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Switching to Passive Funds

Wealth managers should stop chasing alpha and start switching their clients into passive funds

Fundamental Tracker Investment Management 7 February, 2013 | 6:00AM

This article is part of Morningstar's 'Perspectives' series, which features contributions from third parties such as asset managers, academics and investment professionals.

Sometimes it is the simplest phrase that captures everything. A private client fund manager encapsulated the challenge that everyone in the financial sector is currently facing when she said “The problem is no wealth is being created right now”. The GDP figures for the UK certainly bear that out.

The Good Ol' Days

For years, banks, fund managers, intermediaries and brokers feasted on a rising tide of wealth. Some of it came from economic growth, some of it came from government largesse, but the bulk of it came from the miracle of fractional reserve banking. Each additional pound of equity a bank retained could be lent out nine times to others clamouring to buy a bigger house, larger kitchen or just pay off the credit card. No one liked banks particularly much then but, hey, if it was going to lend you 100% of the value of your dream home that you could flip for a 20% increase in five years who were you to moan about greedy bankers.

It couldn’t last of course. And it didn’t. Moreover, it was much more convenient to blame investment bankers, especially those in America, than our own greed when the Ponzi scheme stopped.

Nevertheless, the 16 years between the “green shoots” of recovery so accurately spotted by Norman Lamont, Chancellor of the Exchequer, in 1992 and the crash in 2008 did create huge amounts of wealth for householders, builders, plumbers, car dealers and a whole host of industries relying on consumer spending. That fuelled a boom in savings and eventually some of it did find its way into the stock market via ISAs, SIPPs and pensions. Wealth management is a late cycle business because saving is the last thing you do with cash.

Even the tech bubble of 2000 didn’t really dent the wealth management business. It was the bank collapse in 2008 that did that. That was when the downside of fractional reserve banking showed its ugly head. Each pound of equity destroyed by bad lending by a bank meant that another nine pounds had to be called-in to maintain the capital ratios. On its own that would have been bad enough to trigger a recession as bank lending reversed and loans were repaid.

The government and the regulator then made matters worse by demanding that banks raise the capital they held against stormy weather. In contrast to only wanting Tier 1 ratios of 3% in the good times, the great and the good now wanted 10% for the bad times. And the times were very bad indeed.

A Squeeze on the Wealth Management Industry

So now banks are not lending, house prices are not rising and there is little demand for the associated goods and services that go with a housing boom. Incomes are flat and few people like saving when petrol prices are rising, graduates are paying off debt and pensioners face falling income from rising bond prices and low interest rates.

No wonder no wealth is being generated and wealth managers are being squeezed as never before. And the ramifications are being felt far and wide. After years of expansion the cake has stopped growing.

In such a time of stress could there be a better moment to introduce two radical ideas into the industry: the Retail Distribution Review (RDR) and auto-enrolment? Probably, but they did it anyway.

Passive Funds Overhauling Investment Industry

The arrival of low-cost passive funds in force from the USA is changing wealth management in the UK in the same way that cheap reliable Japanese motor bikes and cars eviscerated the UK motor industry in the seventies. 

Wealth management is an industry that has no, or little growth, has too many competitors, has a high cost base and an erratic range of products some of which are complex. Car manufacturing and many other UK businesses reacted by shrinking from the mass market and retreating into specialised, niche and high-margin areas. Even that was not enough to prevent brand names like Rolls Royce and Lotus succumbing to foreign buyers.

We have already seen a great deal of consolidation in wealth management and there is undoubtedly a lot more to come. The lesson from other industries is that consolidation is inevitable and will be driven by the low cost manufacturers. While many people aspire to owning an Aston Martin more people drive a car made by Ford (F). Top speed is simply not a factor for most buyers when choosing a car. The same applies to funds. Investors and intermediaries are shifting away from hunting for alpha, which is the industry term for outperformance. Instead, low cost and reliability are more important factors and those features will be the ones that predominate in an industry that is consolidating.

It is of course possible that economic growth may return but it would not be prudent to rely on that. So the challenge for intermediaries is how to slice the cake so that they and the clients can adapt to the new world. Cutting costs by switching to funds with lower fees is an obvious first step. It is true that there are costs in the transaction like CGT, stamp duty, commission, spreads and platform fees as well as the risk of being out of the market. Even so, the inexorable arithmetic of compound interest means quite simply that the sooner you switch from a fund charging 1.5% to 0.5%, the better off the client will be.

The original version of this article was written by Robert Davies, managing director at Fundamental Tracker Investment Management. The article was originally published in "The Munro February Update" e-newsletter.

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Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Ford Motor Co16.65 USD0.42
Rolls-Royce Holdings PLC1,013.00 GBX-0.39
About Author

Fundamental Tracker Investment Management  is dedicated to the investment philosophy of constructing tracker funds using measures other than price. The company runs one fund, The Munro UK Dividend Fund, and uses fundamental measures to assess companies.