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Balance of Power Tilts Away From Asset Managers

Fees and performance will loom large over industry.

Laura Pavlenko Lutton and Greggory Warren, CFA, 06/06/2017

The past decade has been a disruptive one for asset managers and their fundholder clients. Investors have not only been put off by the poor performance of actively managed funds, but they have also increasingly sought out lower-cost options, with passively managed index-based products becoming the default choice for many. The rollout of the U.S. Department of Labor’s fiduciary rule has only heightened the scrutiny that active asset managers will face as they look to secure access to retail-advised platforms. Funds with poor performance track records, high expense ratios, or low inclusion rates on platforms are less likely to make the cut with gatekeepers of the broker/dealer and advisory platforms longer term.

The shift in the balance of power from fund manufacturers to distributors is also leading to greater fee and margin compression. Active asset managers will need to narrow the spread between the management fees charged for their funds and the fees being charged by index-based products. They also need to improve active investment performance and enhance distribution to remain competitive. Industry consolidation is inevitable as asset managers pursue increased scale to help offset lower fees and profitability. We expect to see fund companies consolidate their funds internally, to increase scale and eliminate underperforming offerings, and externally, with midsize to large asset managers pursuing deals that increase scale and product breadth.

We expect passive fund managers—such as Vanguard and iShares, which are the two largest providers of exchange-traded funds—to continue to garner much of the attention in the next decade. There’s plenty of room, however, for active asset managers such as American Funds and T. Rowe Price TROW that have scale, established brands, solid long-term performance, and reasonable fees. To be especially successful in the coming decade, though, we believe that asset managers will be best served by differentiating themselves from the competition, offering low-cost funds with repeatable investment strategies, and prudently adapting to the changing competitive landscape.

Fees and Performance Under Scrutiny
For many years, the balance of power in the retail channel for the U.S.-based asset managers has been shifting to the distributors of mutual fund products—the broker/dealers and advisors that drive many fund sales—without significantly having an impact on management fees. While the 2008–09 financial crisis sparked consolidation among many of the broker/dealer and advisory networks selling funds to retail investors, the shift primarily limited the amount of leverage traditional asset managers had when negotiating payments for shelf space as opposed to lowering management fees. Asset managers have kept management fees fairly stable; however, funds with large asset bases that allow asset managers to spread their costs more efficiently have achieved reduced expense ratios through scale benefits.

The institutional channel has long faced more scrutiny. Consultants, which act as gatekeepers for clients, put fees and performance under the microscope, forcing active managers to clearly articulate their investment philosophy and process, as well as provide relevant data analytics related to portfolio construction, risk parameters, attribution analysis, and sources of alpha generation. This analysis helped justify the strategies’ fees. Retail-advised networks have not been as heavily focused on these metrics as most of their compensation has been generated by sales loads and distribution-related fees. With more retail-advised accounts moving to fee-based structures, which favor low-cost offerings with benchmark-like or better performance, brokerage platform gatekeepers have more influence as to which strategies are included in client portfolios. This influence should grow with the introduction of the DOL’s fiduciary rule. It puts fees and performance under a much stronger microscope.

Broker/dealer and advisor platforms are looking to eliminate funds with small balances, especially those that have been underperforming or that carry higher fees. We were not surprised to see outflows tick up dramatically among less-competitive offerings over the past couple of years. Net outflows for actively managed U.S. equity funds exceeded $260 billion during 2016—a far larger amount than the $175 billion in outflows seen in 2015 and the $125 billion in net outflows recorded in 2008. Nonetheless, these funds still account for close to one fourth of the more than $15 trillion in open-end and ETF assets that Morningstar tracks. As U.S. equity funds remain big drivers of fee revenue for active asset managers, the increased fee and performance analysis on the part of retail distribution platforms will put additional pressure on active asset managers’ revenue and profitability.

Active Managers Struggle to Beat Indexes
We expect outflows to continue for actively managed U.S. equity funds, given their poorer performance records and higher fees relative to benchmark indexes, which are readily investable via low-cost index funds and ETFs. Poor investment performance has been a problem for most active equity fund managers during the past decade.

The Morningstar Active/Passive Barometer report, which is published biannually, has found that actively managed funds have underperformed their passive counterparts, especially over long time horizons. They have also experienced high mortality rates—that is, many more funds were merged or closed. In addition, active funds’ failure has tended to be positively correlated with fees, with higher-cost funds more likely to underperform or be shuttered or merged away, and lower-cost funds likelier to survive and enjoy greater odds of success.

Laura Pavlenko Lutton is an editorial director in Morningstar's fund research group. She would love to hear from you, but she can't give portfolio advice.

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