Passive funds an active threat for Europe’s fund managers

Warren Buffett built a fortune of nearly $60bn from astute stock picking, but when the 83-year-old dies, the vast majority of the money he leaves his wife will be parked in a fund that simply moves in step with an index.

The afterlife plans of the man nicknamed the Sage of Omaha, revealed in a letter to his investors earlier this year, underline a sea change afoot in the investment industry.

Fed up with high fees and poor performance, investors are increasingly shunning active fund managers who promise to beat the stock market in favour of cheaper, passive funds, which simply track it.

Such funds account for about a quarter of the money invested in the UK stock market, up from 15% a decade ago. The switch is accelerating, with index funds attracting inflows of $3bn in the first half of this year, while active UK-focused funds saw $4bn leave, a Reuters analysis of data from fund tracker Lipper showed.

The passive wind blows even stronger in the United States due to years of underperformance by active funds, which has led to institutions parking half of their equity allocations in index trackers, according to data from State Street.

And the shift is spreading to other parts of the world, putting at risk revenues earned by money managers, banks and brokerages that service funds and more than half a million jobs related to fund management in Europe alone.

Industry experts expect Europe, where active mutual funds are still the dominant force, making up 80% of allocations, to move more in sync with the United States, following the lead of Britain, the region’s top capital market.

“It’s only a surprise that investors have taken this long to realise that the puffery around long-term outperformance, star managers, etc., is just that … puffery,” said Peter Douglas, founder of investment consultancy GFIA.

Nice n’ easy, till now

Patchy economic recovery since the 2008 crisis and increased regulation, such as a proposed clampdown on a fund’s activities in times of a crisis to ensure stability, have hampered active managers’ ability to outperform.

Weak gains have already made it harder to justify fees that are sometimes 10 times or more than the cost of a passive fund, which in the case of the most liquid exchange-traded funds can be less than 0.1% on a headline level, before factoring in brokerage, transaction and tax costs.

While some active funds have cut their charges or introduced cheaper products in response to the threat, the gap is still large.

Leading index fund providers such as Vanguard, Deutsche Bank and BlackRock have cut fees this year to grab market share, putting further pressure on the active managers to do more.

“You can’t charge what you could in the past,” said Chris Iggo, chief investment officer for fixed income at AXA Investment Managers, which manages 582bn euros.

“In a way it’s a good thing. For many years the fund management industry had it easy … Return on capital in fund management has been very nice.”

Vanguard, whose S&P 500 index fund Buffett favoured in his letter to investors, and BlackRock have taken in the bulk of new money to European fund houses since the summer of 2013.

The biggest equity fund investing across Europe, Vanguard European Stock Index Fund, managed $22.4bn at the end of July, more than twice the size of Fidelity Funds-European Growth, the biggest actively managed fund for the region.

The growth in passive funds is reflected in the industry’s net revenues, which have remained flat globally for the last four years, according to the Boston Consulting Group, even as funds under management hit a record $69tn in 2013.

Added value?

The biggest problem for active fund managers charging more for their services is consistently beating the market.

A study of fund returns in local currency over the last 10 years using data from Lipper shows only 35% of the funds investing in Britain have outperformed the FTSE All Share Total Return index, which includes dividend payouts from constituents.

That percentage declined to 29% in the first half of the year.

Active funds investing across continental Europe, meanwhile, have performed even worse, with just a fifth of them gaining more than the MSCI Europe Total Return index since 2003.

The star managers that do manage to beat the crowd often fail to maintain their outperformance.

Of the 107 top quartile funds, or those ranking among the top 25% by gain from investing in British stocks in 2013, only 18 managed to repeat the feat through June-end this year.

Two of them held that spot for the previous five years, and none managed to achieve the feat over the last 10 years.

A similar pattern is found when looking at other regions around the world, Reuters data showed.

For Buffett, this meant one thing for the average investor.

“The goal of the non-professional should not be to pick winners – neither he nor his ‘helpers’ can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal,” he said in his letter to investors.

The struggle to pick a winner consistently has led some leading institutional investors to change how they invest, with some of them putting the bulk of their funds, as much as 70% in some cases, in passive investments, said Laurence Wormald, head of research at Sungard APT.

Money managers of all stripes are also developing new products to offer cost-conscious investors a middle ground between the pure passive and active. So-called “smart beta” funds track a bespoke index that has been tweaked to weight it in different ways, using factors such as stocks’ cheapness or price momentum.

Net flows into US-based smart beta equity funds stood at $234bn in the first seven months of the year, already exceeding the total inflows of $208bn recorded last year, according to data from BlackRock.

In spite of the strong demand for low-cost passive funds, active fund managers will continue to play a key role in the global investment industry because the possibility of higher returns is always attractive, particularly in a low yield environment.

In addition, there is only so far the market can go passive before the price of a stock – still the most popular asset class for passive investing – becomes detached from fundamentals, thereby allowing an active manager to profit more handsomely.

The ability to profit in such as manner has been evidenced most recently by firms such as Glaucus Research and Gotham City Research, who have spotted corporate fraud through a deep investigation into company accounts, such as at Gowex.

“Passive investing is obviously at the mercy of these frauds,” said Michele Gesualdi, chief investment officer of hedge fund investor Kairos.

“If you are with a long-only active fund or a hedge fund, then certainly you have a chance to avoid these frauds or maybe finding them as shorts,” he added, referring to short-selling, the ability to sell a borrowed stock and profit when it falls.

Still, some 3,200 money managers in Europe will need to broaden their expertise across asset classes and develop new products to reassure investors they are adding value.

“That’s the acid test,” said Thomas Ross, head of European distribution at US money manager William Blair, which manages $62bn, largely for institutions.

“Can you beat the benchmark after fees? If you can, you’ll fare well, and if not, the market will move against you and you’ll be indexed.”