INDUSTRY TRENDS—ETFS, PASSING MANAGEMENT, MARKET CONSOLIDATION The industry has been undergoing an upheaval over the past 20–30 years. As Exhibit 7 shows, the number of UITs (trusts) declined sharply from 1997 to 2014, dropping to about half its numbers. During this same time period, the growth in ETFs has exploded along with corresponding AUM. As Exhibit 8 shows, the largest dollar growth occurred with mutual funds and the strongest percentage growth rate occurred with ETFs during the 1997–2014 period. Mutual funds grew from $4.4 trillion to $15.8 trillion over this cycle, while ETFs increased from $7 billion to approximately $2 trillion. Much of the move- ment occurred in passive fund management and index- based strategies. As Exhibit 9 shows, the average assets per invest- ment company have increased significantly, too. Even though the number of firms has increased, the amount of dollars at each firm has risen at a faster rate. For example, as Exhibit 7 shows, the number of mutual funds has increased 37% (from 6,778 to 9,260), while Exhibit 8 shows that the growth in assets within mutual funds has increased by 254% ($4,468 billion to $15,852 billion). Exhibit 9 provides the simple implication (Assets/Number of firms) that the average mutual fund company has nearly tripled in size from approximately $660 million per firm to $1.71 billion. Interestingly, the average ETF size has dropped in the past 10 years (from $1.5 billion to $1.36 billion), while the number of ETFs has soared (228 to 1,974).
Hedge funds often charge a management fee of 1% (or more) along with a performance fee, but many tradi- tional managers can no longer charge even 1%. Passive investment strategies and exchange-traded funds (ETFs) have been driving management fees down below 50 basis points (0.5%). This brings pricing pressure to the industry. As Exhibit 6 shows, the average expense ratio has dropped by more than 1/3 in the past 15 years (from just above 1% to less than 70 basis points). This pricing pressure is squeezing emerging manager margins con- siderably and shifting more risk to setting up a firm. Managers either have to shoulder the burden personally or cut costs—further limiting essential staff or removing critical databases. Neither outcome is desirable for long- term growth/performance. Running a business below break-even causes prob- lems with service providers, prospective employees, and potential investors. Service providers concerned about non-payment will either refuse to engage business or demand personal guarantees. Top-level personnel will favor organizations that offer superior perks/salaries/ financial security. They will avoid emerging managers until they become established. And savvy investors will shun unprofitable ventures out of fear of morale hazards and hidden liabilities. These converging forces create a tough environment that makes it difficult to gain orga- nizational momentum. As a result, fragile infrastructures tend to decay over time, further reducing the likelihood of success. Once a vicious cycle is set in motion, it is unusual to reverse course. In the financial industry, the rich get richer and the frail go out of business.
E X H I B I T 6 Equity Funds Average Expense Ratio
Source: Fidelity platform 9/1/2015: 16,660 listed mutual funds and ETFs.
8 T HE E PHEMERAL L IFE OF AN E MERGING F UND M ANAGER
W INTER 2015
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