group. According to a survey of more than 60 companies running a combined $7 trillion in assets, two-thirds of fund firms expect performance fees to become more prevalent on equity, fixed income and property funds this year. About three-quarters of respondents forecast that fees for active asset management will fall.
The launch of GLG Partners’ UK Select Equity Oeic may prompt other managers to re-assess their fee structures.
The fund, which was unveiled in August, charges 20% on returns above the FTSE All-Share index, in combination with an AMC of just 1%, 25 basis points below other British equity portfolios with a performance fee. Richard Phillips, the firm’s joint head of UK retail, said the charging structure is “a welcome change in a market in which there is a surfeit of middling funds.” The move was also praised by some industry figures, including David Ferguson, the chief executive of Nucleus, an IFA-owned platform.
“It is well known and reported that costs play a huge part in the overall performance of a fund, and while asset managers are prepared to offer all sorts of discounts behind closed doors, in public they have tended to strongly defend their traditional, and high, charging structure,” said a statement from Ferguson. “Vanguard and GLG have reignited the debate around funds and the fees they charge at a time when costs and transparency are high up the industry agenda. Their actions could help force the asset management industry to finally bring itself more in line with the interests of those whose money it so actively covets.”
However, others are more sceptical on how much pressure passive funds will put on active fund managers. Lipper’s Ramyar and Jason Britton, chief investment officer and a fund of funds manager at T Bailey, say that most retail investors do not sufficiently understand the issues surrounding fees. “Despite fees being the most important variable that is always clear, the average Joe does not know how they relate to long-term wealth,” says Ramyar. Britton, who has increased his exposure to ETFs in recent months, adds: “In the modern world, investors do not have the time to monitor holdings closely and move funds – there is no pressure on charges.”
Nevertheless, a gradual shift towards lower TERs appears likely if European fund markets are set to follow trends established in America. A report published this month by Lipper Fund Market Information, titled “Fund expenses: a transatlantic study”, shows that the cost of investing in actively managed products is significantly higher for British fund-buyers. British-domiciled equity portfolios command an average TER of 1.66%, compared with 1.32% in America. For bond funds, the American simple average TER is 0.83%, almost 40 basis points lower than in Britain.
The financial crisis is focusing consumers’ attention on seeking value for money in all areas of their lives, from minimising their shopping bills to holidaying at home. Fees associated with financial products are also coming under greater scrutiny. Coupled with the arrival of lower-cost passive funds, underperforming actively-managed products are likely to feel the pressure as cost-conscious, predominantly sophisticated investors increasingly switch their core allocations into index trackers and ETFs. A degree of consolidation among actively managed funds operating in efficient markets appears likely.
However, a range of opportunities exist for active managers able to adapt to this new scenario. Long-only funds investing in inefficient indices and niche sectors such as environmental companies are likely to remain popular, while managers with hedge fund and shorting capabilities are meeting investors’ rising demand for absolute returns.
Brave long-only managers investing in liquid markets may also be able to compete head-on with trackers if they forgo a proportion of their fixed annual charges in favour of variable performance fees. GLG has set the bar at 1% for British equity exposure. In the game of fund management limbo, does anyone dare go lower?