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Are the economics of active management becoming unsustainable?

Fidelity called the viability of a major fund platform into question, according to a report

Feb 27, 2019 @ 3:01 pm

By Greg Iacurci

When one of the world's largest money managers calls the economics of a major fund platform into question, it raises a few eyebrows.

Fidelity Investments, which manages $2.5 trillion for investors, said the ongoing movement to low-cost mutual funds presents "unsustainable economics" for its FundsNetwork platform, the business model of which is "broken," according to a company document from 2017 detailed in a story published Wednesday in the Wall Street Journal.

Fidelity is being investigated by the Department of Labor for a hidden fee it supposedly charges fund companies whose products are available on the platform, which holds $1.5 trillion in customer assets, according to the Journal. That fee could be passed on to investors and make up for reduced revenue elsewhere, the report said.

A lawsuit filed last week also attacked this so-called "secret" 401(k) fee, calling it a "kickback" that's undisclosed to investors and employers. The Labor Department has jurisdiction over employer-sponsored retirement plans.

A Fidelity spokesman declined to comment on the Labor Department investigation and memo discussing business economics.

Fidelity's "infrastructure" fee, at issue in the DOL investigation, seems to be a way to combat some of the low-cost trends playing out in asset management. Someone with knowledge of Fidelity's business operations said the firm had not yet been contacted by the DOL about the investigation. The firm doesn't share details of the administrative fee for competitive reasons, the source said.

Fidelity isn't the only one feeling the pinch from broad industry dynamics. Active managers, whose fees are often higher than those of their passive-management counterparts, have been getting clobbered over the past several years. Passive managers have gobbled up market share and seen a massive influx of new money while active managers have seen net redemptions as investors and their advisers have ridden a decade of positive market returns and become more cost-conscious.

"The active equity world has been bleeding assets over the past few years," said Todd Rosenbluth, head of ETF and mutual fund research at CFRA Research. "It's just a newer world for these asset managers that focus on active management."

Assets held in actively managed mutual funds and exchange-traded funds still eclipse those of index funds: $10.4 trillion versus $6.6 trillion as of year-end 2018, according to Morningstar Inc.

But last year saw $308 billion in net assets leave active funds, while index funds took in $457 billion in net money, according to Morningstar. Passively managed funds have swelled six-fold since 2008, while active assets have roughly doubled.

Total fund assets
Net fund flows
Source: Morningstar

Concurrently, overall investment fees have dipped. In 401(k) plans, fees for domestic equity mutual funds dropped to 0.46% from 0.65% on an asset-weighted basis from 2009 to 2015, according to BrightScope Inc. and the Investment Company Institute.

Roughly 95% of inflows into target-date funds went to passive investments in 2017, according to Morningstar, citing employers' "demand for low costs." While Vanguard Group, which primarily sells index funds, has extended its dominance over the TDF market, swelling its market share more than 4 percentage points to 36% in two years through 2017, Fidelity's has decreased nearly 3 points to 14.1%, according to Sway Research.

Fidelity and other firms have taken several approaches to tackling some of the negative aspects of the low-fee trend on their bottom lines. Some have introduced more index funds of their own as a sort of hedge and to cater to investors' preferences. Fidelity has taken this to the extreme, introducing the industry's first zero-fee funds last year.

And this isn't to say all active managers are struggling. American Funds, for example, boosted its share of the TDF market 2 points, to 5.1%, over 2015-17, according to Sway Research.

To some observers, despite the bleak data, the economics of active management haven't become unsustainable, and likely won't get to that point.

"I think there will be a leveling out," Mr. Rosenbluth said. "I don't think we're anywhere close to a path where there's no role for active management."

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