Fatter and fewer is a recipe for mediocrity

City & Business
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THE lumbering mammoths that control huge chunks of corporate Britain were joined by a new member of the herd last week. NatWest is paying pounds 466m for Gartmore, the fund-management company. The addition of Gartmore to its own asset-management business transforms NatWest into one of the biggest beasts on the plain. With pounds 55bn of funds under management, it will own an average of 1.8 per cent in every British quoted company. Modest beside the Pru's 3 per cent, perhaps, but still putting it among the top five or six.

There are two fascinating (and potentially worrying) trends apparent in the fund-management industry - the industry that invests money on behalf of pension funds, life assurers, unit trusts and investment trusts. One is that it looks destined to grow very quickly over the next 20 years. The other is that it looks destined to be concentrated in fewer and fewer hands. In other words, the mammoths are going to get both fatter and fewer.

Why the fast growth? First, people are increasingly demanding a better return than the paltry few per cent available from ordinary savings accounts and so will turn to more sophisticated investment vehicles. Americans nowadays already have more invested in mutual funds than in bank and savings & loans deposits. Britain is nowhere near as advanced as this, but the writing is on the wall.

Second, demographics. An ageing population is one that invests more for its old age via pensions.

Third, the increasing reluctance of Western governments to fork out for long-term health and retirement benefits. People are expected to make their own arrangements. Relying solely on the state pension is a grim prospect today and will be grimmer still tomorrow.

Why the increasing concentration? There are three powerful forces at work here. The scale economies in fund management are substantial. It doesn't cost much more to manage pounds 10bn than to manage pounds 1bn, and certainly not 10 times as much. NatWest is doubling its funds under management by the acquisition of Gartmore, but it won't need all the extra staff. Hence the jobs axe, as we report opposite.

Size is helpful, and size allied to distribution is even better. If NatWest can succeed in selling Gartmore products to its millions of account-holders, the deal really will pay dividends. Investors also want greater geographic spread, investing not just in other advanced economies, but also in riskier developing countries, where the growth prospects are so much more promising. Again the larger, more global fund managers score here.

The other factor favouring the giants is the caution - or perhaps pusillanimity - of pension-fund trustees. They will never be criticised for placing pension-fund money with the established fund managers such as Mercury Asset Management or Schroders, say. The Maxwell pension scandal has made trustees even more risk-averse. Moreover, pension funds are tending to reduce the number of different managers they use, and again this favours the bigger players.

There is more concentration to come. Fund management is still comparatively fragmented in contrast to, say, the drinks industry or package holidays or indeed newspapers. There are plenty of banking groups on the look-out for acquisitions to beef up their fund management arms.

They include Dresdner Bank, Merrill Lynch, Morgan Stanley, ABN Amro and Standard Chartered. Meanwhile, talk of mergers between some of the medium- sized Scottish fund managers continues.

Is this a good thing? The evidence is pretty thin. Mergers are all very well if the benefits end up being passed on to the customer. There is little sign of this so far. True, front-end fees for unit trusts have come down, but ongoing annual charges have gone up to compensate. Pension funds still pay almost as much in management fees as they ever have.

But there is a much more serious question about the big-is-beautiful brigade. Are they actually any better at picking investment winners and avoiding the dogs?

They have advantages: they can afford to employ lots of country and sector specialists and they have the clout to ensure that they get the best advice from brokers, and get it first.

But for all that, they increasingly struggle to beat the average, and it is their very size that holds them back. When they go into the market to buy, the market-makers see them coming, and mark prices higher. When they try to sell, the price is lowered.

As it is, fund managers are not primarily concerned with beating the market, but with beating one another. They judge themselves against the industry median, not against any external measure.

There was barely a ripple when almost every fund manager was caught overexposed to the declining markets of Hong Kong and south-east Asia in 1994: it didn't really matter because everyone else was in the same boat. Last year everyone was underweight in the US, and so missed out on the spectacular returns available on Wall Street, but it did not worry them much because their peers were were all similarly caught with trousers round ankles.

The thinking among pension fund managers is that you're more likely to be given the push by a client for being in the bottom 20 per cent than you are to win new business by being in the top 20 per cent. The safe course, therefore, is to be deeply average. It is a recipe for mediocrity and one that can only get worse as the industry heads towards oligopoly. Greater concentration can only encourage the herd instinct and stifle the urge to take positions.

There is a second downside. The bigger you are, the fewer people you can afford to offend. More and more companies become pension fund clients - actual or prospective. One of the theoretical advantages of being big is that you can use your muscle to reform greedy and incompetent managers. The irony is that the bigger you get, the less willing you are to wield that power.

Fatter, fewer and possibly less effective mammoths then, but much more visible ones. The days when institutional investors were shadowy and anonymous are over. Carol Galley, head of investment at MAM, already knows the feeling, after playing the pivotal role in Granada's hostile takeover of Forte in a glare of publicity. The scrutiny can only intensify.

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