John Maynard Keynes described Wall Street as being like a beauty contest where the judges don't choose the best-looking candidates. Instead, they choose who everyone else thinks are the best candidates.
And those opinions can change suddenly. Up until Election Day, the conventional wisdom on Wall Street was that assets would flow to the largest fund companies with the lowest costs. But with Donald Trump's victory, Wall Street suddenly sees the beauty in broker-sold active management funds.
“The planets are lining up for old-line money management firms,” said Erik Oja, research analyst for CFRA Research. “Investors are expecting fund companies to get some regulatory relief, and, with expectation of a faster-growing economy, they're getting more of their animal spirits back to work.”
While big, low-cost fund companies may be the winners in the long run, fund companies with good long-term track records — and the advisers who sell them — may have the most admirers on Wall Street.
Fund company stocks have long outperformed the funds they sell. While the largest fund companies — Vanguard, American Funds and Fidelity — aren't public, a handful of companies are publicly traded, and they tend to do very well indeed in a bull market. Cohen & Steers (CNS), for example, has gained an average 26.7% a year since the bull market started on March 9, 2009, versus 18.8% for the Standard and Poor's 500 stock index with dividends reinvested. Blackrock (BLK) has soared 22.9%. T. Rowe Price (TROW) is up 21.0%.
And the reason is fairly simple. Funds, like advisers, charge fees based on the percentage of assets they manage. Fidelity Contrafund (FCNTX), for example, charges 0.7% a year in expenses. The fund has $105.9 billion in assets, and the fund grosses roughly $741.3 million a year.
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But fund companies have faced two powerful headwinds. The first is an increasingly risk-averse investing public that has been burned by two epic bear markets in the past 16 years. Those who fled high-flying growth funds in 2000 got burned by value funds in 2007. The result: Flows to funds have overwhelmingly favored bond funds, which typically have lower expense ratios than stocks.
Investors have poured $171.9 billion into stock funds since January 2014, versus $337.5 billion into bond funds, according to the Investment Company Institute, the funds' trade group. On a global basis, $1.5 trillion has poured into bond funds in the past decade, while exactly zero has gone to stock funds, according to Bank of America Merrill Lynch.
The second blow to fund companies' bottom line: Much of the money that has flowed into funds of all stripes went into low-cost index funds. In the past 12 months, actively managed funds have seen $294.7 billion in investor cash walk out the door. Passively managed funds have welcomed $212.3 billion, according to Morningstar.
The charm of passive management, from an investor's viewpoint, is low fees, and both individual investors and institutional investors have come to appreciate the power of cost savings.
“You're seeing a lot of pressure on fees all the way down the chain,” said John Stomper, partner at Grant Thornton. “Investors are moving toward the low-cost funds.”
For fund companies, falling fees mean falling profits, something Wall Street loathes. If Fidelity Contrafund charged the same as the Vanguard 500 Index fund, it would take in about $169 million — a welcome amount for many small fund companies, but not the kind of profit margins Wall Street prefers from mutual fund companies.
“The shift from active to passive management has been going on for more than two decades, with the emergence of lower-cost ETFs accelerating this trend,” wrote Greggory Warren, who covers fund company stocks for Morningstar. “We continue to forecast 10%-14% organic growth for ETFs during the next five years, albeit at the lower end of that range now, as the industry was expected to get a lift from full implementation of the Department of Labor's fiduciary rule.”
At least until the election, the pinch of lower expense ratios had been apparent in fund companies' stock prices. T. Rowe Price stock, for example, had fallen 8.72% from the start of the year through election eve. Invesco (IVZ) was down 12.7% and Legg Mason (LG) tumbled 24.4%.
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Hardest hit were midsized companies that relied on sales from advisers and brokers and strong performance for their funds. Calamos Asset Management, for example, plunged 31.1%. Waddell & Reed (WDR) dove 39.9%.
“Mid-sized fund companies that can't get the economies of scale are struggling with their cost structure,” Mr. Stomper said.
At least for the moment, however, the election of mr. Trump to the presidency has alleviated some of wall street's fears. waddell & reed stock has jumped 18.2% since election day, versus 2.75% for the s&p 500. Ameriprise (amp) has soared 24.6%, and franklin resources (ben) gained 12.8%.
“There's good reason for them to be up so much,” said Mr. Oja.
Part of the reason, of course, is that the stocks were clobbered in the run-up to the election. Nevertheless, while the majority of the electorate wants action on health care from Mr. Trump, the financial services sector has long bemoaned its regulation requirements.
“There won't be a rollback of Dodd-Frank, but anything that will slow the growth of regulations will help,” he said.
Many investors in fund company stocks are hoping, of course, that the DOL rules will not be implemented, or at least will be significantly watered down. (This is exactly the opposite, of course, from what many investors and registered investment advisers hope.) Among other things, they would require that advisers and retirement plan sponsors act in the best interests of their clients — which would include offering the lowest-cost funds available to meet a client's need.
Many brokerage houses have already made adjustments to their offerings ahead of the DOL rule, and those have hit higher-cost funds hard. Edward Jones, for example, announced in August it would curtail access to high-fee funds for retirement investors and slash investment minimums. Commonwealth Financial Network, a leading independent broker-dealer, said in October it would stop offering commission-based products in individual retirement accounts and qualified retirement plans, although recently it said it would go back to commission IRAs if the law was repealed.
(Related read: Merrill Lynch eliminates commission IRA business in response to DOL fiduciary rule)
Fund flows have shifted violently from bonds to stocks since Mr. Trump was elected. During the first post-election week, U.S. stock exchange-traded funds and mutual funds saw a $25.4 billion net inflow, according to Bank of American Merrill Lynch. It was the largest inflow since December 2014.
Part of the reason for the newfound enthusiasm for stocks could be Mr. Trump's promise to spend billions on infrastructure, as well as to slow the growth of regulation. Because such spending would likely be inflationary and lead to higher interest rates, money has poured out of bond funds, to the tune of $9.1 billion in the first post-election week alone.
“If Brexit marked a 5,000-year low in global interest rates, Trump marked the moment when investors started to position for a secular bond bear market,” said Brian Leung of Bank of America. “Price action is always violently big at secular inflection points.”
The stock market, however, isn't noted for its long-term wisdom, and the post-election pop in mutual fund stocks could be a temporary retracement of a longer-term trend. Morningstar's Mr. Warren doubts that Trump's election will slow the long-term trend toward lower fees and fiduciary standards.
“Many geographies, such as the United Kingdom and Australia, have already passed fiduciary regulations, so enhanced fiduciary duties in the U.S. are in keeping with the times,” he wrote. “Within the U.S., the move to fee-based advisory accounts from commission-based, increasing market share of passive investment products, and use of productivity-enhancing technology, such as automated investing, were all occurring well before the initial Department of Labor's fiduciary rule was proposed.”
And, he notes, from a purely technical view, fully repealing the DOL fiduciary rule could take months or even years. And in that time, the notion of low fees and fiduciary responsibility would be even more firmly entrenched in investors' minds.
So for brokers and other advisers, rejoicing at the demise of the DOL could be premature. While funds and advisers may see fewer regulations and a reduction in some old ones, a large rollback is unlikely. If you're an adviser selling high-cost products in retirement accounts, you will probably either have to change your model or expect an erosion of assets.
The same is most likely true for the mutual fund industry. Small, boutique firms will likely continue to appear and prosper. Even though the bulk of the industry's assets are concentrated in the top 100 mutual fund companies, there are still thousands of funds and hundreds of fund companies.
Midsize funds, like midsize advisers, will probably have to merge to achieve the kind of scale they need for a future of lower fees. That's a trend that has been in full swing this year: Janus Capital (JNC) and Henderson announced a merger agreement in October, while Eaton Vance (EV) said this month it would buy social investment firm Calvert Investments.
And large fund companies will be able to compete on price. A company like Vanguard, which has an unusual mutual structure, can get by comfortably charging 0.16% a year on a $100 billion fund. (That's still $160 million.) Privately owned Fidelity, which has many other profitable arms, can use a low-cost index fund as a loss leader in the hopes that sooner or later active management will rebound.
Otherwise, even big fund companies will need strong returns to justify their fees.
“A five-star fund can help you immensely,” said Mr. Stomper.