Industry faces 'fire on the horizon'

Jonathan Davis: The latest annual survey of the investment management industry shows that 1999 was another excellent year for the business

This has hardly been a vintage year for index funds, but they continue to make inroads into the professional and retail investor market. At least a quarter of pension funds assets are now managed passively, at an average cost that rarely exceeds 0.15 per cent a year, and, in some cases, is given away for nothing as a loss leader. In the retail market, the charges remain considerably higher, with most funds continuing to charge 1 per cent per annum, not as much as the average actively managed fund charges, but a hefty whack for a simple product.

This has hardly been a vintage year for index funds, but they continue to make inroads into the professional and retail investor market. At least a quarter of pension funds assets are now managed passively, at an average cost that rarely exceeds 0.15 per cent a year, and, in some cases, is given away for nothing as a loss leader. In the retail market, the charges remain considerably higher, with most funds continuing to charge 1 per cent per annum, not as much as the average actively managed fund charges, but a hefty whack for a simple product.

Despite this, the amount of money in the index-tracking sector continues to edge up: around £11bn is now invested in this way in the unit trust business, and there is more to come as the long-term performance figures become more widely known.

The indexing trend is causing concern in fund management, where fat fees and healthy margins have long made for a comfortable existence. The latest annual survey of the investment management industry by PricewaterhouseCoopers, shows that 1999 was another excellent year for the business, with profit margins stable at 30 per cent of revenue.

As the chart shows, except in the institutional market, the profitability of many types of funds/services increased again last year, after dipping in 1998. Investment trusts retain their enviable status as the most profitable of all managed products, a stark contrast to the general perception that investment trusts are having a tough time. The analysts at PwC attribute the decline in profitability of UK institutional business to the continued advance of indexed mandates, whose impact has resulted in fees charged by investment managers dropping by 5 to 6 per cent per annum over the past five years.

Their data shows the average retail fund generates between 1.25 per cent and 1.75 per cent a year from the funds it manages, six to eight times as much as professional investment institutions pay for what is in many cases a similar product.

The consultants say while the robust profitability of the funds you and I buy in the retail market is a cause for satisfaction to the industry, this happy state of affairs "may not be sustainable beyond the short term in light of recent shifts towards greater transparency and openness in this sector". This is a polite way of admitting consumers are finally wising up to how much they have been paying for the funds their advisers put them into, and are increasingly making use of the much more widespread data on costs and performance now becoming available, especially on the internet.

The more enduring worry for the investment management business is that the real reason for their continued stable margins is not their efficiency or ability to service their customers satisfactorily.

In fact, the survival of those 30 per cent profit margins mainly reflects the continued strength of the stock market over the past five years, during which the market has risen by a third. As fund managers' fees are based on a percentage of how much money they look after, every time the market goes up, their profits go up by the same percentage, a so-called "endowment effect".

If you adjust the costs firms reported for this rise in the market, the figures actually show the underlying cost profile of the business is continuing to rise. If we experience stabilisation or decline in market levels, the profitability of the business is going to take a nasty hit unless corrective management action is taken.

The consultants talk about the industry facing "a fire on the horizon". They feel the only companies to survive and prosper long-term will be those which acknowledge the trends developing in the industry and clearly differentiate themselves by their efficiency, the superiority of their products or the quality of their service. Given the economies of scale in fund management, one aspect becoming apparent is increasing consolidation in the industry: barely a month now goes by without some fresh example of a merger or acquisition by the biggest players within the industry.

Pulling in the other direction is a trend towards increasing specialisation, with the investment process (the actual buying and selling of shares and portfolio construction) among several elements in the industry's value chain. Packaging funds in tax-efficient wrappers such as ISAs is another increasingly important segment of the process where, PwC observe, the market is "especially inefficient, providing advantage to those with genuine expertise". But "as regulatory and fiscal differences are ironed out, and investor education advances" it thinks "the fire will burn especially fiercely here".

At the operating end of the business, outsourcing of things such as custody is common. The recent emergence of fund "supermarkets" is one example of how the distribution channels for managed funds are starting to change. In a fund supermarket, a provider such as Fidelity offers a range of funds from different suppliers, not just its own. The internet provides the technology which makes this a reality, though advisers rather than investors seem to be making most use of the new medium, so far.

Where will it all end? That partly depends on how rapidly consumers move to take advantage of the new power they have. Only when they are sufficiently well-informed to know how much muscle they really have will they be able to take full advantage of change.

In the United States, one of the more disturbing trends is that the annual expense ratios of the average mutual fund have gone up rather than come down. Investors there seem strangely happy to pay for the massive marketing budgets rival providers spend trying to gain market share from each other, although investors will pick up the bill for all this zero sum game.

The consultants point to the day when many mutual fund customers choose to invest directly, relying on automated advice from intermediaries who tailor portfolios to the individuals' investment objectives, just as always happens in the professional market.

Another possibility they suggest is the emergence of complex and specialist financial products which are devised by clever investment bankers and sold directly for the first time to individuals.

We have already seen some of this in guaranteed equity products, which use the derivatives markets to change the risk/reward ratio of equity investment for investors. At present, most of these guaranteed products have not been cost-effective, once you analyse the price of the insurance you are taking out, but you can be sure many more clever schemes will emerge.

Finally, PwC suggest, ordinary investors may eventually opt to take their investment management from several providers: for example, in time you may want to have your own performance measurement recording service rather than rely on the one provided by the fund management company you chose to put your money with.

The most remarkable aspect of industry practice is not how quickly it is changing, but how slow investors and fund managers have been to embrace the brave new world they are now in.

But these are the directions in which the business is going and ordinary investors have much to gain from riding the trends as hard as they possibly can.

* Davisbiz@aol.com