Asset management’s ‘Napster moment’

In just the last five years the amount of money invested in exchange-traded products around the world has more than doubled. According to data provider ETFGI, assets held in exchange-traded funds (ETFs) and exchange-traded notes (ETNs) grew from $2.16 trillion at July 31, 2013 to $5.12 trillion at the end of July 2018.

Earlier this year, research house Morningstar showed that the annual organic growth rate of ETFs in the US had been 16% for the 10 years from 2008 to 2017. Mutual funds, which are the US equivalent of unit trusts, grew at an average of just 2% over the same period.

Last year Moody’s Investor Services predicted that the assets in index funds will surpass those in active funds in the US by 2024. This is as money continues to flow into passive products while active managers struggle to outperform.

In South Africa, index funds are a much smaller part of the market. Only between 5% and 10% of the money in collective investment schemes is held in these products, but they are slowly gaining more market share.

Richard Garland, managing director of Investec Asset Management’s global advisor business, says this is a reality that the active management industry has yet to really come to terms with.

“The passive managers in the US dominate flows,” he says. “But what’s so interesting is that people say it’s going to change. They say that when the market turns everyone is going to switch back to active. I don’t think that’s going to happen.”

He believes that index funds have fundamentally changed the industry. This is because they have shifted what people have become used to paying for asset management.

“All the advisors I speak to have 30% to 40% of their client’s funds in passive because they want to keep the fees down,” he adds. “That is not going away. Fidelity now charges zero for passive. They make money from stock lending. There has been a structural change in the industry.”

Morningstar’s analysis shows that the rise in passive investing has corresponded with a decline in fees across the industry – both in active and index funds. Investors are selling high-fee funds, and this is putting pressure on the entire market.

The reality in the US is that even active managers are not able to attract inflows unless they are low cost. As the table below shows, flows into higher fee funds have been negative for the last four years.

“There is incredible pressure on fees for active managers and advisors,” says Garland. “To me this is a little like asset management’s ‘Napster moment’.

“When we started being able to download music, nobody bought LPs or CDs anymore,” he explains. “In our industry we are not recognising how quickly it’s going to change. The biggest shift I see globally is the move to passive and the focus on fees.”

The challenge to the industry is, however, also an opportunity. The consensus is that we are moving into a lower return environment, where markets are not going to deliver the same kinds of numbers we have seen for the past 20 or 30 years.

Investing only in index funds may therefore not deliver the inflation-beating returns that investors need. Philip Saunders, co-head of multi-asset growth at Investec Asset Management, believes the opportunity will be there for active managers to find ways of delivering that additional performance.

The key, however, is that this will require active managers to offer products that are compellingly different.

“We have a more difficult world ahead of us in the next five to 10 years,” says Saunders. “The old beta cruising style of investing has passed its sell-by date. We do need to change and adapt. You really have to be a good active investor. It’s not good enough being an average one.”

Garland agrees.

“Active is not dead, you just have to be good,” he says. “You have to be able to provide excess return against the benchmark. The only way you can do that is by looking different to the benchmark. You can’t just replicate it. That’s the only way we can survive and grow – by providing strategies you can’t easily replicate, providing excess returns, and providing solutions.”