Strong equity markets are currently insulating active asset managers from the impact of losing market share to indexing strategies, but if markets turn, these firms will be facing declining assets, eroding market share, and shrinking margins, warns a new report from New York-based credit rating agency Fitch Ratings.
This loss of market share to passive strategies is not a new trend, the report notes, but it represents a continued source of pressure on active fund managers — due to both an increasing concern with cost among investors, and the proliferation of cheaper exchange-traded funds (ETFs).
“If and when an equity market correction occurs, underperforming active fund managers would feel the triple effects of shrinking assets under management, declining market share and lower fees on AUM,” Fitch warns.
The report cites growing acceptance of indexing and other low-cost, passive strategies by investors as boosting the growth of passive-focused managers and elevating their importance in the investment management landscape, at the expense of active managers. Indeed, the growth rate of assets under management (AUM) in passive strategies has surpassed the growth of AUM in active strategies by an average over 10% per year for the past four years, it reports; noting that this is a wider margin than before the financial crisis.
Net inflows to U.S. index mutual funds and index-based ETFs reached a record US$148 billion in 2014, up from US$114 billion in 2013, which was itself a record year at the time, Fitch says.
At the same time, active strategies are suffering outflows, it notes. “Cumulatively, the outflows from active strategies have nearly matched the cumulative inflows into passive strategies over the past 15 years,” Fitch says.
The biggest beneficiaries of this trend, Fitch says, are the large, passively focused managers such as Vanguard, BlackRock, State Street Global Advisors, Invesco Ltd. and Dimensional Fund Advisors, which boast “an overwhelming majority” of the passive U.S. market.
“Their size and scale makes it very challenging for competitors to win share and earn solid profits,” says Fitch.
The competition from passive strategies is also pressuring fees at traditional active investment managers, Fitch says. Asset-weighted expense ratios for all U.S. equity funds dropped another four basis points (bps) in 2014 to 70 bps, according to data from the Investment Company Institute (ICI), Fitch reports.
Over the past five years, overall equity expense ratios are down by about 20%, on an asset-weighted basis, Fitch says.
Despite these negative trends, Fitch has a stable rating and outlook on the investment management sector.
“This reflects investment managers’ increasingly diversified AUM (by product and strategy), strong margins and modest leverage, among other factors,” the credit rating agency says. “Individual ratings could be pressured if the shift toward passive investing results in more material AUM outflows, reduced fees/margins or increased cash flow leverage.”
Active fund managers still represent nearly 80% of the overall U.S. equity fund market, and generally still earn higher fees, Fitch notes.
“The sheer size of the active investing market still leaves significant market opportunities for individual active managers to perform better than overall trend averages,” Fitch says.
“Yet the direction of the market share graph leaves little doubt that the markets’ acceptance of passive strategies remains strong. In fact, over the past two years, the trend toward indexing and indexing-based ETFs appears to be accelerating.”