The active management industry will have to shrink significantly if it is to successfully compete with index-tracking products, according to a report by Moody’s. 
Index-tracking products have been gathering momentum over recent years, thanks to a number of factors including much lower fees than active funds, greater transparency and regulatory drivers such as the retail distribution review pushing advisers to look at all the investment options for their clients.
Figures from the Investment Association show there were £111.2bn in tracker funds at the end of May 2016, accounting for 10.8 per cent of total industry funds under management. This is up from funds under management of £40.5bn, or 6.7 per cent of the industry, five years ago.
Of course, these figures do not take into account exchange-traded funds – meaning the actual share of UK investor monies in passive products will be higher than these open-ended only figures.
In the US, passive investing is more commonplace. According to Moody’s Investors Services, there have been consistent net outflows from traditional actively managed mutual funds into passive investments since 2007.
Cumulative inflows into US index funds vs outflows from US actively managed funds
Source: Moody’s Investors Services
Around one-third of the US fund market is now in passive products and this is expected to grow further, especially if more expensive active funds disappoint their investors.
“According to numerous studies, traditional active management has consistently underperformed in all varieties of market conditions,” the ratings agency said.
“In a recent study, underperformance for the approximately two-thirds of all US active managers who miss their benchmarks over the past 36 years was estimated at -530 basis points per annum, net of fees. In the present low-yield environment, the high fees of actively managed funds are also more noticeable and impactful to investors.”
These points concern the US market, which – given its relative efficiency – is seen as a difficult environment for active managers to outperform in.
However, it would be a mistake to think that active funds are guaranteed to outperform in the UK market. FE Analytics shows that the average IA UK All Companies fund has made a 74.20 per cent total return over the past 10 years, meaning it has underperformed the FTSE All Share by a narrow margin.
Performance of sector vs index over 10yrs
Source: FE Analytics
What’s more, 56 per cent of the funds in the peer group have made a lower return than the index over the past decade. While the highest return achieved was 247.93 per cent (by Liontrust Special Situations), the lowest was an 18.86 per cent loss (by Aviva Investors UK Equity MoM 2).
Moody’s added: “Looking ahead, absolute fund performance will be a more important consideration than a fund’s performance relative to its peers, given that the majority of active funds underperform the indices.”
However, the group also suggests that traditional asset management houses may need to adjust their business models in light of the above. In order to address the shift from active to passive, some firms have moved into the ETF and smart beta industries; BlackRock and Invesco are examples where successful active and passive businesses are run under the same roof.
But the strategy of growing by buying up other active managers – which has been commonplace in both the US and the UK – is unlikely to prove helpful in adapting to the challenges thrown up by a growing passive industry.
“Although there may be cost synergies, in most cases this type of M&A is not a long-term solution since it does not reduce the amount of capital managed by active managers, so overcapacity continues to hamper performance. A handful of managers, such as AllianceBernstein, have acknowledged that overcapacity is an issue the industry will have to address. Over time, active management will likely have to shrink substantially,” Moody’s said.
“Outside of the academic logic for active underperformance, among the main practical causes of underperformance is the sector’s overcapacity. There are more than 9,520 mutual funds, and 10,000 hedge funds, compared to 3,691 stocks in the Wilshire 5000 – and 505 stocks in the more liquid S&P 500. For comparison, in 1962 there were 338 registered mutual funds, shortly after the S&P Index expanded to its current number of approximately 500 stocks.”
“Overcapacity leads to investment mediocrity, since true talent is limited and size works against the investor in the form of increased transaction costs and difficulty in identifying scalable investment opportunities. An investment truism, ‘Size is the enemy of returns’ still holds. Finally, as returns become ‘average’, which they must, the end result to the investor is significantly below average after the effects of higher fees and trading costs.”
While the ratings agency believes that passive investing has further market share to take, it does concede that active management will survive.
“Cursory logic would dictate that the market cannot have only passive investors – active investors will always be a necessary component for efficient price discovery,” it said. “But the current one-third level of passive investments and two-thirds of active is not necessarily near an equilibrium point and we expect the passive share to expand well above current levels.”
The UK, of course, is some years behind the US when it comes to the shift to passive but the existence of around 3,500 open-ended funds in a market much smaller than the US’ suggests overcapacity is an issue here as well.
But there may not be too much lamentation over the most obvious victims of this trend. Moody’s singles out ‘closet trackers’ – or funds that only produce index-like returns but at a higher cost - as being the products “at most risk of extinction” – a development that would be welcomed by all aside from those running these products.
