Trend toward low-cost passive mutual funds will reduce margins.
For many years, you could have made better money for your clients by investing in the stocks of mutual fund companies rather than the funds they offer. No more — and the Department of Labor's new fiduciary rule may well have something to do with that.
If you were to look at the list of the companies in the Standard & Poor's 500 stock index with the best stock returns over the past 25 years, you'd be surprised to see that T. Rowe Price (TROW), which has gained 7,668% with dividends reinvested, ranks just below Apple (AAPL), which has gained 7,682%. Charles Schwab & Co. (SCHW) has more than doubled those returns: It's up 16,892%. Imagine what American Funds, Vanguard or Fidelity would be worth if they were publicly traded.
And imagine how delighted any fund shareholder would be with returns half that. But mutual funds are designed to reduce risk — and returns — through diversification. While comparing fund returns to individual stock returns isn't entirely fair, it does showcase the mammoth earnings that big fund companies can provide investors.
Those returns aren't the result of speculative bubbles, although fund companies' stocks often get a boost during times of high enthusiasm for stocks. It's because asset management has been an incredibly lucrative business. T. Rowe Price, for example, sports a 25.87% profit margin. Schwab has a 24.34% profit margin. Poor Apple has to struggle along with a 21.70% profit margin, and lives and dies by its ability to create amazing new devices.
But the trend isn't the asset manager's friend here. T. Rowe's profit margin has fallen from 30.9% in 2013. The Baltimore-based fund company certainly isn't alone. Franklin Templeton's margins have fallen to 23.4% from 28.1% over the same period. And the amazing new device in asset management — passively managed open-ended mutual funds and exchanged-traded funds — aren't going to be boosting anyone's earnings.
In the past 12 months, investors — typically at the direction of their advisers — have shifted $306 billion out of actively managed funds and poured a net $176.8 billion into passively managed funds, according to Morningstar Inc. Part of the reason for this, of course, is because of the wretched record of actively managed funds versus their benchmarks. S&P Dow Jones Indexes found that 85.81% of institutional accounts in the large-cap equity space underperformed the S&P 500 over the past five years.
The new DOL rule mandates that advisers take a fiduciary role in retirement accounts. All other things being equal, the rule would strongly push advisers to place clients in the lowest-cost mutual funds. Such an approach would have been mildly helpful over the past five years, S&P suggests: Ignoring fund expenses, 76.23% of actively managed large-company stock funds beat the S&P 500.
A recent report by Moody's Investors Service says the DOL rule will accelerate the move to passive (and less profitable) investments. “Under the new regulation, advisors are expected to ensure investments are in the best interests of their clients, rather than merely suitable for them. In practice, it will become more difficult for advisors to place their clients into higher-cost and more complex investment products,” Stephen Tu, a vice president and senior analyst at Moody's, said in the report.
“Selling low-fee index products, on the other hand, will eliminate many apparent conflicts of interests and minimize fiduciary risk … In addition, the legal risks are highly significant in the new regulatory regime and will impose a higher bar on new sales of more expensive actively managed funds to retail investors,” Mr. Tu added.
As a practical matter, moving investors to lower-cost options means lower gross income from the funds. The retail shares of the T. Rowe Price Growth Stock fund (PRGFX), for example, charge a relatively modest 0.67% in expenses. On $35.6 billion in assets, however, that translates into roughly $238.5 million in gross revenue for T. Rowe Price. T. Rowe Price Equity Index 500 charges just 0.27%.
Similarly, the Franklin Templeton Income A fund charges 0.61% in expenses on $44.1 billion, for roughly $269 million in gross income. Franklin has just started to move into the ETF space and doesn't have an ETF with a similar objective. But if it did, it's unlikely that its expense ratio would be higher than its open-end offering.
For fund companies, the trend toward lower-cost — and less profitable — offerings means their stocks may no longer be the rockets they once were. It also means that smaller fund companies likely will find that consolidation is their best option.
“We've seen outflows from funds that no longer have sufficient asset bases to continue operating,” said Todd Rosenbluth, director of ETF and mutual fund research at S&P Global Market Intelligence. “As we've seen the industry changing, it's going to be harder to be a small player or run a small portfolio.”
