Last week, I popped in to see the smartly attired men who run Weatherbys. It is one of the few genuinely private banks in the UK. The business from which it stems was established in the late 1700s (it is still a privately owned family affair) and it comes with a good story — the bank itself was founded from the family’s horseracing business. But in one aspect, it is strikingly modern.
Weatherbys has backed out of the old-fashioned wealth management business in favour of being “at the cutting edge” of investment. This means no active fund management. Just a passive global tracker portfolio held on someone else’s platform and rebalanced every now and then. Why?
Beating indices is very hard (over the past 15 years, about 90 per cent of active fund managers have completely failed to do it) and paying them to try to do it is very expensive. So why not go passive and cheap?
Weatherbys may be a traditional bank, its head of private banking told me, but passive is the “modern way”. Indeed it is, which is why everyone’s at it. Nobody with even the tiniest bit of interest in investing can have failed to notice the huge rise of passive investing.
Almost all experts on investing have endorsed it (including me); most new launch businesses in the wealth management sector in the UK rely on it; and the global exchange-traded fund market has expanded from a mere $700bn in 2008 to about $4.4tn now.
And this might only be the beginning: Morningstar notes that the amount shovelled into passive funds in 2016 was more than four times that of active funds. Four times!
This is all terrible news for the big active fund managers. They’ve been making huge profits on the back of overcharging for their services for decades now. And they really, really don’t want to have to stop.
For normal investors such as you and me, this means the fun is just beginning. The big fund managers have started to fight back (I accept that your view of fun might be different to mine — don’t write in).
There are several interesting sides to this battle. Some are quite right, some are nonsense. Under “quite right” comes the argument that there is actually no such thing as passive investing — someone has to choose which indices to track and someone has to choose which stocks go into any one index. So a passive strategy is really no more than an active strategy which is followed by millions of people.
Next is governance — or social utility. Shareholder capitalism is based on the idea that caring and engaged shareholders keep an eye on companies — berating or selling them if they are unproductive; if they grotesquely overpay their managers at the expense of their workers; if they mess up their odds of long-term profitability by mistreating staff, suppliers and the environment; or if they put themselves in legislative danger by generally behaving badly.
But if shareholders are only in it for cheap, mediocre returns — and have no idea or interest in what they actually own — none of this holds. The corporate world can do as it wishes, and in the end our valuable capital is allocated according to size (the biggest get it) rather than quality (the best get it). That’s bad.
This argument should be filed under “quite right” — and I would love it if it were. Sadly, most fund managers are absolutely useless at fulfilling their corporate governance role. I can’t believe their existence makes much difference to the way global companies behave. So that argument is filed, with a heavy heart, under “nonsense”.
The third argument put forward by the big boys as to why we should stick with them is performance. Sure they say, things have been embarrassingly awful for years now. But the pendulum is swinging. Tracker funds have done brilliantly since 2008, largely because of the way in which cheap money has made all asset classes move together. Instead of focusing on company fundamentals and on valuations, the market has been obsessed with QE, low interest rates and the global growth and political dynamics that drive them.
That has made stock picking — and hence paying for active management — appear to be verging on pointless. But this will change as the crazy monetary policy of the last decade reverses, and the things that should matter (namely valuations and individual company behaviours) start to matter again.
It could even be starting already. In the first half of 2017, just over 50 per cent of active funds managed to outperform their index. Hmmm. I’m going to be kind and file this half under “quite right”, and half under “nonsense”. One six-month period, in which investors who agreed to pay more for overperformance ended up with a slightly better than even chance of getting it, is not evidence of a new dawn.
You will have noticed an elephant in the fightback room. Cost. Given that the main attraction of a passive fund is that it is cheap (and the less you pay in fees, the more likely you are to make money) you would have thought that the big managers would have had a go at slashing fees, or at least realigning them in the interests of their investors. You’d be wrong.
Some have (honourable mentions to Equitile, Orbis Access, Woodford Patient Capital and Bailie Gifford). But in the main, the focus has been on avoiding rather than confronting the issue. That may have just changed.
Fidelity — one of the biggest asset managers in the world — announced on Tuesday that it is changing the way it charges investors in its active funds. Cost, it says, is “one of the challenges the industry can no longer duck”. From January next year, Fidelity will start to introduce new share classes of active funds which come with what it calls a “fulcrum fee” — essentially, a variable management fee.
The basic charge on the funds will be low, and the variable bit will reflect performance. Ergo, if the fund underperforms, the variable bit of the fee will be returned to investors. If it outperforms, a bit more will be charged (with a floor and a cap — levels of which are yet to be determined). We are, say the firm’s management “going to put our money where our mouth is”.
This represents progress in that it really does align the interest of investors and managers (when we lose, they lose). But I can’t tell you quite how much progress it represents until I know what the fees will actually be (“the modelling is ongoing”, says Fidelity) and we can see in detail how the performance fee actually works. You can call it a “fulcrum fee” all you like, but if it depends on performance, it is still a performance fee.
However, if (and it is a big if) the net result is that the base cost (before the performance bit, but after all other costs) to someone holding an actively run Fidelity fund is the same as the cost of holding a passive fund elsewhere, then we will really be getting somewhere.
The industry has always demanded that we pay more to have the chance of outperforming. I don’t like that (the odds are not in our favour). But a system in which we pay more than passive equivalent fees if — and only if — the manager outperforms? That could save the active management industry, assuming of course that active really can outperform passive.