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Posted on 19 Jul 2016 by Steve Johnson

Fuzzy Future for Fundies

Fuzzy Future for Fundies

 

I have been questioning the sustainability of the asset management gravy train for the best part of two decades. Fred Schwed was lamenting the lack of satisfactory outcomes for clients way back in 1940 when he wrote Where are the Customers’ Yachts?: or a Good Hard Look at Wall Street (the book is full of wonderful quotes but the title sums up the main argument perfectly).

A brief look at the BRW Rich List or the largest and most profitable Australian companies suggests not much has changed. The big four banks all have wonderfully profitable asset management businesses. Macquarie Group‘s highly successful transition from traditional investment bank to asset manager has been the main driver of its share price appreciation in recent years. And a pure-play fund manager, Magellan Financial Group, has been one of the best performing stocks on the ASX over the past five years.

You could argue, therefore, that it would be a brave man or woman to suggest that the wonderful economics of the industry are about to change. I am going to suggest exactly that, however. It is already changing, but it is going to change a lot more over the next decade.

Three forces at play suggest to me that we are at a tipping point where the competitive nature of the industry changes dramatically.

First is that expected returns on all asset classes are dramatically lower than they have been in the past. Whether it be residential property, government bonds, shares or cash in the bank, exceptionally low interest rates have driven asset prices to levels where implied future returns are very low. From today’s prices, an overall return of 3 to 5 per cent on a balanced portfolio is about the best investors can hope for.

This may not yet be apparent to most investors, but it will become so over the next few years. As expectations change, the impediment of fees is going to take on increasing significance. The average balanced super fund has returned about 8 per cent over the past 20 years. Paying up to 2 per cent of that return in management, platform and advice has a huge impact on final retirement balances, but the end result has still been palatable for most investors.

Focus on fees in low-rate environment

If future returns are closer to 4 per cent than 8 per cent, however, losing half of that return in frictional costs is going to become completely unpalatable. In a world of exceptionally low interest rates, fees are finally going to get the investor attention they deserve.

Secondly, low cost alternatives have proliferated. Index funds, where the provider simply tries to mimic the return on an underlying index and fees on the vanilla options can be less than 0.1 per cent a year, have become widely available. New entrants into the asset management game, with lower cost direct distribution models are offering active management for less than 0.5 per cent a year. In the old days, distribution was so tightly controlled among a few large players that it was impossible for these new players to get any traction.

Finally, and related to the previous point, the ability for investors to bypass gatekeepers and make their own investing decisions has completely changed the landscape. Full administration services for self-managed super funds are now available for less than $1000 per annum. Computers are able to provide simple financial plans – which is all most investors need – for a few hundred dollars. And boutique fund managers are able to communicate directly with potential and existing clients thanks to the internet.

We remain a drop in the ocean, but Forager’s funds management business has grown from nothing to $210 million of funds under management without being accessible via a platform or sold through financial planners. Before the rise of the internet, there was no way our more than 1700 clients would have found us without paying someone a fee.

Given a percentage of the management fee was often kicked back to the financial planner, there was little incentive to apply fee pressure to the fund manager. For investors coming direct, fees are of the utmost importance (that I can tell you from experience).

These forces are combining to place enormous pressure on the industry globally.

According to a recent article in the Financial Times, stockmarket exchange traded funds attracted nearly $US200 billion of net inflows in the past year, while actively managed equity funds lost $US124 billion. Hedge funds – which make the typical retail investment fund look cheap – saw $US15 billion of net outflows in the March quarter of this year, the worst since 2009, according to Bloomberg. Stories abound of active managers cutting their fees dramatically to attract inflows.

Australia likely to follow suit

So far Australia’s highly paid fund managers have escaped relatively unscathed. This could be because interest rates have been relatively high here, property prices have kept rising and attractive, low cost product is not yet as available here as it is overseas. The past 12 months have highlighted how useless the All Ordinaries Index is as a low risk way to access the sharemarket. Its absurdly high weighting to banks and resources companies meant that it underperformed an equal weighted index by some 7 per cent during the past financial year.

There is nothing there that is permanent though. Interest rates are already catching up with the rest of the world and better quality index products are already available to investors.

Whether it is possible to outperform the market with $40 billion of funds under management is a debatable question, but with an excellent track record, strong brand awareness and well-known star investors, the likes of Magellan are unlikely to suffer in the short term. But how does AMP justify its fees in a world where investors have a choice?

This article first appeared in the Australian Financial Review.

Fuzzy Future for Fundies
Fuzzy Future for Fundies  Fuzzy Future for Fundies  Fuzzy Future for Fundies  Fuzzy Future for Fundies

19 thoughts on “Fuzzy Future for Fundies

  1. steve, a reflective and critical stance with presence to 1,700 Forager unit holders is exactly why we have >20% portfolio as Forager Investments, being equally divided between Aust and Int Share Funds

  2. The way it is supposed to work is that asset managers get paid a fee for delivering risk-adjusted outperformance to clients, and brokers get paid by asset managers for helping deliver that outperformance. In practice, the FM industry (in the aggregate) has been charging investors for delivering underperformance, and brokers have been paid by FMs for helping deliver that underperformance. In essence, the industry has gotten away with ‘selling beta’ but ‘charging for alpha’. This giant fee factory has not justified its existence for a long time, and it is high time something changed.

    Not only have higher past market returns masked fees to an extent that will be difficult moving forward, but the problem seems to be that the active management industry has simply grown too large, making the quest to generate outperformance self-defeating. Everybody can’t outperform. In the early days of hedge funds (the Soros/Rodgers era), hedge funds were expected to consistently deliver 20-30% returns impervious to the market to justify their 2/20 fees, exploiting major market inefficiencies that then existed, including the slow transmission of information. Now 2/20 gets charged for single digit returns. A frog in boiling water is called to mine.

    The gravy train also seems to have been perpetuated in recent years by desperation for returns. Money has flowed into private equity, hedge funds, and other ‘alternative’ asset managers in the post-GFC era to escape the oppression of zero interest rates. However, returns on these exotic funds have regressed to the mean pretty hard as their size has grown, and after a woeful year in 2015, investors are losing faith (correctly) in the ability of these alternative asset classes to deliver better returns. The reckoning could be pretty severe.

    That being said, passive investing only works if markets a reasonably efficient, and markets are only reasonably efficient if you have lots of highly-paid analysts scouring the market for bargains. Indexing then becomes something of a free lunch. You get to buy a basket of reasonably efficiently priced assets without doing (or paying for) any analytical work. If the world become mostly passive, markets could well become extremely inefficient.

    I’ve already seen examples of stocks being dropped from key indices dropping by 20%+, for instance, and passive is still in its early days of market share growth. You could also see very wide valuation differentials between index and non-index stocks; ETF flows driving momentum flows into popular and unpopular markets, driving the former to extreme levels of overvaluation and the stock level and the latter to extreme levels of undervaluation, and tight valuation clustering within indexes, without sufficient quality differentials being reflected in price. This should provide ample opportunity for skilled and diligent value-based fund managers to widely outperform.

    There seems to be room for a stable equilibrium where there are a smaller group of fund managers that deliver material risk-adjusted outperformance which more than justifies their fees. However, this stable equilibrium is at a level far smaller than the current bloated size of the global funds management industry. The pendulum has a lot further to swing yet.

    The market for financial services has always been far from ‘efficient’, however. Marketing and distribution networks will remain important for many years. But the tide is definitely turning. This will be good for fund investors, and also be more meritocratic for fund managers as well – fund flows will be more linked to performance moving forward than marketing muscle.

  3. What a great article, and really helpful insights, Steve.
    From the perspective of a potential ‘fund’ investor I make my comments. Unfortunately I don’t have any spare or lazy funds available currently, and we find we can do better in our own businesses (and that includes superannuation which we generally minimise due to distrust of govt which I know makes me a bit of a dinosaur). However the day will come when I wish to diversify and have some safe place to place excess funds, or the interest in own businesses wanes.
    I would be looking to the likes of Forager to provide guidance and such a safe place because it adopts a value investing approach (which to me focuses on any investment being a good business in the first place, as well as buying at the right price).
    The obvious thing to say in response to your article is that it means you need to get out there and market your services and approach. There seem to be a lot of fund managers living on easy street and that makes them potential targets for their funds. You mentioned an obvious giant (AMP) but there are lots of copycats it would seem.
    If I were you Steve I would suggest you need to plan for a doubling of the money you invest, say from $200m now to $500m by the end of 2018 with the aim to hit $1 billion by end of 2020. And importantly let the market know of your goals. Part ‘tongue in cheek’, but you catch the drift.
    Magellan and Platinum (not Macquarie I suggest for lots of reasons with one being their reputation as being a millionaires producing factory – obviously at someone’s cost, and their involvement in the Dick Smith float say a lot to me of their modus operandi) set the standard for funds management. Apart from size I put Forager in the same category of a fund that can be trusted and get good returns. So I would suggest you market yourselves accordingly.
    I just look at how Guvera and AMMA were able to (it would seem) extract considerable funds from lots of small superannnuation funds via accountants, as a pointer to a possible source of funds for Forager.

  4. Nice Steve,
    As someone who is often ahead of the curve, will you be future-proofing your own business and lowering fees for us – your dear investors…? 🙂

  5. 1% pa plus 10% of performance over 8% already looks good when compared to your typical boutique of 1.25% pa and 20% of performance over an index.

  6. Steve

    Brave of you to address this issue the way you have i.e. a balanced critique rather than fee justification, which you could easily have done on the basis of peer performance alone. The Australian Fund’s recent success speaks for itself. Am I frustrated the International Fund has not performed better recently – totally. Would I have been better off with Perpetual (Global Shares), Colonial First State (First Choice Global Shares) or the much lauded Platinum International Fund – nop!

    You’re right, fees are important but not the last word on my investment decision. For me the Forager value add includes:

    – Skills set: commentary and performance together confirm this key attribute.
    – Flexible: broad mandate allows flexibility in unpredictable economic and business climate.
    – Agile: easier to park millions (optimally) than billions.
    – Co-investment: You’ve got skin in the game, same as us. Correct me if I’m wrong?
    – Attitude: honesty, integrity, transparency: good and bad. No superiority complex’s getting in the way.
    – Respect: you treat your investors as if they are intelligent. It would be dangerous to do otherwise given the competitive forces you described.
    – Access: you (and your team) talk to us directly via these posts, etc. That’s good. How about a capital city roadshow?
    – Costs: competitive. And no finders fees, which are not in my interest as an investor.

    Keep these things in order and organic growth should continue to serve you well.

    Thanks, Ron

  7. Emphatically agree with your first point, it is going to have more effect on fundie remuneration in the medium term than every other reason combined (both mentioned by you and unmentioned).

    One other point that you didn’t mention is demography. The lion’s share of wealth in Australia and every other Western economy is owned by Baby Boomers. Until recently, the Boomers have been too busy working and making money to care much about the camouflaged fees that financial intermediaries routinely help themselves to. They were supported by their employment income, and scrutinising the fees on their savings generally weren’t at the top of their priorities.

    Now, they are retired, retiring, or thinking about retirement, which means that they need to fund their lifestyles out of their savings, and they’ve got plenty of time to shop around for a better deal. Add to this the fact that once a Boomer retires, his/her savings will become a wasting asset, so collectively, the amount of superannuation in the system is going to start steadily contracting in a few years’ time.

    However, the funds management industry will remain bloated, and it will continue to take a disproportionately large slice of this country’s economic output for the same reason that people pay hundreds of dollars for an oil and filter change in their cars. There is a fear of the unknown. And there is a fear of f*cking up.

    As an ex fundie myself, I am often asked for advice on what I think of one group of overpaid charlatans vs another. They think that I’m being facetious when I tell them that they’d be better off using a dartboard, blindfold, and ticker page from the AFR for stock selection than paying those clowns. Incidentally, Forager is one of the names of the low-charlatanism money managers that I refer them to.

  8. John Bogle highlighted the mathematics in his important book Common Sense on Mutual Funds: “Earlier, I noted that during the 16-year bull market through June 1998, the average equity mutual fund provided a return of 16.5 percent versus 18.9 percent for the total stock market. This shortfall of 2.4 percentage points per year – engendered importantly by annual costs of about 2 percent – may not look excessive when subtracted from a market providing an annualized return of nearly 20 percent. But, over time, it would consume fully one-fourth of a 10 percent return, to say nothing of confiscating one-half of a 5 percent return.”

  9. Most people don’t know what an Index Fund or ETF is. For example, our share portfolio is about $3M but my wife has no idea what it is. I’ve tried to explain this to her many times but she has no interest. She’s probably more interested in watching something like The Batchelor.

    Financial Planners / Advisers play an important role to assist clients who have no idea about asset allocation, portfolio manager blending, risk profiling etc. They also assist with the ongoing monitoring of the Fundie and funds chosen. Whilst one can argue they charge a lot (usually 1% x FUM including kick-backs up to a flat fee), most Financial Planners don’t earn a lot of money after business expense. All fundies earn a lot of money – usually over $1M per year. However, the Financial Planners often cop the flack when things go wrong (since they are in the front line) and Fundies often get away unscathed.

    That said, I believe uneducated investors deserve the returns they get.

    • Aside from being a money geek and a chess geek, I’m also a history geek, and I can’t help but notice the parallels between the cushy deal that financially literate people have in today’s world and the cushy deal that scribes had in the ancient world.

      I’m sure that back then, there were plenty of people bemoaning the fact that people who could read and write didn’t have to risk their necks in battle, didn’t have to do any sort of physical work, and generally lived much longer, more prosperous lives than their illiterate counterparts.

      Yet I’m sure that people didn’t or couldn’t learn to read and write back then, for the same sort of reasons that people don’t learn basic financial skills today.

  10. Steve

    I have often pondered the difference in fees between real estate agents managing rental properties and fund managers.

    Fund manager:
    Average fee = say 1.5% of FUM
    Average income yield of FUM = say 4% of FUM
    Thus average fee as a % of income from FUM = 35%

    Real estate agent: typically say 8 % of rental income

    Arguably the real estate manager is a more costly business as it actually involves the management of real people and issues on an individual basis in disparate locations – very time consuming.

    If I was a fund manager I would be setting my long term business plan on an > 60% decline in revenue from current levels.

    A good indication of a sustainable level of fees being reached is when I see fund managers working from fringe city or suburban locations … I don’t need to go into the CBD to see my rental property manager.

    • Interesting way of thinking about it, Rob. I agree with your general conclusion, though I’ve been perplexed by the lack of downward pressure on fees in general in the industry.

      I’ve never owned an investment property but my understanding is that the agent’s role is to manage the income only, they don’t make decisions in relation to capital (buy/sell or renovations/extensions). Is there an analogy for a situation where, say, Forager might advocate strategically on behalf of clients in a takeover situation?

      With the sharemarket’s long-term returns split roughly 50/50 between income and capital, an equity fund manager has a greater impact on your overall returns.

      A lot of effort and skill goes in to managing the portfolio in Forager’s office and my experience of renting properties is that relatively junior agents are empowered to manage many dozens of properties each (and the service level is variable). I’ve never spent significant time inside other funds businesses, so can’t speak for them but it seems another difference worth considering.

      I’m not trying to justify the funds management’s industry’s fee levels, just trying to tease out the issues in your analogy to see how far it might extend.

    • Rob,

      Not an apples-for-apples comparison in my view.

      A property manager is managing the day-to-day administration/affairs of a property only, and not the capital allocation/investment decisions. The latter requires a lot of additional time and effort, and also more specialist expertise (to be done well).

      A better analogy still would be the fees charged by fund administrators to fund managers, to handle fund flows, statements to holders, etc. They are typically only 10-20bp at most, to my knowledge (depending on fund size).

      The fees charged by the fund manager itself should be compared to the funds charged to manage an actively property investment fund/private equity fund etc. I think you’ll find they are much higher.

  11. It’s a good point you raise Rob, although expressed a bit unfairly with your example of only a 4% return given Foragers recent performances on the Australian shares.
    I suggest thinking just in terms of global % returns are missing the point as many businesses earn much greater than that – the clue is to find, analyse and invest in them (and surely that is one of the selling points with a good find).
    I’ve just done a few quick calc’s based on $1million invested with Forager at various return %’s (1,7,14,21,28) and if the return is greater than 8% on the funds invested than the return to Forager on the income made hovers around the 11% to 12% range (which is considerably less than the 35% you have calculated) which isn’t bad given that all the risk is carried by the
    owner of the funds and not the fund manager.
    I think a similar comparison needs to be done, and perhaps publicised a little more widely, to see what the return is for other fund managers.
    The other aspect of the comparison with the real estate property manager is that the potential for a greater return with a funds manager is there (along with the risk obviously of reducing the capital funds themselves as well as very low to negative returns).
    But your point is helpful to keep perspective.

  12. Pingback: Active Fees for Passive Returns – How Did it Come to This? - Forager Funds

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