"As a long term investment strategy, I don't think the index fund has any competition at all," said the Godfather of passive investing Jack Bogle at a recent speech he gave in Manhattan.
With the recent growth in passive investments, one can see his point of view. Compounding this is the talk in the market about active management being dead. PwC, in its publication Asset and Wealth Management Revolution: Embracing Exponential Change, predicts that passives charge into the limelight is set to continue. Currently, passives account for 17% of the market, but by 2025 we predict that they will account for a quarter of global AuM, a staggering USD 36.6 trillion (see Figure below).
The question we need to ask ourselves then is, why are they growing so strongly? ETFs are transparent, flexible, and cheap. As investors increasingly turn to digital advice and regulators push for a change in asset and wealth management distribution fee models, this inexpensive way of investing will become all the more popular. Furthermore, the bull market that has characterised global equities in recent years is seen by some experts as having inflated the returns of these products substantially, driving more investors to index tracking funds. Recent criticism surrounding active managers has been that they are receiving relatively high fees, even if the fund underperforms its benchmark.
Global AuM projection for 2020 and 2025 in USD trillion
However, active managers are not going down without a fight. Striking back against passives' relatively low fees by moving to performance based models. These new models set a precedent for active management, charging a low base fee and then, depending on performance compared to a benchmark, charging a higher or lower performance fee. Expected to put fund managers to the test, performance based fees are more closely aligned with both investors and regulators desires for a more transparent market. If implemented correctly, and truly providing investors with real "discounts" if performance is low, they will also whittle away at funds that are deemed closet-trackers.
Alliance Bernstein, Allianz Global Investors (AGI), and Fidelity are the first movers in this space. Alliance Bernstein has launched a new fee structure for select US active strategies, and is planning to introduce a similar model in the future for certain European strategies. The model includes a "passive base" management fee with a fee linked to performance on top of this. AGI is set to launch three strategies this December in Europe which will make use of the new performance model. The firm already has three US based funds - US fixed income, US equity, and managed futures - that make use of the structure. The new structure charges almost no management fee if the funds do not beat their benchmark, however if the fund outperforms they can earn a management fee of up to 120 basis points depending on the fund. Fidelity on the other hand will make the first funds available from Q1 2018. Unlike AGI and Alliance Bernstein, Fidelity's new fee structure will pay investors back if the fund underperforms its benchmark. Their "fulcrum" fee is something new for UK-based investors and the manager has yet to announce which new funds will make use of the structure.
I believe that this move to performance based fee models will be revolutionary for active asset management, assuming that they truly align with the expected value proposition that investors are searching for. It will separate those providing Alpha with those that do not and it should restore confidence in active amongst investors. While this may signal tough times for high-cost/low performance active management, it is certainly not a death sentence for all. Active managements' time is in no way at an end.