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Rekenthaler Report

The Great Investment Industry Roll-Up

Gradually, its inefficiencies are being competed away.

Wasted Efforts
The U.S. investment business resembles the video-rental marketplace during Blockbuster’s early days. It is scattered, diffuse, inefficient--but with the hint of something better on the horizon.  

Rather than pool their resources, thousands of institutional pension funds and endowments operate separately, each paying for their investment decisions. Half a million companies offer 401(k) plans, each different from the next (or at least, obtained through a separate negotiation). Tens of thousands of financial advisors select investments for their clients, choosing from myriad money managers. 

In a sense, such variety is admirable. Industry professionals may freely innovate. Although fiduciary regulations do prevent some approaches, there nevertheless are abundant ways for pension funds, 401(k) sponsors, financial advisors, and money managers to express their individualities by choosing routes that differ significantly from their competitors’. They are not judged against a gold standard. 

Mostly, though, that diversity is cumbersome. Too many people work on the same problems, and--opportunities for creativity notwithstanding--arrive at the same answers. Such replication is unproductive. Agriculture wasn’t more efficient when it consisted of family farms. Yields rose when those farms combined to become agribusinesses. Similarly, Blockbuster made renting videos easier. Its stores were blander than what they replaced, but cleaner and usually cheaper.  

In short, the U.S. investment business needs a roll-up. That process has already begun. Following is a brief synopsis, starting with the segment that has advanced the furthest and concluding with that which has moved the least. 

Financial Advisors
For several decades now, the leading financial advisors have redefined their practices. Once, they selected stocks; then they found mutual funds; then they built portfolios. Now, increasingly, they leave even much of the portfolio construction to others, borrowing from outside models. Along the way, they have adopted broader views of their roles, serving as overall guides for their clients. 

Those changes make sense. One needn’t be a financial advisor to evaluate investments or even in most cases to create portfolios. Those tasks can be accomplished just as well (if not better) by somebody who is unburdened by customer demands. But financial counseling tends to be specific, applying to one individual’s situation but not to another’s. The advisor can therefore provide what the general investment researcher cannot. 

Financial advisors have experienced a consolidation of ideas, not of manpower. Many predict the latter, arguing that technology will permit financial advisors to grow their reach, so that the strong will acquire more clients, while the weak will be forced to seek other employment. Perhaps. Or, perhaps, the customer pie will increase, as existing financial advisors reach those whom they now do not serve. 

Money Managers
By some measures, the oft-predicted consolidation of professional investment managers is well underway. The five largest mutual fund/exchange-traded fund providers now control 54% of industry assets, as opposed to 45% a decade ago. Once, both financial advisors and avid direct investors scoured the charts to find “unknown” boutique managers before the crowds arrived. Now, few can be bothered. 

The same increasingly holds true within institutional investing. Earlier this month, the nation’s largest pension fund, CalPERS, slashed its list of active equity-fund managers. The $380 billion behemoth now employs only four such firms, which collectively run a less-than-whopping 1.5% of the CalPERS portfolio. Don’t let your babies become stock fund managers. 

That, however, speaks to the past, not to the present. Because investment management is so profitable and because most mandates gradually wither, as opposed to being forcibly removed, the field has not yet been greatly pruned. The industry’s unwashed masses will continue to lose market share, but most will remain in business for many years to come. 

Pension Funds
This month, Illinois passed legislation to merge 650 police and fire pension funds into two far larger funds. Illinois authorities argued that the local funds had posted annual gains that averaged 200 basis points below those of the statewide Municipal Retirement Fund. Some of that discrepancy owed to the smaller funds’ higher average expenses and some to weaker investment performance. 

Investment performance comes and goes. Just because the 650-fund aggregate trailed the Municipal Retirement Fund in the past doesn’t mean that it would have done so in the future. It’s quite possible that that Municipal Retirement Fund’s superiority owed solely to the good fortune of riding an investment-style tailwind. However, the benefits of lower costs are ongoing. There is no doubt that the two new funds will profit from their lower expense ratios. 

Such economies of scale make further mergers inevitable. This process is further along in several other countries. McKinsey reports, for example, that the number of Dutch institutional funds was more than halved during the decade from 2005 through 2015. McKinsey foresees “limits” to the amalgamation trend--but those limits lie far past where U.S. pension funds are today.  

401(k) Plans
Defined-contribution plans are the most obvious candidates for consolidation but also the furthest away. 

The “obvious” part requires little explanation. Current regulations require that each employer establish its own 401(k) plan, although few companies evaluate investments for a living. Few employers wish for such responsibility (as well as the accompanying cost); they would rather piggyback onto another firm’s plan. Better yet would be to have no 401(k) at all.  

The result: Almost 40 million working Americans lack access to a defined-contribution plan. Many others are in expensive plans, not because 401(k) providers reap large profits by overcharging small companies, but instead because of the current system’s inefficiencies. (The television host John Oliver publicly lamented the 401(k) industry’s pricing for startups, about which he was largely correct, but he erred by blaming cupidity rather than structural stupidity.) 

The problem can easily be addressed. Morningstar has advocated incremental improvements that rely on existing proposals. Others would scrap 401(k) plans altogether, replacing today’s system with an entirely new scheme. Such ideas are not federal overkill. Quite the reverse; today’s plans are regulated by a messy IRS tax provision. Altering them would reduce government intrusion, not increase it. They would also require Washington bipartisanship, so they don’t look to be arriving anytime soon.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.