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Investment: Easy street a dead end for fund managers

Jonathan Davis
Tuesday 20 July 1999 23:02 BST
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EACH YEAR around this time comes publication of an important annual survey of the performance of the fund management business. Last year I commented on its findings, which were - broadly speaking - to say that the business is living in a fool's paradise, coasting on the back of a bull market, but doing little to prepare itself for more demanding times.

A year on, and with the bull market still intact, it is no surprise to discover that the message of the survey, by the management consultants PricewaterhouseCoopers, is also little changed.

The consultants are too well house-trained to use such a vulgar phrase as "living in a fool's paradise". This is my gloss on their findings. The consultants actually say: "1999 showed signs of real pressure on fund managers' margins. Average profitability across all survey participants fell to 29 per cent (from 33 per cent)".

They go on: "More telling than this is that for two-thirds of firms, profits were lower in 1998 than 1997 and for the core sample of participants who have taken part each year and who give the most reliable indication of overall trends, profitability has dropped by around one-fifth. Three participants turned in loss-making results compared with just one in 1997 ... This is in marked contrast to the performance of the market which, despite increasing volatility, has continued to grow year-on-year. So for the second year running, the results are disappointing: firms have again failed to capitalise on the additional revenue available at higher market levels."

The detailed figures, recorded in the chart, spell out how profit margins on all the main types of investment product have fallen in the past two years. For the benefit of those not au fait with the mechanics of how fund management companies make their money, the system - almost uniquely among financial service businesses - has a built-in growth factor that simply rewards firms for doing nothing in rising markets.

Thus, most fund managers are paid by those who invest in their funds on the basis of an annual management charge linked to the total amount of money they manage. So a fund manager with, say, pounds 10bn in funds under management and an annual management fee of 1 per cent will be paid pounds 100m a year. If the market rises 15 per cent the following year, and provided only that the manager does not lose any customers, the next-year fee income will also rise automatically by 15 per cent before the manager gets up to go to work.

This so-called endowment effect is nice work if you can get it - and one reason why, in a long bull market, fund management companies have become such hot properties.

But why then, if things are so good, are they not getting better, despite the exceptionally favourable market environment? It is important to keep these figures in perspective. There are very few industries where the average company makes a 29 per cent profit margin. As PricewaterhouseCoopers point out, the average figures conceal sharp differences in individual performance: the most successful firms have profit margins of more than 50 per cent, and some companies somehow manage to continue losing money even in the longest and most powerful bull market in history.

The answer to the conundrum comes in several forms. One is the persistent tendency of costs to rise in the business. The consultants report that unit costs rose by 31 per cent last year, after allowing for inflation and the rising market. Many firms are spending heavily on IT costs, on marketing, on wages and on administrative systems. Yet productivity is falling, not rising.

No doubt every firm has its good competitive reasons for this phenomenon, but collectively it is hard to see this as anything other than a management failure. The obvious explanation is that it ultimately stems from lax management and so many years of easy pickings. A second factor is the continued advance of our old friend, the tracker fund.

The amount of pension fund money now managed passively rather than actively has risen to 22 per cent. This figure ignores the large amount of money managed by what are know in the trade as "closet trackers", managers who effectively keep their portfolios very much in line with the relevant market indices, but continue to charge an active manager's fee, hoping not to be rumbled.

Last year was an exceptionally bad year for active managers: figures from CAPS, one of the two main pension fund performance analysts, show actively managed funds underperformed the market indices by a whopping 3.5 per cent in 1998. In the retail market, contrary to the doomsters' predictions that index funds would fare less well in market downturns, PricewaterhouseCoopers' figures show tracker funds outperformed actively managed funds by 2.5 per cent even during the sharp market downturn in the summer and autumn of last year.

It would be silly to expect index funds to do quite so well every year. Equally, they are not going to go away, since what they have done is expose the heavy - and on average insuperable - cost burden that active management places on those who invest in that way.

The important point for the fund management business is that the cost genie is out of the bottle, and won't be easily replaced. Costs have been rising, and prices are at last coming under pressure as more and more investors wake up to the reality of what their fund managers are costing them and demand a better deal. One way this is manifesting itself is in a recent move towards performance-related fees. It would be a big surprise if we do not see more of them. The industry is left facing a future of continued pricing pressure and rising costs, even before you factor in the effect of any market slowdown (which can only exacerbate the effects). It doesn't take a genius - or even a management consultant - to foresee that this is not a sustainable state of affairs. Something must give.

So we may at last be entering a buyer's market. The Internet, which makes hitherto arcane price and performance data available to anyone, should further reinforce that trend. Better education in financial matters will also help. But the consultants rightly warn against assuming that life is necessarily going to change overnight, or in a simple direction. They make the point that investors logically should want more than just cheap investment products and the highest possible returns. They are (or should be) just as interested in good service, in management of risk and in consistency of performance against expectations.

The future will lie in part with tracker funds and with fund managers who can best meet these wider aspirations of service and value for money. Performance on its own will cease to be the main driver of success and fund managers will have to work harder to earn what will probably be a smaller slice of the industry cake.

Davisbiz@aol.com

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