The mutual fund industry in the United Kingdom could be wasting as much as 700 million a year managing smaller funds that could be more efficiently managed on a consolidated basis. Or so claims an analysis published today by Mercer Oliver Wyman.
At a time when fund managers are casting around for antidotes to plunging asset values, the Mercer Oliver Wyman analysis suggests they could reduce cost:income ratios by 20 per cent via the simple device of lumping funds together- transferring assets to competitors and third-party providers to exploit the economies of scale.
Mercer Oliver Wyman point out that the average UK mutual fund investor is faced with a bewildering array of choices. At the end of last month, at the start of year four of a bear market, Bloomberg identified over 240 billion invested in over 2,100 different funds in the UK*, managed by 135 asset managers. The funds range in size from the top 30 (ranging from 1 billion to 5 billion) to the bottom 40, each of which has less than 1 million under management. Nearly three quarters of the funds – or 1,570 of them – manage less than 100 million, and 544 less than 10 million.
Mercer Oliver Wyman argue that, far from keeping prices down and performance up, competition of this kind denies consumers the benefits of economies of scale. “The costs of managing a fund simply don’ t vary much as the fund grows, although it obviously requires investment to capture those flows in the first instance,” says the consultancy firm.
Mercer Oliver Wyman estimates that the average fund should have annual fixed costs of approximately 400,000, with each 1 million of assets costing just 260 a year to manage once the fund is in place. On that basis, a 200 million fund should cost about 25,000 more than a 100 million fund in “manufacturing” costs, while producing 1.5 million on average of additional income.
“Obviously, this varies according to the asset class, geography and other factors, but the point is clear: size clearly matters here,” says Mercer Oliver Wyman. The firm goes on to argue that, for the UK mutual fund industry as a whole, these economics produce an average manufacturing cost of 37 basis points, giving a cost:income ratio in the 25-30 per cent range for manufacturing alone (excluding the cost of marketing and distribution).
“But the scale curve is steep,” warns Mercer Oliver Wyman. Funds under 25 million in size will have costs greater than annual fees and will therefore make a loss unless other cost-cutting measures are employed (see graph). Generally, funds will struggle to deliver profit at less than 40 million in funds under management- and this group of sub-scale funds includes nearly 1,200 funds (or more than half the total number of funds in the UK). Mercer Oliver Wyman estimate that 285 have succumbed to the sub-scale “trap” as a result in falling markets over the last three years.
Which means that, with the average fund size of over half of the parent companies below the 40 million threshold, one in two fund managers must consolidate or die. Even amongst the top ten managers, nearly one in three are sub-scale by this definition. Mercer Oliver Wyman warn that ignoring the problem and waiting for a rising market to rescue them would be an extremely optimistic strategy. For the smallest 700 funds, stock market values would have to return to 1999 levels to have any effect.
Cutting costs by putting multiple funds under a single fund manager or team of fund managers will only reduce their appeal to retail investors, argues Mercer Oliver Wyman. Similarly, eliminating the fund managers altogether by switching to passive indexing – a logical step for the ‘average’ manager, who on average fails to beat the index anyhow – will also make funds harder to promote and price generously. Adopting a cynical, semi-passive approach, of managing the fund less actively, might cut costs, but would again fail to impress retail investors. And simply closing smaller funds, says Mercer OLiver Wyman, is complicated and expensive. “None of these presents a great solution to the problem,” concludes the firm.
Which means the only solution is consolidation of funds. Mercer Oliver Wyman estimate that, if the industry was limited to a maximum of 100 funds in each sector, operating costs could be halved. These savings rise to 67 per cent if the number per sector was limited to 50 and to 80 per cent with a maximum of 20 funds per sector. “This last would still present the retail investor with over 260 funds to choose from, while presenting owners of asset managers with an average improvement in overall cost:income ratio of 20 per cent,” says Mercer Oliver Wyman. “If, even a portion of these savings were passed on to investors, overall returns, after adjusting for costs, could improve dramatically.”
Mercer Oliver Wyman adds that, while its analysis covers only the UK, the same problems and opportunities are present throughout Europe. “Domestic fund consolidation within each country market offers the first level of opportunity,” it says. “Beyond that, to the extent that regulatory frameworks and tax treatments harmonise, consolidation across borders will allow further consolidation within the Euro zone.
However, the firm says it does not expect change of this type and scale any time soon. “Fund managers will always look to use new fund launches and smaller funds strategically as ways of having top quartile performance available or creating interest in the IFA and direct markets,” it says. “However, for individual asset managers, there is a real opportunity to re-think whether competitive advantage accrues from the management of those smaller funds or the branding and to look for opportunities to outsource accordingly. On the other side of the trade, insourcing has fantastic economics, with cost:income ratios of less than 10 per cent readily achievable on funds ‘bought in’ from other providers. New Star’s recent deal with Aberdeen may point the way to further deals in the sector in this respect. Certainly we should see a rise in ‘white labelling’ of funds as a way of cutting cost on the smallest without closing them.”
Mercer Oliver Wyman is also encouraged by regulatory developments in the UK, which will release independent distributors from the need to distribute products from every provider. “This will accelerate the need for manufacturers to demonstrate value to distributors and the retail investor,” says the firm. “Forward-looking manufacturers are already reviewing the future of smaller, uneconomic funds that don’t contribute in the world of the near future. Fund consolidation will be one outcome of this trend.”