If the investment world were a fashion house, the hot trend among its customers and designers right now would be the active versus passive argument.
The active versus passive debate has been going on for around a decade – since active managers proved during the financial crisis that they were no better than the indexes they were trying to track. Underperformance has continued since the crisis; the cost of passive investing has continued to fall increasing passive investing’s appeal compared to the higher cost and performance lagging active management.
Passive is gaining market share
According to Morningstar Inc. (MORN, Financial), more than one-third of mutual fund and ETF assets are now passively managed, compared to one-fifth five years ago. Passive funds continue to report record inflows, and PwC forecasts that the value of assets under management following passive strategies will hit $22.7 trillion by 2020, up from $7.3 trillion as reported for 2012. As a percentage of overall global assets under management, PwC believes passive mandates will account for 22% of the industry by 2020, up from 11% in 2012.
Active management is expected to retain the lion’s share of investor cash. PwC estimates active mandates will still account for 65% of global assets under management by 2020 down from 79% today. Meanwhile, alternative assets are expected to grow by some 9.3% per year between now and 2020 to reach $13 trillion.
There’s a tremendous structural shift going on in asset management, but it appears many fund managers are failing to acknowledge this change and adapt to the environment. According to figures published in the middle of 2016, since 2007 passive investments have seen over $800 billion of inflows, while active funds have reported outflows of over $700 billion (domestic U.S. equities only).
These inflows have helped push down the cost of beta in the asset management industry thanks to Vanguard’s (the largest player in the space) unique ownership structure whereby fund investors own the company.
As Vanguard’s fees have fallen, so have those of other passive providers that wish to remain competitive with the industry behemoth. Vanguard ETF’s charge 13 bps vs. iShares at 39 bps. In comparison, the average dollar-weighted expense ratio of mutual funds is about 100 bps. The median fee rate for Smart Beta funds has fallen by 25bps since 2012. The standard account fee for a Vanguard Robo account is only 30 bps, 70 bps less than the average mutual fund fee.
Looking at these figures is easy to see why investors are choosing passive funds over expensive, underperforming active managers. Only 16% of large cap managers beat their benchmark through May 2016, versus 34% during 2015.
The changing face of passive management
The asset management industry will undoubtedly change as this trend picks up steam. Morgan Stanley (MS, Financial) estimates that the profit pool for the asset management industry is around $83 billion, but as management fees fall and new competitors enter the market, it looks as if asset managers are going to be left chasing an increasingly small percentage of this profit pie.
Considering all of the above, asset managers now appear a very attractive short in the current market. If you’re not into shorting, the data suggests that asset managers could be a value trap and are not worth buying despite recent declines. One of the most unattractive asset managers is Franklin Resources Inc. (BEN, Financial), which has the highest fees in the space and is losing billions of dollars in assets per quarter as a result.
Franklin’s average fee is 60 bps VS 45 bps to 55 bps for peers and outflows are running at a rate of around 11% per annum. Franklin’s assets under management peaked at $921 billion in the fourth quarter of 2014 and have since declined to $732 billion. At the current rate, the company is losing $80 billion per annum in assets, which makes it tough for the business to grow through acquisitions or mergers.
Waddell & Reed Financial Inc. (WDR, Financial) is facing a similar set of problems. In fact, Waddell’s problems are much more severe than those of Franklin. During the first half of 2016, Waddell reported asset outflows amounting to 31% assets under management, Franklin’s outflows during the first half were only 12% of assets under management. For some reason, the company’s management doesn’t seem to be all that bothered about outflows and continues to press on with Waddell’s high-cost structure. Per Morgan Stanley, the company’s average dollar-weighted expense ratio stands at a staggering 1.4%, 33 bps higher than Franklin which has the second-highest dollar-weighted expense ratio in the industry.
So overall, the asset management industry is facing severe headwinds right now, and it may be best to avoid some companies in the sector altogether as they looked to be value traps.
Disclosure: The author owns no share mentioned within this article.
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