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The UK’s asset management sector is a classic case of market failure. Its services are allocated in a sub-optimal way, while clients are not shifting their resources to achieve better outcomes.

The Financial Conduct Authority’s (FCA’s) interim report on asset management, released earlier today, demonstrates the lack of effective competition via a couple of charts.

The average ongoing charges for actively managed funds have remained static during the last decade, while those for passive (index-tracking) funds have been declining.

active

passive

How is this possible? After all, it’s passive that has been taking a steadily rising share of the funds market. Assets in index-tracking funds have risen fivefold in the last decade and they now represent 23 percent of the overall market, says the FCA.

On the basis of the increasing competition from the passive sector, you’d expect the active fund operators to be cutting fees to compete. That they haven’t done so at all is an indictment of their business model. And it’s a very short-sighted one, suggestive of senior executives angling for a last fat bonus before the tide turns, and reminiscent of the well-publicised excesses in the banking sector.

The FCA cites a number of reasons why active managers may have been so immune to competition.

First, there are too many intermediaries between savers and fund managers, and many of those advising on the selection of active managers—whether pension fund consultants, fund ratings services or fund supermarkets—overemphasise the importance of past performance. This facilitates a merry-go-round of managers, lucrative for the intermediaries but detrimental for the clients.

The success of consultants’ own manager recommendations may be poorly monitored, while the consultants increasingly risk conflicts of interest, such as when providing fiduciary management services—getting involved in asset allocation, portfolio construction and risk management, traditionally the asset managers’ domain.

Meanwhile, retail clients may either be woefully misinformed about the costs of the products they invest in—according to the FCA, about half of retail investors don’t know they are paying a fee at all—or may be restricted from accessing the lowest-priced funds, either because their financial advisers don’t suggest them, or because their fund supermarkets don’t have them on the menu.

If it may be uncomfortable reading for many active asset managers, the FCA’s report threatens even worse news for the consultants and supermarkets, whose business models are now under close regulatory scrutiny.

But while the FCA report provides substantial evidence that there is cartel-like behaviour amongst active managers, it’s striking how competitive the passive funds business has become (see the sharply falling ongoing charges figure in the second chart above).

We’ve witnessed a wave of competition amongst ETF providers in the last few years, with firms forced to cut fees to compete with the likes of Vanguard, which prices its funds at cost.

There’s also been a substantial automation of passive fund management, with firms seeking to cut out expensive human intermediation and improve their operational efficiency.

The FCA’s survey reminds us of some basic human psychology. Every basis point in fees matters if you’re trying to track an index, while if you’re sold on high future performance you may turn a blind eye to what you pay. This is despite the overwhelming evidence that the costs you incur are the best indicator of what you’ll end up with.

So there will always be some demand for high-octane versions of fund management, with the associated high fees. But for the bulk of the active funds industry, there’s now a version of passive management that threatens to eat their lunch and shave zeros off the annual bonus.

The evidence released today by the FCA suggests that smart beta funds, which aim to deliver better risk-adjusted returns than conventional index trackers by using alternative weightings, are likely to take substantially more market share.

(Disclosure – I’ve done paid writing work in the last year for firms that provide smart beta and index products) 

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Could the post-LIBOR regulatory crackdown on banks exacerbate price movements when indices are rebalanced?

Late afternoon on Friday shares in Dutch bank ING jumped nearly 5% in heavy trading on the Euronext Amsterdam exchange.

ING Price Spike

ING

Source: Yahoo Finance

The price spike has now been fully reversed. A 5.75% increase in ING’s share price on Friday has been followed by a 4.69% decline yesterday and a further 1.23% fall so far on Tuesday morning.

ING’s late-Friday price move seems related to the reconstitution of equity indices. Friday’s market close set the price at which ING’s shares entered two indices from STOXX—the Euro STOXX banks index and the STOXX Europe 600 Banks. The latter index is a popular one: it underlies several European equity sector ETFs and is reportedly used in many bilateral swap agreements.

Both STOXX and ING declined to comment on Friday’s share price movements.

Price movements in shares entering and exiting benchmarks are a well-known phenomenon, and an unsurprising one. Index changes mean unavoidable cash flows in a whole range of tracker products, including futures, swaps, ETFs and index funds, which other market traders can try to exploit.

STOXX announced the September constituent changes for its indices on August 26 and between August 25 and September 18 ING shares had already risen 8.43%, a not-uncommon price rise between the announcement date for an index addition and the date on which the addition becomes effective.

So why the unusual late-Friday action?

According to one trader I’ve spoken to, post-LIBOR restrictions by banks’ compliance departments on their traders’ index-related deals may be having the effect of forcing market participants into the end-of-day auctions on stock exchanges, which are used to set closing prices.

Previously, said the trader, bank dealers could pre-position their trading books for index changes. Now, he argued, after the LIBOR revelations banks are scared of being seen to exploit benchmark-related trading flows. Instead, he told me, they are now taking the most conservative option: trading at the actual price point at which the index change occurs, even if this leads to a less efficient execution.

Managers of index-tracking funds and financial products face a similar dilemma: place a trade in the closing auction and risk losing money (as anyone buying ING at Friday’s close would have done by Monday morning) or attempt to trade either pre- or post-close. Shunning the closing exchange auction may mean you avoid involvement in a crowded trade, but fund managers will incur tracking error if the fund’s execution price is significantly different from the price used by the benchmark calculator.

Rebalancing-related share price movements may be exacerbated by another factor, the trader told me: the widespread use of volume-weighted average price (VWAP) algorithms. VWAP algos automatically seek to trade when volumes are highest.

“The more volume in the closing auction, the more the VWAP will seek to execute there, leading to more volume in the auction, more VWAP execution….in other words, a feedback loop,” the trader told me.

Not everyone I’ve spoken to agrees with this explanation. The ING price spike could have been caused by someone realising late in the day that they were incorrectly positioned for the index change, or even by a mistake, other traders suggested.

As the volumes of money in tracker products increase, there’s more at stake when indices rebalance. It’s clear that these events involve a trade-off between transparency and making it difficult for those seeking to game index changes. But it would be ironic if, by making trades more crowded, measures taken to clean up the benchmark business had a detrimental effect on the efficiency of indices.

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On the face of it, mutual funds are a huge global success story.

Assets in collective investment schemes have grown seven-fold in two decades and now top $30 trillion.

Growth in global mutual fund assets

mutual fund assets

Source: Investment Company Institute

Yet the mutual fund structure contains weaknesses.

First, funds need to apportion correctly the costs associated with investors entering and departing the fund, a tricky job. So-called dilution levies (also called entry fees or front-end loads) and exit fees are there to make sure that the costs of any purchases (or sales) of securities incurred on behalf of an entering (exiting) investor are borne by that investor, rather than by the rest of the fund holders.

Unfortunately, many fund managers have historically set entry/exit fees too high and used them as a disguised source of revenue.

A more important drawback of funds is that they may carry liquidity risk.

If a fund invests in less liquid assets but promises immediate liquidity to its investors, the fund manager may cope with a sudden withdrawal of investors’ funds by selling the most liquid of the underlying assets. This would disadvantage those remaining in the fund by leaving them with a rump of less liquid securities. As a result, investors are incentivised to “run” from a fund in stressed market conditions.

Given the increasingly large size of many mutual funds (including ETFs) and the potential liquidity problems in certain asset classes (like corporate debt) it’s not surprising that regulators have been focusing on fund liquidity as a potential source of broader, systemic risk.

In most jurisdictions, the managers of mutual funds have the little-advertised ability to “gate” (ration) redemptions—a right that, if invoked, could contribute to a panic.

Mutual funds have historically been expensive, too. ETFs are a welcome recent exception to the trend of overcharging, but fund fees pay for hefty salaries at asset management firms, as well as for the services of a whole range of middlemen: lawyers, accountants, custodians and transfer agents.

The world’s largest investors don’t use mutual funds: they insist on their own, flexible managed accounts. What if smaller investors could follow suit?

It turns out that they now can.

Firms like US-based Motif Investing allow you to buy a diversified, thematic portfolio of stocks in one transaction. Motif charges $9.95 for a trade in up to 30 stocks, much cheaper than online brokers’ rates for buying or selling 30 individual securities. You can customise your own portfolio (called a motif) or copy someone else’s.

You end up with an investment that’s very similar to an index fund, but with significant advantages: no annual fees, no administrative overheads, no worries about how costs are mutualised and no concerns over gating. Unlike some funds, a stock basket doesn’t lend shares, use derivatives or incur collateral risks.

Under this model you own the stocks in your motif, with full entitlement to dividends. You retain voting rights, rather than delegating them to an anonymous fund manager, who may not even use them (except, potentially, if the small size of your basket means you own fractional, rather than whole units of shares).

Mutual funds first came into being as a way of spreading risk. Reducing company-specific exposure via a shared portfolio seemed an attractive prospect for European investors recently scarred by Tulipmania and the South Sea Bubble.

But that technological advance came nearly three centuries ago. Now we can see the prospects for another significant shift in the savings market. The emergence of cheap, tradeable thematic baskets of stocks threatens to render funds obsolete.

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Active fund managers may offer poor value for money. But some index fund costs are hidden too.

Professor David Blake of Cass Business School has just released a paper in which he argues for better disclosure of the costs of active management.

Between 50-85% of the costs of active management fall outside the headline “ongoing charges” figure that every European retail fund has to display, estimates Blake.

Commissions and taxes paid on securities trades undertaken by the fund manager are excluded from ongoing charges, for a start.

Other, harder-to-measure “invisible” costs, as Blake calls them, include the bid-offer spreads payable on trades in securities, transaction costs in any underlying funds, hidden revenue earned by the fund manager from stock lending or interest, market impact costs and market timing costs.

The high undisclosed costs of active fund management are often used by advocates of passive funds as an extra justification for indexing.

Unfortunately, some of the arguments being made in favour of indexing are fallacious.

In another study published this month, Blake and co-authors Tristan Caulfield, Christos Ioannidis and Ian Tonk argue that active management is not worth paying for.

Having measured the performance of 561 domestic UK equity funds against the FTSE All-Share index over 10 years, Blake, Caulfield, Ioannidis and Tonk conclude that “the average mutual fund manager cannot ‘beat the market’ (i.e., cannot beat a buy-and-hold strategy invested in the market index), once all costs and fees have been taken into account.”

There’s a major problem with this argument. Tracker funds don’t match the market index, as Blake appears to assume as a matter of fact: they underperform as well.

Clearly, you should expect any index-tracking fund or ETF to lag its index by the annual ongoing charges, which are admittedly smaller on average than those of active funds.

But in harder-to-track equity markets the underperformance of the average index fund/ETF may be greater than the headline fee would imply. This occurs as the result of extra, frictional costs that closely resemble the hidden charges Blake talks about in the context of active management.

For an example of this effect, note that most trackers of the MSCI Emerging Markets index underperform it by more than their ongoing charges (see this recent Lyxor publication for evidence).

This additional performance lag occurs as a result of access costs: you pay more in the form of bid-offer spreads, taxes and commissions when buying stocks in smaller and less developed equity markets. Index funds have lower turnover, on average, than active funds, but they do trade.

[Disclosure—I’ve recently done writing work for Lyxor]

Index fund managers can, however, mask their funds’ underperformance in ways that are even less transparent than some of the below-the-surface active fund costs described by Blake.

One way to do this is to include extra costs in the index (whether as an index fee or, more cleverly, by depressing the assumed post-tax dividend rate in a total return index to make the fund’s performance look better).

If the index fund manager also gets to produce the index, a practice that the US regulator now appears to be condoning, then there’s even more scope and incentive to embed additional costs, to the investor’s detriment.

Another way of hiding index fund costs is to include collateral in a derivatives-based fund that is of lower quality (from the perspective of the repo market) than the quality of the securities basket represented by the index. This generates extra income for the counterparties to the repo trade, who can pocket the revenue with the average investor none the wiser that he’s losing out at all.

The equivalent practice in a physically replicated tracker fund is to exchange the index securities via a securities loan for lower-quality collateral, again resulting in extra income, a large portion of which has historically been retained by the fund issuer or its affiliate.

There’s a little more transparency regarding these practices than there used to be, and more of this hidden income is now being credited to fund investors than before. But securities lending and repo market trades are also much more characteristic of index-tracking than active funds, meriting extra scrutiny when indexing is involved.

It’s worth reiterating that if you buy an index fund assuming that you’ll get the index’s return, you are making a mistake. And if you compare index funds on the basis of their headline fees only, you are ignoring potentially substantial hidden costs.

I’m a fan of ETFs and am all for criticising active fund managers if they are providing poor value for money. But we shouldn’t give indexing a free ride as a result.

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The cost of owning an index-tracking fund via Hargreaves Lansdown’s Vantage platform is going through the roof.

Vantage is the largest fund “supermarket” in the UK, designed for do-it-yourself investors looking for a convenient way to hold funds, shares, Individual Savings Accounts (ISAs) and self-invested pensions in one place.

Hargreaves highlights its platform’s key features as the safe custody of investments, easy dealing and account administration, and fund and share research.

Earlier this month the firm announced a new pricing model for its clients, prompted by incoming changes to the regulations for savings products.

From 6 April this year, the UK’s providers of fund platforms—such as Hargreaves Lansdown—will have to charge openly for the services they offer (with a two-year transition period for existing clients).

In the past, platform providers were paid by hidden rebates from the annual management charges levied by the managers of the funds they sold.

Fund managers paid these rebates to platforms as part of a lump sum that included commissions payable to the financial advisers promoting their funds. The platforms then passed part of the lump sum on to the advisers.

Understandably, this bundling of fund manager charges, platform fees and adviser commissions raised concerns that investors were receiving biased advice, paying too much for savings products and earning sub-optimal investment returns as a result.

Last year, the director of policy at the UK financial market regulator, the FCA, said that his agency’s platform reforms would ensure that customers know what they are paying and the levels of service that they can expect.

Whether clients holding low-cost index funds on Hargreaves’ Vantage platform could have expected what they will now encounter is another matter. That’s a gigantic increase in costs.

Currently Hargreaves charges between a monthly platform fee of between zero and £2 per month for a range of over 100 index funds.

From April 6 this is going up to an annual charge of 0.45% for the first £250,000 of fund investments held on the platform (there’s a sliding scale for larger holdings).

Below I’ve shown what effect this price change will have on investors using Hargreaves to hold their index funds, using two popular trackers as an example and assuming three different invested amounts: £10,000, £100,000 and £250,000.

£10,000 Fund Holding

Index Fund

Annual Fund Cost (%)

Annual Fund Cost (£)

Current Platform Cost (£)

Future Platform Cost (£)

Vanguard FTSE UK Equity

0.15

15

24

45

SWIP FTSE All Share

0.09

9

24

45

£100,000 Fund Holding

Index Fund

Annual Fund Cost (%)

Annual Fund Cost (£)

Current Platform Cost (£)

Future Platform Cost (£)

Vanguard FTSE UK Equity

0.15

150

24

450

SWIP FTSE All Share

0.09

90

24

450

£250,000 Fund Holding

Index Fund

Annual Fund Cost (%)

Annual Fund Cost (£)

Current Platform Cost (£)

Future Platform Cost (£)

Vanguard FTSE UK Equity

0.15

375

24

1125

SWIP FTSE All Share

0.09

225

24

1125

For a £10,000 index fund holding, the platform charge will nearly double from April 6. For a £250,000 holding, the platform charge will increase by a factor of nearly fifty. For any sizeable holding, the platform fees will also dwarf the fees being charged by the funds’ managers.

Hargreaves says that the new FCA rules mean it has to apply the same platform charge for all funds.

It says it’s removing the existing flat £1 or £2 per month platform fee currently levied on a number of index trackers, and applying the same “low-cost tiered tariff” across all its fund range.

“This means most investors with smaller passive holdings will be better off. Investors with larger passive holdings may pay more,” Hargreaves says in what is surely the understatement of the year.

Of course, it’s possible that the UK’s leading fund supermarket is simply trying to get rid of low-fee index fund business and to focus on higher-margin active funds. Active funds have traditionally charged about 1.3-1.5% a year and will now levy so-called “clean” fees of 0.65% to 0.75%, plus the new platform fee. For such funds, the platform fee is offset by the reduction in the headline fund charge.

A commercial objective of encouraging index fund investors to leave would be surprising, though, given the rapidly increasing market share of benchmark-tracking funds and the continuing outflows from more expensive and, in the main, poorly performing active products.

The FCA, which is tasked with ensuring competition as well as regulating the markets, now faces a dilemma. When it introduced its reforms to the UK retail investment product market in 2006, the regulator (in the guise of the FSA, the FCA’s forerunner) said it wanted to ensure better overall outcomes for savers.

The fee hikes just announced by fund platform providers hit hardest at those seeking to save at the lowest cost, suggesting the regulator’s objective is getting farther away, not nearer.

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