Thirty years ago, investment management was largely a boutique business where fund managers graciously agreed to pass on their wisdom to clients in return for a hefty annual fee.
These were great days for star managers. I interviewed Jeff Vinik back in 1995, then running the world’s largest mutual fund, Fidelity Magellan. He let slip to me that the fund had added a billion dollars in value that morning. Good news for Fidelity’s fee income.
Back then, a large number of fund management groups were able to make a decent living, with none dominating the market. In truth, this was partly because performance was not far from being random. This worked in managers’ favour, since they would always have a few funds that were outperforming the market. These could attract optimistic clients who hoped that, despite the regulatory disclaimer, past performance would be a guide to the future.
But all that changed. Over the past three decades, the asset management industry has undergone a revolution. A sector which prided itself on its expertise has become a commodity business. Inevitably, fund managers are trying to adapt to this revolution by introducing new products. But while these innovations may look like great opportunities for investors, they may turn out to be a trap — a costly one.
The revolution has been driven by economic realities: clients have gradually woken up to the fact that passive funds, which merely track an index, give them a cheap, simple method for investing in major asset classes. In the US, passively managed funds have grown from just 19 per cent of the market in 2010 to comprising the majority of the market in 2024. The trend is relentless. Morningstar found that the cheapest quintile of funds in 2023 experienced net inflows of $403bn, while the rest of the sector suffered outflows of $336bn.
This has meant that the fees paid by clients have fallen dramatically. Research by Morningstar found that the asset-weighted average annual fee paid by US investors fell from 0.87 per cent in 2003 to 0.36 per cent in 2023. Given that the US industry manages about $30tn in mutual funds and exchange traded funds (excluding money market funds and funds of funds), that is a saving (compared with 2003) of $150bn of fees a year.
That must be one of the biggest and least-heralded economic gains to consumers in recent history — they are clearly better off under the new regime.
For fund managers, however, the result has been a Darwinian struggle, in which survival went to the cheapest. Index tracking generates economies of scale; it does not cost a lot more to manage a $10bn fund than a $1bn fund. So the industry has consolidated. In the world of exchange traded funds (ETFs), the top three managers (BlackRock, Vanguard and State Street) control nearly two-thirds of all the assets, according to Lipper, the financial data service.
A fightback was inevitable. One of the biggest trends in the industry is the launch of active ETFs, which have higher fees. Active ETFs charge 0.4 per cent a year (using an industry asset-weighted average) around three to four times as much as a typical passive fund. Goldman Sachs launched fixed income active ETFs in February and Cerulli Associates says that 91 per cent of ETF managers are planning to develop an active product.
A significant proportion of active-based ETFs, with around $2.76tn of assets according to Lipper, are in the field of factor-based investing, or “smart beta” in the industry jargon. These select stocks based on a set of financial characteristics. Value ETFs pick stocks with a high dividend yield or a low price relative to their asset value, for example. Momentum ETFs pick stocks that have recently risen in price and so on. In a sense, such funds attempt to exploit the stockpicking insights used by traditional fund managers in a systematic fashion. Fees on such funds average 0.18 per cent a year, about half the level charged by other active funds.
These investment styles can appear to be common sense; in the case of value stocks, it seems attractive to buy shares that are “cheap”. The problem is that the strategy can underperform for very long periods. A study in the UBS Global Investment Returns Yearbook 2024, by academic investment gurus Elroy Dimson, Paul Marsh and Mike Staunton, found that UK value stocks underperformed their growth counterparts from 1987 to 2020. Timing the shift between factors looks very difficult, the academics found, and risks making premature portfolio shifts with high transaction costs.
Thus, it remains to be seen whether active ETFs will be any more likely to outperform the market than their mutual fund equivalents. The maths make it unlikely. The index represents the performance of the average investor, before fees; therefore the average fund manager cannot expect, after fees, to beat it. For the retail investor, buying an active ETF thus seems like the triumph of hope over experience.
Whether active ETFs are replacing passive funds in investors’ portfolios is another question. It may well be that they are taking the place of actively-managed mutual funds instead. This is part of a general shift away from mutual funds and towards ETFs in recent years. Michael O’Riordan, a founding partner of Blackwater, a consultancy, says that “ETFs are basically eating the lunch of mutual funds at a rate that even the most diehard ETF cheerleader would have been surprised by.” According to Oliver Wyman, a consultant, ETF assets grew at 16 per cent a year between 2016 and 2022, compared with 5 per cent for traditional mutual funds. In the US, ETF assets have grown from just $66bn at the start of 2001 to $10tn at the end of last year. Global ETF assets were over $14tn. Zachary Evens, a research analyst at Morningstar, says that ETFs are generally less expensive than mutual funds, are more transparent (in the sense that investors can see their underlying holdings) and are tradable daily.
Active ETFs are not the only alternative for retail investors. Option-based ETFs use derivatives to offer a different type of return. One group of ETFs enhances the yield on the fund by selling call options on the shares in the portfolio. These calls give other investors the right to buy those shares; in return the ETF earns premium income. The effect is to create an equity fund with a higher income but with limited upside (if the shares in the portfolio rise in price, the calls will be exercised and the ETF will have to sell those securities).
A second type of option ETF is called a buffer fund. In these funds managers buy put options giving them the right to sell shares at a certain price. This limits the amount the ETF can fall in price. But buying puts costs money and to offset this cost, the ETF managers sell calls on the shares. This limits the upside of the fund as well. So buffer funds offer a narrower range of returns, which may appeal to more cautious investors.
How should investors view these assets? The point of investing in equities is the prospect of long-term returns. Higher income in the short term can be achieved by combining equity assets with government or corporate bonds, or with deposits. Many investors will already do this. A diversified asset allocation can thus deliver a higher yield, along with the limits to the upside and downside of returns that option-based ETFs offer. And the DIY option for investors may be cheaper. Figures from Morningstar show that fees on option-based ETFs vary from 0.66 to 0.82 per cent a year depending on the type of fund, well above the charges levied by passive funds.
Perhaps the ETF sector is best seen as a maturing industry where the basic product is repackaged to give consumers a much wider choice. Whether this choice is in the best interests of consumers or producers is another matter. Starbucks makes a virtue of its ability to offer a wide range of caffeinated beverages. Consumers can order a Java chocolate chip frappuccino with whipped cream if they wish. Whether that is the best value, or indeed healthiest, option is another matter.
One choice that has become less popular recently is the ESG (environmental, social and governance) sector, the modern version of what used to be called ethical funds. There has been a big shift away from this school of thought in the US, particularly after the election of President Trump. Corporate America is scrambling to drop its emphasis on diversity, equity and inclusion; presumably to focus on uniformity, inequality and exclusion. The speed of this reversal brings to mind the old Groucho Marx quip: “Those are my principles and if you don’t like them, well, I have others.”
Well before Trump’s re-election, ESG funds were far more popular in Europe than the US. Europe makes up 84 per cent of all sustainable funds, compared with just 11 per cent in the US. That suggests the sector will not disappear; there were $54bn of inflows last year, according to Lipper.
There is a respectable case for arguing that ESG funds could outperform in the long run; companies that damage the environment, act unethically or are poorly run might fall foul of regulators and the courts or be a casualty of changing consumer sentiment. And they have beaten other funds over some time periods; in the five years to end 2023, for example. But they do involve big sector bets; they tend to be underweight energy and overweight in technology and healthcare, for example.
In the past month or so, the apparent US retreat from its security commitment to Europe means there has been a big rise in European defence stocks; something most ESG funds, which shun defence, wouldn’t capture. Furthermore, while fees charged by sustainable funds have fallen by a third over the past 10 years, they are still, at 0.52 per cent, higher than the average active fund.
Another potential new choice for retail investors is private credit. This is debt that is not traded on a public market, unlike corporate debt. The bulk of this debt has been issued by private equity firms to finance the purchase of the companies that make up their portfolios. This debt can be pretty high-yielding and this can deliver decent returns; institutional private credit funds made double-digit returns in both 2021 and 2023, for example.
But this asset class is, by its nature, illiquid and thus there is yet to be an ETF launch specialising in the sector. Only high net worth clients are likely to be able to get exposure. And they should be aware of a couple of caveats. The first is that the funds that invest in private credit tend to be issued by the same private equity firms that are issuing the debt; that is a potential conflict of interest. Secondly, in the event of a recession or sustained rise in interest rates, private credit, like any other high-yield debt, is likely to experience defaults.
The latest IMF global stability report warned: “Some midsized companies borrowing at high interest rates in private credit markets are becoming increasingly strained and have resorted to payment-in-kind methods, effectively deferring interest payments and piling on more debt.” The report also warned that competitive pressure in the sector was leading to deteriorating underwriting methods and weaker covenants (where borrowers agree to financial conditions).
The industry is offering many new options to tempt investors away from the low-cost index funds that are starting to dominate the market. Some may appeal to investors looking for diversification in their portfolios. But one rule should never be far from such investors’ minds; higher returns are not certain, but higher fees are.
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