Long tail of small European funds on borrowed time

Traders are pictured at their desks in front of the DAX board at the Frankfurt stock exchange March 11, 2015. REUTERS/Staff/remote

LONDON: When British investment firm Hargreaves Lansdown compiled a list of the best funds for its clients more than a decade ago, it came up with 150 names. Now only 84 make the grade.

The shrinkage of Hargreaves’ ‘Wealth 150’ list is all the more striking because assets in funds for British retail investors have grown two and a half times over the same period to $1.3 trillion, while 3,000 new funds have been created, data from Lipper and the Investment Association showed.

Indeed, the race to launch new fund products in Europe means there are now more actively managed stock funds in the region as a whole than actual, listed companies.

“There are as many funds ... as there are bright sparks coming out of the marketing departments at investment companies,” Laith Khalaf, senior analyst at Hargreaves, said.

“The problem is these sparks considerably outnumber the number of talented managers in the industry.”

The proliferation means the top 10 percent of active U.K. stock funds by size hold nearly 60 percent of the assets. The bottom 40 percent, however, control just 3 percent and are all sub-$100 million funds, a level which is increasingly seen by those in the industry as unsustainable.

With regulators driving up costs, rivals offering cheaper investment strategies and a desire from asset managers to boost the marketing potential of their successful funds, the active stock fund sector is set for long overdue consolidation.

“It’s in the manufacturer’s interest, ultimately, to reduce the number of products to make it more simple for the end-customer to select the appropriate products,” Alex Birkin, global leader of wealth and asset management at consultants EY, said.

“Managers are realizing some of the intangible benefits of cleaning up the product range, the fact you can then declare that two-thirds of the funds are outperforming, as you start to do away with some of the underperforming funds.”

In the past, many poorly performing or sub-scale funds remained open given the low marginal cost of maintaining them, with many fixed costs shared across an asset management group but the break-even level for funds is growing.

Among recent high-profile closures, Neptune Investment Management shut nearly 40 percent of its funds in a “product rationalization” that some feel should be mirrored elsewhere.

While the cost of running a fund may not be a big drag for a large asset manager, investors in smaller funds end up paying significantly more than those in larger funds as the cost gets distributed between those holding the fund.

While a hedge fund needs about $100-$300 million to turn profitable, depending on the strategy, the break-even point for mutual funds is less clear. It depends on the firm, where it is based and the assets it trades, among other factors.

There is no universally agreed common figure but less than $100 million is often seen as too small.

M&G Investments, the fund arm of insurer Prudential, said this month it was winding up an 81 million pound fund because it was difficult to manage it in a “cost-effective way.”

Active stock fund managers are also facing pressure on fees and criticism of their performance amid competition from cheaper rivals, which just track an index or group of stocks, known as passive investing.

Multi-asset funds that can profit in a range of market environments given their increased flexibility are also challenging stock-pickers’ domain.

Schroders, for example, collected a net 16.9 billion pounds in its multi-asset funds last year, primarily due to a large investment by one institution, more than three times the amount that went into its fixed income or equities products.

Actively managed stock funds can charge up to 2 percent of an investor’s assets a year in management fees but many have struggled to justify this through benchmark-beating returns. In 2014, nearly 70 percent of active European stock fund managers failed to beat their benchmarks, data from Lipper showed.

Exchange-traded funds, however, are stealing market share. They charge as little as 0.1 percent a year to make sure investors keep in step with their chosen index.

Adding to the pressure on smaller firms, the asset management industry is now firmly in the crosshairs of regulators, keen to improve industry operations and behavior after cleaning up the banks.

While Britain has already enacted the Retail Distribution Review (RDR), which unbundled trading and execution costs, the European Union is set to follow suit with its even more wide-reaching Markets in Financial Instruments Directive II.

The RDR forces fund advisers and online platforms selling funds to charge clients a fee for their services, rather than being paid by asset managers. This reduces the chances of firms paying higher commissions to have advisers push their funds.

Fund managers “are struggling to get in shape for the arrival of the lower fee world,” said Nick Hamilton, a partner at lawyers Smith Hamilton Partners. “The additional regulatory burden that has arrived is being implemented at a time when they already have an unsustainable marginal cost.”

On top of that, Britain’s financial watchdog said it may look into competition in the sector, with a potential focus on how products are developed and sold to consumers, to ensure they are not being overcharged.

As governments want consumers to save more for their pensions, they have been increasingly looking into fees charged by management funds, which can swallow a chunk of any investment gains.

The FCA declined to comment when contacted by Reuters but noted that its overall approach to asset management is to ensure that funds and firms deliver the right outcomes for consumers.

All of which is likely to bring down the number of funds over time, Geir Lode said, head of global equities at Hermes Investment Management.

“It’s becoming more and more costly to run a compliant fund,” Lode said. “You need scale and to get that scale you have to start consolidating.”

A version of this article appeared in the print edition of The Daily Star on March 12, 2015, on page 6.




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