Morningstar Magazine - June/July 2017 - 44

Spotlight: The Future of Investing

Balance of Power Tilts Away
From Asset Managers
Fees and performance will loom large
over industry.

ASSET MANAGER

Laura Pavlenko Lutton and Greggory Warren

The past decade has been a disruptive one
for asset managers and their fundholder clients.
Investors have not only been put off by the
poor performance of actively managed funds, but
they have also increasingly sought out lower-cost
options, with passively managed index-based
products becoming the default choice for
many. The rollout of the U.S. Department of Labor's
fiduciary rule has only heightened the scrutiny
that active asset managers will face as they
look to secure access to retail-advised platforms.
Funds with poor performance track records,
high expense ratios, or low inclusion rates
on platforms are less likely to make the cut with
gatekeepers of the broker/dealer and advisory
platforms longer term.
The shift in the balance of power from fund
manufacturers to distributors is also leading to
greater fee and margin compression. Active asset
managers will need to narrow the spread
between the management fees charged for their
funds and the fees being charged by index-based
products. They also need to improve active
investment performance and enhance distribution
to remain competitive. Industry consolidation
is inevitable as asset managers pursue increased
scale to help offset lower fees and profitability.
We expect to see fund companies consolidate
their funds internally, to increase scale
and eliminate underperforming offerings, and
externally, with midsize to large asset
managers pursuing deals that increase scale
and product breadth.

44

Morningstar June/July 2017

We expect passive fund managers-such as
Vanguard and iShares, which are the two largest
providers of exchange-traded funds-to
continue to garner much of the attention in the
next decade. There's plenty of room, however, for
active asset managers such as American Funds
and T. Rowe Price TROW that have scale,
established brands, solid long-term performance,
and reasonable fees. To be especially successful
in the coming decade, though, we believe that
asset managers will be best served by
differentiating themselves from the competition,
offering low-cost funds with repeatable
investment strategies, and prudently adapting
to the changing competitive landscape.
Fees and Performance Under Scrutiny

For many years, the balance of power in the retail
channel for the U.S.-based asset managers
has been shifting to the distributors of mutual fund
products-the broker/dealers and advisors that
drive many fund sales-without significantly
having an impact on management fees. While the
2008-09 financial crisis sparked consolidation
among many of the broker/dealer and advisory
networks selling funds to retail investors,
the shift primarily limited the amount of leverage
traditional asset managers had when negotiating
payments for shelf space as opposed to
lowering management fees. Asset managers
have kept management fees fairly stable;
however, funds with large asset bases that allow
asset managers to spread their costs more
efficiently have achieved reduced expense ratios
through scale benefits.
The institutional channel has long faced more
scrutiny. Consultants, which act as gatekeepers for

clients, put fees and performance under the
microscope, forcing active managers to clearly
articulate their investment philosophy and process,
as well as provide relevant data analytics
related to portfolio construction, risk parameters,
attribution analysis, and sources of alpha
generation. This analysis helped justify the
strategies' fees. Retail-advised networks have not
been as heavily focused on these metrics as
most of their compensation has been generated by
sales loads and distribution-related fees. With
more retail-advised accounts moving to fee-based
structures, which favor low-cost offerings with
benchmark-like or better performance, brokerage
platform gatekeepers have more influence as
to which strategies are included in client portfolios.
This influence should grow with the introduction
of the DOL's fiduciary rule. It puts fees and
performance under a much stronger microscope.
Broker/dealer and advisor platforms are looking
to eliminate funds with small balances,
especially those that have been underperforming
or that carry higher fees. We were not surprised
to see outflows tick up dramatically among
less-competitive offerings over the past couple
of years. Net outflows for actively managed
U.S. equity funds exceeded $260 billion during
2016-a far larger amount than the $175 billion in
outflows seen in 2015 and the $125 billion in
net outflows recorded in 2008. Nonetheless, these
funds still account for close to one fourth of the
more than $15 trillion in open-end and ETF assets
that Morningstar tracks. As U.S. equity funds
remain big drivers of fee revenue for active asset
managers, the increased fee and performance
analysis on the part of retail distribution
platforms will put additional pressure on active
asset managers' revenue and profitability.
Active Managers Struggle to Beat Indexes

We expect outflows to continue for actively managed U.S. equity funds, given their poorer
performance records and higher fees relative
to benchmark indexes, which are readily investable
via low-cost index funds and ETFs. Poor investment
performance has been a problem for most active
equity fund managers during the past decade.
The Morningstar Active/Passive Barometer report,
which is published biannually, has found that



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