Cape Town – South African investors still favour active fund management even though actively managed funds have no reasonable prospect of delivering superior returns over low-cost alternatives such as passive funds, says Tracy Jensen, chief operating officer of 10X Investments.
“Investors in the US are turning their back on active managers in large numbers and choosing low-cost indexing. However, in South Africa the majority remain blind to the evidence. The high industry charges are the price they pay for their ignorance.”
Jensen says there is a lively debate in the media over the comparison between active and passive fund management.
“There’s no dispute that local active fund managers charge a lot more than index funds. However, where does the money go?”
She cites research done by Morningstar that shows the average retail fee (excluding advice) for a multi-asset fund was 1.63%.
“Indexing-based equivalents generally cost half, or less.”
She says intuitively, premium pricing makes sense, as active management is a more expensive process. It requires expert fund managers backed by research analysts. The research process is not cheap, involving frequent travel and access to market data.
“The thinking is that the combined intellect and efforts of these highly qualified, well paid individuals must surely improve the investor return.”
Why active fund management is more expensive
Running an index fund is a low cost, mechanical process. The intellectual and financial capital is invested in design rather than execution of strategy. “With proper systems, the daily processes can be handled by a small team, irrespective of the size of the cash flows”, says Jensen.
Although active managers have higher fixed costs, once these businesses achieve critical mass most of the incremental revenue drops to the bottom line. “If assets keep growing, these businesses become extremely lucrative,” says Jensen
“Economic theory dictates that in a free market ‘super-profits’ don’t last,” says Jensen. “If the marginal revenue is essentially just profit, the incumbents will compete on price until returns normalise.”
Jensen is of the view that asset managers don’t have a competitive advantage to defend margins.
“None can beat the market on a reliable basis nor do they have monopoly power – this space is heavily over-traded.”
Yet, according to Jensen, there is no attempt to compete on price, or share the scale benefits with investors, certainly not as far as retail clients are concerned.
Rewarding scale benefits
She uses an example of the assets under management of a leading South African active asset manager (Active Asset Manager A) and the progression of its fee income as a percentage of those assets.
“Since 2003, Active Asset Manager A has grown from R54bn to almost R600bn. The published net fees, as a percentage of those assets, have remained quite steady, range-bound between 0.52% and 0.79%.”
Despite Active Asset Manager A’s profound growth, the staff complement has barely doubled since 2003. This underlines the enormous productivity gains this business model can achieve.
Normally, it would lead to soaring operating margins, but with Active Asset Manager A it has stayed at 45% to 55% because compensation at the company has increased substantially. The average employee at Active Asset Manager A earned almost R4m in 2016, ten times more than in 2003.
Scale benefits have handsomely rewarded staff and the company’s shareholders, who have seen their annual dividends increase twelvefold over this period, Jensen points out.
“Active management costs more than indexing – not because the process is more expensive, but because the scale benefits have been retained almost entirely by owners and employees. Index funds achieve a fairer balance by charging much lower fees,” Jensen says.
No price competition
This raises the question as to why there is no price competition among active managers.
“Why is this business not subject to the same ‘invisible hand’ that guides other industries in a free market economy? Normally, this ensures that services are offered at the functionally lowest prices possible.”
Jensen believes that the “price clustering” evident in the industry suggests the industry effectively operates as a cartel, obscuring its tacit price-fixing with poor disclosure, the so-called complexities of the craft.
“The real culprits are the investors themselves,” Jensen says. “Many are price-sensitive in all areas of their life except here. This is deeply ironic because these investment services are one of the single biggest purchases they are likely to make.
"Notwithstanding, they willingly pay twice the price for actively managed funds, even though these have no reasonable prospect of delivering a superior return over the low-cost alternatives.”
She attributes this behaviour to investors' expectations that brokers act in their best interest.
“Or they see past returns as a guide to future results. Others are taken in by the marketing hype around smart fund managers, the unspoken promise of an above-average return, or they are swayed by the subtle messaging that you get what you pay for,” says Jensen.
“But these myths have been exposed by academic studies and by the financial media.”
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