Morningstar Magazine - June/July 2017 - 37

In a recent study of U.S. equity funds, we found
there were thousands of funds that charge
annual expenses that exceed the average prefee
excess return for their category. In other
words, these funds-which collectively held
around $2 trillion in assets-appear priced
to fail. Their expense hurdles are too high.
What brought us to this point? The confluence
of several trends:
Bundling Management and Distribution Expenses
While investment management is a scalable
business-one doesn't need to hire dozens of new
portfolio managers to handle each incremental
billion in assets-distribution expenses tend not
to be. Why? Because platforms and distribution
hubs demand a steady revenue-sharing stream
from asset managers. While 12b-1 is capped, that
doesn't preclude fund firms from padding their
management fees to defray any extra distribution
costs. This has made running a fund a whole lot
less scalable than logic would suggest, and it
partly explains why expense ratios have remained
stubbornly high.
Availability of Passive Funds
Index funds and ETFs used to be harder to access
through advisors, some of whom were limited to
"menus" of pricey proprietary funds or those of other
firms that revenue-shared their way onto the select
list of options. But today, cheap beta is everywhere.
Given this, active funds' fees are measured against
the cost of passive alternatives. That's a much
bigger challenge, one that many funds are failing.
Competition Growing Stiffer
As mentioned, excess returns appear to have
become scarcer in some areas, and activefund success rates have fallen accordingly. In our
most recent Active/Passive Barometer report,
we found that only about 10% to 20% of active U.S.
equity funds beat their benchmark over the
10 years ended Dec. 31.
The way forward is clear: Funds must cut prices
and take steps to better share scale economies
with their investors.
Align with Shareholders

The time has come for fee structures and other

incentive programs that more strongly align fund
company interests with those of shareholders. This
is not the first time I've taken up this cause: I
wrote about the appeal of performance-based fees
in the February/March 2015 issue of Morningstar
magazine ("An Investor Friendly Fee," Page 80).
I suggested active funds should consider adopting
performance-based (so-called fulcrum) fees
as a way of differentiating, offering a number of
potential benefits to investors, including:
Less Index-Hugging
There's nothing to stop a manager from mirroring
the benchmark and collecting a base fee. But this
manager will lag by the amount of his or her
expenses, if not more, a fact not lost on investors
(many of whom are already abandoning closetindex funds for index funds and ETFs). A
properly structured performance-based fee could
create an incentive to take prudent, wellpredicated bets.
Less Trading
Managers might be prone to feel like they need to
"be active" to earn their flat (or, if investors
are lucky, tiered) management fee. This can lead
to shorter-than-healthy time horizons and wanton
trading, which hurts performance before
and especially after taxes. A performance-based
fee isn't an antidote to this problem, but could act
as a healthy deterrent, mainly in decoupling
"trading" and "value-added." For example,
if investors in a fund realize that the manager
won't get paid full freight if he or she doesn't beat
the bogy, then they might be less insistent on
seeing evidence that the manager had turned over
the portfolio in the prior quarter. Investors and
portfolio managers alike will realize that it's not
about trading for trading's sake.
Less Bloat
Today, given the prevalence of flat management
fees, funds are reliant on unit growth. That is, they
must ramp up their assets to grow fees and
keep all of the mouths in the organization fed. This
can lead to asset bloat and funds outgrowing
capacity. A performance-based fee could
create incentives for firms to proactively monitor
capacity. If they didn't, it would threaten
performance and, thus, their ability to earn the
performance fee.

Less Product
Finally, because performance-based fees are
harder to earn, they're likely to repel new
entrants to the industry and thin the herd of its
weaker members.
As I wrote in 2015, "There are still too many active
funds, most of them marginal. A smaller pool of
higher-quality funds is better for investors and,
therefore, the industry itself over the long term."
Differentiate

As of May, there were nearly 2,100 unique active
U.S. equity funds, more than half of which
were large-cap funds. Do we really need this many
active U.S. stock funds? The answer, of course,
is no. And that takeaway probably can be
applied to the broader active-fund complex, which
seems overgrown and commoditized.
Fund companies will need to differentiate to
succeeed-to build a hard-to-replicate set
of capabilities or carve out a toehold in a hard-toenter, indexing-resistant niche.
A good example is Cohen & Steers, an active fund
complex that has notched positive net inflows
in 75 of 97 months since the global financial crisis
(as of April). The firm has gathered around $8
billion in net fund inflows over that span.
The firm has been disciplined about carving out its
niche-real estate-and largely staying within
it. It has built a global following for its
specialty. The firm has also chosen an area that
is inherently tougher to index and that is known for
generating plentiful income, factors that
probably alleviate some pricing pressure and
ensure that it has a strong following among
yield-focused investors.
There's room for only so many niche players,
especially in a world in which scale and
efficient reach is so critical. But Cohen has
demonstrated that it's possible to profitably
differentiate. It's a model that other firms would
do well to at least consider. K
Jeffrey Ptak, CFA, is head of manager research
with Morningstar. He is a member of the editorial board
of Morningstar magazine.

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Table of Contents for the Digital Edition of Morningstar Magazine - June/July 2017