Brian Herschberg writes in the Wall Street Journal that annual fees charged by active managers are not falling as one might expect, given competitive pressures from index funds and exchange traded strategies (ETFs and ETNs). The Journal cites Morningstar research that more funds’ annual expenses went up than down between 2015 and 2016: fees stayed the same at 2,853 U.S. stock funds, fell at 1,607 and rose at 2,306. Annual expenses on U.S. stock funds dropped slightly, from 0.786% in 2015 to 0.774% in 2016, according to Morningstar data.
There are many possible interpretations of this data: it could be that a significant number of funds exited their “expense waiver” period, often adopted for a year or two at the launch of a new fund. But the fact that expenses dropped at 1,607 funds, almost a quarter of the total surveyed, suggests that there still are competitive pressures facing active managers.
One that’s not answered in this article: what is the average expense ratio of new funds today, compared to the average expense ratio of new funds a year ago, three years ago, or five years ago? Conventional wisdom is that expenses must be falling; active fund formation is declining, assets are moving out of active and into passive strategies, and the entire active segment is in retreat. But we believe there is another market development that runs counter to this expectation: the growth of alternative fund strategies. We have described this process as a “hollowing out” or “barbelling” of the market.
At one end of the asset management spectrum, growth of passive investments and ETF strategies continues to outpace growth of the overall market, and the assets are coming from active managers. Index fund market share will soon top 40%, up from 4% 20 years ago. At the other end of the spectrum, there has been an explosion of new alternative investment products. Private equity, managed futures, direct lending, peer-to-peer, hedge strategies….. the number of distinctive strategies is limited only by managers’ creativity and perceived ability to offer alpha. Why perceived? Because some of these funds are just repackaged active equity exposure. Others take advantage of market anomalies that may be ephemeral and not enduring or persistent. Still others offer investment exposure that may or may not represent a new source of alpha. Many quantitative analysts, including this one, believe that it is impossible to verifiably differentiate luck and skill among fund managers without several years of performance data.
All of this potential alpha comes at an actual price, which flows through to investors in mutual funds in the form of higher expense ratios. These higher fees could be mitigating the general, broad downward pressure on active fees. While we do not have any hard data to support our hypothesis (although I think this will be a project for a summer intern), we have loads of anecdotal evidence. My best guess is that research would show that where there is asset growth, except in index strategies, expense ratios are rising. In other words, money is flowing to index funds on one end of the barbell, and to alternative strategies at the other…. and leaving active managers in the middle. We are investigating several of these alternative strategies ourselves, testing out investment theses with our own capital before allocating any client capital to them. You should expect to hear more from us on this topic during the coming months.