How to Fix the Fund Industry

Can a new initiative from the Investment Association fix what ails actively managed funds in the UK? 

Christopher J. Traulsen, CFA 13 May, 2015 | 3:18PM
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On April 28, the Investment Association (IA) released a statement of principles to which it has asked its members to sign up. The initiative is a good one and aligns with the stewardship principles that Morningstar has espoused for more than a decade.

Both are focused on ensuring that fund investors’ interests come first, and that asset managers’ interests are aligned with those of investors.

I would argue that this is simply good business. If an asset manager puts its own interests before those of its clients or otherwise gives them a bad experience with its funds, they may have near-term success, but the durability of the business is questionable.

Morningstar’s studies of dynamics in the US market show that fund flows to individual firms have a much higher correlation (0.49) with money-weighted investor returns (which reflect the experience of a typical investor in a fund) than with total returns (0.20). In other words, even if funds did well from a total return perspective, the money moved to fund houses that offered investors demonstrably better experiences over time. This was not a short-term event—the data covered 10 years through to August 2011.

Furthermore, Morningstar flow data shows that money is increasingly going to passives in both the US and Europe. In Europe, for example, although active offerings still dominate in terms of assets under management, growth rates show a shifting field. The organic growth rate for passives in Europe over the past 12 months is 16.43%, compared to 7.4% for active offerings.

On a more refined basis, equity passives grew at 12.63%, while active equity funds saw outflows, shrinking by 0.24%. Fixed-income passives grew by 32%, while active fixed-income grew by just 8%.

It seems clear why investors are turning to passives. Active funds too often fail to deliver given their costs. Based on a review of UK domiciled offerings, we find that roughly half or more of active equity funds underperform the index assigned by Morningstar to their Morningstar Category over the past one, three, five, and ten years.

That’s not a bad hit rate actually—and active funds are better in UK equities than they are in global equities and US equities—but it still means investors are having a poor experience in a large portion of active equity funds. Fixed income is much worse, with clear majorities underperforming the Morningstar assigned indexes over one year (77%), three years (57%), five years (62%), and ten years (65%).

In a post-RDR world, interest in funds that outperform and provide value for money (the two are related) is climbing. We’re seeing it now in Europe and we’ve seen it in the US market previously. In our view, fund houses that want to build durable businesses would do well to focus on being good stewards of capital rather than striving for near-term asset growth via product manufacturing and marketing. Signing and living up to the IA’s statement of principles would be a good place to start.

This article originally appreared in Investment Adviser magazine

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About Author

Christopher J. Traulsen, CFA  is director of fund research, Europe and Asia, Morningstar.

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