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There’s no dispute that local active fund managers charge more than index funds. According to the most recent Morningstar study (1) , the average retail fee (excluding advice) for a multi-asset fund was 1,63%. Indexing-based equivalents cost half or less.
Intuitively, the premium pricing makes sense: active management is simply a more expensive process. It requires one or more expert fund managers to make ongoing investment decisions. They are usually backed by a large team of research analysts. These all tend to be highly qualified and highly paid individuals whose combined intellect must surely improve the investor return.
The research process is also not cheap. It involves frequent travel and access to market data (a single Bloomberg terminal costs upward of $30,000 pa). Also, large teams need large offices, preferably of the lavish kind and at an expensive address.
By contrast, running an index fund is a low cost, mechanical process. The intellectual and financial capital is invested in the design rather than the execution of the strategy. With proper systems, the daily processes can be handled by a small team, irrespective of the size of the cash flows.
So yes, active managers have higher fixed costs. But once these businesses achieve critical mass, most of the incremental revenue drops to the bottom line. If assets keep growing, these businesses become insanely lucrative, so much so that fund management has been called “the most profitable business in history”. Operating profit margins are typically three to four times higher than elsewhere.
But economic theory dictates that in a free market “super-profits” don’t last. If the marginal revenue is essentially just profit, the incumbents will compete on price for this revenue, until returns normalise.
There are a few exceptions to this basic principle. A business may have a competitive advantage – a desirable brand such as Apple, for example – that sustain premium prices. Or it operates as a monopoly, without obvious competitors (think Eskom). Or it is a member of a cartel that colludes to keep prices artificially high.
But asset managers don’t have a “moat” or competitive advantage to defend their margins. None has the skill to beat the market on a reliable basis. None can guarantee their future performance. Nor do they have monopoly power – this space is heavily overtraded, with dozens of local managers and hundreds of international players all wanting your money.
Despite this battle for market share, there is no attempt to compete on price, or to share the scale benefits with investors, certainly not as far as retail clients are concerned (large institutional clients do have some bargaining power).
For local evidence of this ‘non-aggression pact’, have a look at Figure 1. It shows the growth in Coronation’s assets under management (AuM) and the progression of its fee income as a percentage of those assets. Since 2003, AuM have grown more than ten-fold, from R54bn to almost R600bn. But the published net fees as a percentage of those assets has remained quite steady, range-bound between 0,52% and 0,79%.
Despite Coronation’s fantastic asset and revenue growth, the staff complement has barely doubled since 2003. This underlines the enormous productivity gains this business model can achieve. Normally, it would lead to soaring operating margins, but at Coronation it has stayed fairly constant, between 45% and 55%.
That’s because compensation at the company has skyrocketed. This will make your eyes (or your mouth) water: the average Coronation employee earned almost R4m in 2016, ten times more than in 2003. So the scale benefits have handsomely rewarded staff and the company’s shareholders, who have seen their annual dividends increase 12-fold over this period.
This is not to single out Coronation’s largesse; it’s just that their numbers are readily available.
The industry’s sense of entitlement spans the globe. In the UK, it has drawn the ire of the Financial Conduct Authority (FCA). Their recent report on the UK asset management industry was highly critical of the fact that fee percentages had stayed broadly the same for the past 10 years. It noted strong evidence of “price clustering”, and a general reluctance to lower charges, to protect profits. It reported the industry’s operating margins at 36%.
Who’s really to blame?
Active management costs more than indexing not because the process is more expensive but because the scale benefits have been retained almost entirely by owners and employees. Index funds achieve a fairer balance by charging much lower fees.
The far more important question: why is there no price competition among active managers? Why is this business not subject to the same “invisible hand” that guides other industries in a free-market economy? Normally, this ensures that services are offered at the functionally lowest prices possible, to prevent price-gouging.
The “price clustering” evident in the industry suggests that the industry effectively operates as a cartel, obscuring its tacit price fixing with poor disclosure, the ‘complexities of the craft’ and prospects of the mythological ‘alpha’. Except that, unlike the Freemasons of old, the people who run this industry don’t need to resort to clandestine Lodge meetings to further their joint interests.
But the real culprits are the investors themselves. Many are price sensitive in all areas of their life except here. This is deeply ironic because these investment services are one of the single biggest purchases they are likely to make. Notwithstanding, they willingly pay twice the price for actively managed funds, even though these have no reasonable prospect of delivering a superior return over the low-cost alternatives.
They fall for this because they expect brokers to act in their best interest. Or they see past returns as a guide to future results. Others are taken in by the marketing hype around smart fund managers, the unspoken promise of an above-average return, their prescience about impending bear markets. Or they are swayed by the subtle messaging that you get what you pay for.
All these myths have been exposed by academic studies and by the financial media. That is why informed investors turn their back on active managers and choose low-cost indexing. In the US, they do so in large numbers, but in South Africa the majority remain blind to the evidence and pay up for active management. The high industry charges are the price they pay for their ignorance.
(1) Morningstar ‘Global Fund Investor Experience 2015’