Investment

Why active management fee cuts present family offices with opportunities

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After disrupting an array of consumer sectors, technology is presenting active asset managers with an unprecedented challenge, as their equity funds go out of favour.

Its insights are providing clients with a big opportunity to negotiate fee cuts, or get compensation for poor performance.  Family offices should see this as an opportunity, although they tend to be more focused on alternatives, at present.

Data provider S&P Dow Jones Indices has shown 80% or more active managers are lagging their indices over ten and fifteen years

The structure of the industry will dramatically change, giving newcomers a chance to compete. Fees could even fall below zero, says data provider FlowSpring, as cheap passive funds seek scale. Investment consultants at Mercer have suggested that managers could make up for failing to hit performance targets out of their own pockets.

Its rival Willis Towers Watson sees merits in institutional clients paying a base fee as low as zero, plus a performance fee. Marketers have told Family Capital that a number of managers are offering clients fee holidays to stem outflows. Hedge fund charges have become highly negotiable.

And regulators, making extensive use of technology, have been given the ammunition to act like consumer champions.

Esma, the European regulator, has warned that costs eat up 25% of returns to retail investors and demanded greater transparency. Poor active returns have triggered the tech-driven attack. Data provider S&P Dow Jones Indices has shown 80% or more active managers are lagging their indices over ten and fifteen years.  

Some active managers have performed better, but less talented players, plus orphaned funds, semi-neglected by their sponsors, have been pulling down the averages, after costs.

In a cruel twist, managers are also suffering because indices have a 40% tilt towards large growth stocks driven by technology innovation.

These gains have pushed indices skyward over the last decade, and active managers are losing out because they do not dare to be so assertive.

According to a head of quant research: “Portfolio managers are too tentative. They need to take their cue from technology which can suggest more appropriate weightings.”

Advisers Morgan Stanley and Oliver Wyman warn active managers are facing an annual fall of 9% in revenues due to competition in a market heavily supplied with products. They need a fall of 30% in core costs to compete.

The tech-driven assault on active managers has been a long time coming. It began back in the 1970s, when hedge fund managers started using computers to find arbitrage opportunities in the capital markets and develop high-frequency trading systems to take advantage of them.

Passive styles developed from the 1980s. The technology was particularly useful to Exchange-Traded Funds, whose apparent simplicity belies the way they issue and redeem stock so that high-frequency traders support their price close to the underlying index.

Large ETF players can make money by charging fees which range down to a few basis points. Products with expense ratios less than 5 basis points (bps) have grown 20 times faster than those on 20bps, over the last five years, according to FlowSpring.

Fidelity of the US has wheeled out a passive fund with a zero charge, although it is earning money from hedge funds who want to borrow its stock for shorting purposes. Online lender Social Finance filed to launch a zero-fee ETF in February. ETFs now manage no less than $5 trillion and the growth has been stolen from active managers.

Elsewhere, manager skill is being increasingly dissected and found wanting by regulators and lobby groups using technology to show active managers are hugging the index, or allowing too many poorly performing orphaned to stay alive.

Newer “smart beta” funds backing the factors that drive the market, like value and growth, are also competing. Willis Towers Watson has shown that hedge fund managers have relied on these factors, plus leverage, to deliver performance, on the cheap.

The technology revolution continues. Firms are attempting to use it to improve their offering, through robo-advice, big data analysis and a “quantamental” partnership between managers and machines.  

McKinsey says managers are increasingly using data science to pinpoint and correct investment mistakes.  They are working out how to downsize in equities, while pushing private assets and credit funds to the fore.

Evolution will not be easy, given the way incumbents will resist changing their ways. But the Wyman report warns active managers have no choice. “Tweaking existing operational models will not be enough to either respond to aggressive pricing challenges, or free up investment capacity,” it says.

Everything is down to the quality of leadership. The report adds that managers can find 70% cost savings by building new platforms, rather than trying to adapt. Which was how Chinese tech giant Alibaba built the biggest money market fund in the world.

For, in this age of disruption, it has been shown, time and again, that entrepreneurs in different sectors who use technology to build a business from scratch have many competitive advantages.

This could present an opportunity for new players, such as private equity firms, with opportunities to back new businesses in a brave new world.

In fact, it is already getting pretty hard to tell where technology stops, and stock picking starts.

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