June 1, 2020

Monday Morning Memo: Should Active Funds Pass on Economies of Scale to Investors?

by Detlef Glow.

Asset managers around the globe face increasing pressure on management fees since the performance of the average active manager is in a number of cases worse than the performance of their passive peers. One reason for this underperformance can be attributed to the level of fees and expenses charged by active managers since the underperformance is often somewhat similar to the total expense ratios of the respective funds. It is, therefore, not surprising that these management fees are under scrutiny and that investors put pressure on active managers to pass over economies of scale by reducing the management fee once a fund has reached a given size.

Passing on economies of scale is a common practice in the ETF segment since it is often easy to compare like-for-like products and fund promoters can generate a competitive edge by passing on economies of scale. This could force their competitors to reduce fees as well to stay on the purchase list of investors even as this could cost funds their profitability. Consequently, some ETF promoters use aggressive pricing to build barriers of entry for new competitors in some market segments.

Actively managed funds are not like-for-like products since every asset manager has a somewhat different approach to securities selection for their portfolios and claims that their approach will deliver outperformance—the so-called alpha—compared to the fund’s benchmark. Therefore, the active fund management industry was able to maintain a comparably high cost base which drives the revenues of the companies.

Since asset managers are the fiduciaries of investors, the pricing strategies of fund promoters need to be under scrutiny because every penny of revenue for the company is taken from investors’ money. This was not a big issue in the past, but the increasing transparency of fees, expenses, and company revenues will make the overall level of management fees for active funds an important topic for the future. In this regard, it is noteworthy that a look at the so-called super clean or institutional share classes of a fund shows where the real costs for the management of the portfolio are, as the management fees for these share classes are often less than half the price of plain vanilla retail share classes.

From my point of view, this raises the question of whether a fiduciary should be allowed to treat clients differently based on their domicile and/or amount they want to invest. At least the ETF industry provided a clear statement here, as all investors pay the same fees regardless of their domicile or investment. With regard to the above it might be the right time for active managers to think about passing on economies of scale to investors because this may give them a competitive edge. To achieve this advantage, they would need to be serious about the move and make big steps that will impact their revenue stream. Since all revenue of the portfolio management company is taken from investor assets, it would be good corporate governance to reduce the management fees when a given level of revenues is reached.

Taking a corporate view on this, I can understand why asset management companies are reluctant to lower management fees. No director wants to tell his board that his departmental revenues are going down, even as the asset base increased. On the other hand, we already see that regulators in Europe are serious about their ambitions to bring down the costs of financial services for retail investors and, therefore, may increase the transparency of fees and expenses, as well as increase regulatory burdens for some fees charged by asset managers. In light of this, it might pay for a promoter to be a trendsetter since others may struggle if they try to follow suit.

The views expressed are the views of the author, not necessarily those of Refinitiv.

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