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Is Active Management a Commodity?
Active fund managers believe they are better than average and yet most also believe they are all the same. This paradox is explained by their fees: they charge a premium for their services, yet their fees tend to be indistinguishable from each other. This equivalence of fees could suggest a few things which we explore further: perhaps they operate as a cartel, maybe they lack self-belief or they see what they do as a commodity.
Cartels, of course, have similar hallmarks – undifferentiated pricing and high margins being the obvious overlaps with active asset managers. But that is probably where the analogy with cartels should end. Cartels are price setters and active managers – today, anyway – are certainly not price setters, they are price takers. Yes, their margins are high, too high, but they aren’t able to hold their line anymore. We are seeing an indiscriminate collective climb down on fees across the active management industry and expect this trend to continue.
If anything, the active fund management community are behaving the opposite to a cartel today – their actions suggest that what they offer is more like a commodity that is widely available, than a rare, closely guarded proposition. Besides this being reflected in their indiscriminate fee cuts, it seems embedded within their self-imposed M&A activity too. The number of mega active manager mergers is unprecedented, creating behemoth firms that seem to signal from the inside that active management is commoditised. Is it not broadly true that active management is better suited to having less assets, fewer products, more investment focus, good cultural alignment, owner management and long-term shareholders? Many of these traits are up for sale in the mega mergers, rather than being protected. Asset gathering is their mantra and this means price comes down further (in our view).
Another issue is the organisational structure – if genuinely skilful investors reside inside a mega organisation, they lose pricing power too. Sales teams need many products to sell and if one stands out as higher fee compared to similar ones, it is not easy to sell. And relationships need to be protected – will the head of sales in a large firm turn away business from a really important customer on the basis of fees? Probably not. Holding the line on fees inside the larger firms is hard for these reasons and so it feeds a system that ends up pricing active management like a commodity.
Fee structures are also culpable. By linking fees to asset growth, it is no surprise that assets grow and new products are invented. Some managers we see run five different strategies at a time – are they not portfolio administrators then? It seems inevitable, if incentives drive behaviour, that fees that encourage size will also encourage the average. This, in turn, will also encourage lower fees, of course.
There is a further nuanced issue at play here too. Active managers have seldom been able to explain their value proposition to us – and, of course, the onus is squarely on them to do this. Let me explain mechanically what I mean. Active managers back themselves to have skill, not luck, drive the added value they hope to deliver. This means they should also have an idea of what a skill-less outcome would look like otherwise their definition of skill is unsubstantiated. So, all we ask is for them to explain both a skilful and skill-less outcome to us and, in so doing, back out their value proposition.
This discussion of value proposition may seem like semantics or perhaps us trying to quantify what is inherently unknowable. Not at all, it is critically important to do, even if it is difficult. This is because the key piece needed is for active managers to link their fee to their concept of added value. The higher the value (the skill), the higher the fee and so it should be in their interests to do this exercise. But we get few good answers on this and so we have little to tie the fee back to – is it fair, is it in proportion to the added value? We don’t know. And so few managers end up holding their line on fees when they really should.
We believe deeply in the role of active and passive investment strategies and have no real bias either way. But, we also agree that, on average, active managers need to reduce their fees and margin quite materially – because our evidence is that the average active manager struggles to add value after fees. But, equally, we would like to see more self-belief from those in the minority who do add good value and therefore end up in a world where active management has real price discrimination. A commodity type pricing, where bigger is better, will be a poor development for clients and active managers alike. Developing clear assessments of their skill and added value are critical remedies. As is the ability for smaller firms to thrive. We also need to innovate on fees. But our fear is that the current trajectory is towards a world of the mega firm, where commodity type fees pervade and active skills are dampened.