What effect will the index fund revolution and the Department of Labor’s (DOL) fiduciary rule have on active managers? The data shows that active management is still a healthy business model. But industry consolidation is coming and advisors will need to change the way they construct portfolios.
Indexing is a very low-fee business, with the standard-setting fund Vanguard Index 500 Admiral Class (VFIAX) charging a tiny 0.05% of the investor’s asset balance per year. Active managers typically charge a fee some 20 times higher, around 1% per year, although fees for some popular actively managed funds have come down; the popular fund Fidelity Contrafund (FCNKX) has a net expense ratio of 0.70%.[1]
And the two types of funds are in direct competition with one another.[2] A visitor from Mars would guess that, unless high-fee active funds can provide a consistent and predictable return that exceeds the comparable index-fund return by more than the fee difference, active managers will lose most of their market share. Indeed, that visitor would wonder how active managers were able to garner as large a proportion of assets as they currently have.
Yet active managers have thrived, despite not only failing, on average, to beat comparable index funds by at least the fee difference, but also underperforming the index in an absolute sense. (In every period there are, of course, some excellent active managers, but it’s incredibly hard for investors to distinguish the winners from the losers in advance.) And index funds have been available to institutions for 45 years and to individuals for 40 years; if index funds were the better investment after fees are considered, they have had plenty of time to displace active managers.
They have not done so.
Recent trends, however, show that – finally – indexing is taking a real bite out of active manager market shares and profits. Reinforcing this trend is the recent DOL “fiduciary rule,” which makes advisors into fiduciaries who have to act in the sole interest of the client.[3] Most experts interpret the rule as saying that, if an advisor recommends an active manager, she must perform due diligence to conclude that the manager’s expected extra return, beyond that of the benchmark or index-fund alternative, is at least equal to the extra fee. This is a very difficult standard that could inhibit clients’ hiring of active managers.
So, should we expect the movement of assets from active to passive management to continue? How far will it go? How much will it affect the profits of the active management industry? Finally, will a shortage of active managers cause markets to become more inefficient, creating problems for indexers and opportunity for active managers, so that the trend will someday reverse?[4]
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