The active-pricing conundrum

Europe’s passive funds are stealing the spotlight from their active rivals. They have grabbed a huge share of the net flows resulting from a ballooning choice of products coupled with a favourable regulatory environment.

Active managers look suspiciously expensive by comparison and are reflexively trying to justify or modify their prices. This dilemma has yielded some intriguing developments. A number of active groups have responded to these turbulent times with pricing innovations, the most interesting of which I highlight below.

But before delving into these, let’s consider how significant passive investing has become in Europe’s fund industry. According to Broadridge data, €277 billion was parked in European passive products a decade ago, comprising just 6% of total long-term fund assets. Wind the clock forward 10 years to 2017, and passive managers now control €1.25 trillion, or 16% of assets.

Passive funds have been punching well above their weight in the battle for sales.

Of course, 16% is still a fairly small proportion — around half of the equivalent statistic for the US industry — and the resurgence in sales of actively managed funds in 2017 demonstrates that the rise of passive funds is far from linear. But this diminutive figure hides some real pockets of strength for passive funds — such as developed-market equities. For instance, in US equity funds held by European and cross-border investors, just under 50% of assets are in passive funds, according to our calculations. Europe’s active managers really do face stiff competition.

But back to pricing.

The rise of cheaper passive funds has undoubtedly been fuelled by the regulatory changes sweeping through Europe, with the retail distribution review (RDR) and Mifid 2 at the forefront. These measures are forcing greater fee transparency and preventing managers from paying commissions to fund distributors, among other effects. Deprived of this influential income stream, distributors often must choose the lowest-cost solution for clients. As competition has grown more intense in the passive arena, prices have been cut and cut again. Funds charging fees of only 7 basis points to track developed-market equities are now widely available.

How are active managers to respond?

The obvious answer is to slash their own fees. But that means taking a large and undesirable revenue hit. It may also be damaging from a marketing perspective. Active managers aspire to provide a premium service in their search for alpha and do not want to be seen as ‘cheap’. Closet trackers that charge high fees clearly represent poor value, and they muddy the good name of other active funds. Perhaps new pricing initiatives will help fix this?

Some recent examples of these active-pricing innovations include:

• Price drops during periods of low return. These have occurred in some liquidity funds and fixed- and equity-income products to help investors maintain a positive return and hit an income target. Of course, once a price has been dropped, raising it when the sun is shining again can be challenging.

• Price drops to encourage new business. Such measures can boost fund sizes. With new funds, they may take the form of early bird offers. With older funds, they can provide a shot in the arm. One approach is to cull the operating and administration charges for a short period of time.

• Kill performance fees. With investors in specific markets particularly resistant to performance fees, some asset managers have decided to abandon such charges altogether. But this can pose a challenge with the firm’s investors in other markets, who may feel they are getting a poorer deal.

• Sliding fee scales based on fund size. The larger the fund, the smaller the fee approach explicitly passes on the economies of scale to investors. There have been several examples of this in the United Kingdom’s investment-trust space. But if the reverse holds true and fees rise as a result of shrinking invested volumes, it could lead to difficult conversations with clients, particularly if the decline is due to poor performance.

• Levy charges on only part of a portfolio. Some groups charge fees on invested money only, so money held in cash is not subject to a fee.

• Low base fee plus performance fee. On balance this is probably the favoured option of the fund selectors. The main criticism of performance fees is that they typically come in addition to rather than instead of a significant annual management charge. Many managers have introduced funds that have no management fee but do charge operating and administration costs as well as a performance fee.

Pushing the boundaries of pricing transparency cuts across these innovations. Active managers can be more open about the standard fees they charge, their calculations, hurdle rates, swing pricing, performance fees, and any other fee-related methods. Given that actively managed funds charge fees that are a multiple of those on passive products, the benefits of active management must be clearly articulated to clients.

Passive funds look set to retain their allure for the foreseeable future, but there is no need for active managers to simply cut prices and hope for the best or wallow in an existential crisis.

In conjunction with a differentiated, high-conviction product range, imaginative new pricing strategies can help active managers meet client needs and demonstrate value for money.

This blog first appeared on the CFA Institute’s Enterprising Investor platform on 2 November 2017.