Recent FCA Asset Management Study: A Case for Passive Funds

The Financial Conduct Authority (FCA) has recently published a comprehensive study examining the British asset management industry. While the report is over 200 pages long and most of it is of little interest to the end customer, there are a few points worth noting – and some reasons for concern. We will discuss the key findings below, as well as implications for your investment strategy.

You can find the full report here (interim report; the final is due in the second quarter of 2017).

6 Key Findings

  • The FCA has found weak price competition in the UK’s asset management industry, with negative effects on clients’ net returns. Generally, fund managers are unwilling to reduce their charges, as they don’t believe a resulting gain in volume would offset the fall in margins.
  • Not surprisingly, the cost for the client of actively managed funds is significantly (often as much as four or five times) higher than the cost of passive funds. The difference has actually increased in the recent period. While charges for passively managed funds have fallen in the last five years, actively managed funds have maintained their fees at broadly the same level.
  • When a fund is marketed as active (and priced accordingly), it does not necessarily mean that its investment exposures are significantly different from its benchmark, or from passively managed funds tracking the same market. In other words, clients often pay for active management which they don’t really get. This affects as much as £109bn of assets invested.
  • Overall, the FCA has found that actively managed funds (even when they do invest actively) do not outperform their benchmarks after fees. In other words, you are unlikely to get better performance by choosing an active fund over a passive fund – quite the opposite.
  • While some investors may want to invest in funds with higher charges, expecting these to deliver better investment management skills and higher returns, there is no evidence of this being the case. In general, more expensive funds do not perform better than cheaper funds.
  • While many investors consider past performance when choosing funds, it is not a good indicator of future performance. A vast majority of active managers are unable to outperform their peers for longer periods of time.

What It Means for the Investor

If you could summarise the report’s key message in one sentence, it would be the following:
Paying more for active management is usually not worth it.

This is nothing new. There have been many reports by various academics and research institutions, working with data from different markets and time periods, and most have come to the same conclusion. It is also in line with the Efficient Market Theory, which became popular in the 1960’s, but research with similar ideas occurred as early as the first half of the 20th century.

Beating the market is extremely hard, especially after the higher costs which inevitably come with active management. Even when a manager is able to beat a broad market index in one or two years, sustaining outperformance over a longer period, in different phases of the economic cycle and in different market conditions, is close to impossible. The massive growth of index tracking and passive funds in the last two decades is an evidence that investors all over the world have noticed.

Asset Allocation and Passive Management

The above does not mean everybody should just buy a FTSE 100 tracker and sit back. Different investors have different needs, time horizons and risk profiles, and therefore should have different market exposures. For instance, an investor in his 60’s and about to retire would most likely want to have a portfolio structured differently (perhaps more conservatively) than someone in his 30’s. This should be addressed in the asset allocation phase, where the approach should be highly individual. Passive management only applies once asset allocation (i.e. the weights of factors such as equities vs. bonds, developed vs. emerging markets, large vs. small cap stocks, or growth vs. value) has been decided.

At Bridgewater, we have sophisticated models in place to find the best asset allocation for the particular investor’s needs. Once portfolio structure is determined, we invest in passively managed funds, which deliver appropriate exposures to the individual factors at the lowest possible cost. You can find more detailed explanation of our investment approach here.

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