Monday, August 20, 2018
The Future For Equity Funds
The biggest news to come out for a long time for equity funds has to be the announcement By Fidelity Investments that they were introducing two index funds without annual expense charges on August 1st. The ramifications were quite apparent as stock prices for Franklin Resources and Legg Mason eased significantly.
The last 15 years have seen the rise and rise of indexed funds, pioneered by Bogle's Vanguard. The future for active fund management seems to be reminiscent of Jebediah and his horseshoes cobbling business.
The no annual fee index fund by Fidelity reeks of someone scheming to pull them all in and upselling other products to them. The premise was further justified by its policy to only offer the no-fee fund to retail investors and not funds or institutions.
The trend of indexing does not look to be stopping anytime soon. In 2010, Vanguard surpassed Fidelity as the largest manager of mutual fund assets. It had in 2010 $5 trillion compared to Fidelity's $2.5 trillion. The rise of indexing was not only growing, the net effect of investors pulling out of actively managed funds compounded the effect. In 2017 alone, investors pulled $55b from Fidelity's actively managed funds.
The Indexing Trend
The trend of opting out of actively managed funds is worth examining. It is not based on the performance of the fund alone, surprisingly. Danoff, who took over Fidelity's $131b Contrafund in 1990, has seen steady redemptions by investors over the past few years despite his record of BEATING the S&P by an average of 3 percentage points A YEAR.
How is indexing affecting the rest of the fund management market? Well, hedge funds are finding it near impossible to raise funds unless they are proven and has the consistency of returns above 15% a year for at least 3-5 years. Even the 2-20 rule is almost obsolete: 2% annual management fees and 20% shares of profits.
The Lure Of Risk Aversion
Are market forces mushrooming to divert most of investing funds into indexing? Isn't that a bit average? Or is it that the risks of poor performance by pension funds outweighing the benefits of outperformance - is that driven by miss the targets, you are fired mentality... doesn't that reward mediocrity?
The Depletion Of Alpha Returns
Or has retail investor given up on chasing the alpha returns? Or the era of personality-driven investing over???... thanks to the glut of quant trading which theoretically captures the alpha much faster. There is only so much alpha returns in the marketplace. The rise of quant trading has to deplete the alpha returns for active funds.
Studies since the late 80s and 90s have always confirmed that 80%-85% of active funds generally underperform their benchmarks. Maybe that truth has finally taken hold. It does take time for people to react to verifiable truths. I mean the banks and fund also have a lot of marketing dollars to keep the facade on that active fund management is still viable. Well, 20 extra years is long enough before investors say "hey, you're fucking us up royally".
What is the benchmark now? Vanguard should be the golden mean that everything else gravitates to. Investors in Vanguard funds pay only 0.11%-0.14% a year and they get the best of indexed returns without any stress. The rest of the industry (active and indexed) has an average annual fee of 0.62%. You can easily surmise that the 0.62% has the other indexed funds around 0.2% and the other actively managed funds at around 1%. You can almost picture the next few years how this scenario will play out, with Vanguard winning of course. (Blackrock did come out with the lowest fee of just 0.03% for an equity ETF in 2015 but that was an outlier).
Dangers of Indexing
Index funds on its own are fine. The trouble is that plenty of indexed funds are available via ETFs. If every investor in indexed funds stays invested day in day out, there will be no issue. The reality is that while many are ok with indexed investing, they also practice timing the market for indexed funds.. i.e. pull out funds from ETFs when there is calamity in the markets. When they do that in substantial amounts, this will exacerbate any market weakness as the funds will be forced to continue to dump indexed stocks in the respective ETFs.
The sad thing is that it could result in a vicious cycle which could trigger panic selling over days.
The Age Of Normalised Returns
The world will have to be content and contend with very average returns. We are talking of 3%-6% a year over the longest time. This scenario will be further emphasized the larger the pool of funds that are in indexed funds. Presently some 45% of US equity funds are passively managed and should surpass the 50% mark within two to three years. Imagine the figure at 60% eventually... whats the point of having CNBC, whats the point of reading FT or WSJ, whats the point of listening to quarterly results briefing, whats the point of equity research ...
The Last Bastion ...
That is why I keep telling people who want to invest on their own, that the only justification is to directly invest in SMALL CAPS only. Indexing will take care of the mid to large caps. 99.99% of indexed ETFs cannot touch small caps due to lack of liquidity. Only in small caps can alpha be discovered, its the last untouched bastion.
You can also surmise that the only actively managed funds that will succeed are those small caps funds (only thing now is to drop the bloody annual fees from 1.5% to 0.5%).
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