While there is still major debate about the pros and cons of active and passive fund management, there can be no dispute that local active fund managers charge a lot more than index funds. This begs the question, where does all that money go?
According to the most recent Morningstar fund-manager study, the average retail fee (excluding advice) for a multi-asset fund was 1.63%. Indexing-based equivalents generally cost half or less.
This makes sense as active management is a more expensive process. It requires expert fund managers backed by research analysts. The research process is not cheap, involving frequent travel and access to market data.
The thinking is that the combined intellect and efforts of these highly qualified, well paid individuals must surely improve the investor return.
In comparison, running an index fund is a low cost, mechanical process, according to Tracy Jensen, chief operating officer of 10X Investments. The intellectual and financial capital is invested in design rather than execution of strategy.
“With proper systems, the daily processes can be handled by a small team, irrespective of the size of the cash flows,” she noted. She also explained that while active managers have higher fixed costs, once these businesses achieve critical mass, most of the incremental revenue drops to the bottom line.
“If assets keep growing, these businesses become extremely lucrative.” said Jensen
“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 until returns normalise.”
Jensen goes on to say that asset managers don’t have a “moat” or competitive advantage to defend margins.
“None can beat the market on a reliable basis nor do they have monopoly power – this space is heavily overtraded.”
Yet, according to Jensen, there is no attempt to compete on price, or share the scale benefits with investors – certainly not as far as retail clients are concerned.
Jensen explains that 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.
As a result, index funds achieve a fairer balance by charging much lower fees.
Jensen believes that this“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’.
“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,” she said.
Jensen attributes this behaviour to the investor’s expectation that brokers act in their best interest.
“Or they see past returns as a guide to future results,” she noted.
“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,” said Jensen.