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SKARBECK: Investors lose enthusiasm for actively managed funds

October 29, 2016

Ken SkarbeckEarlier this month, mutual fund firms Janus Capital and UK-based Henderson Group agreed to merge. Several factors point toward further mergers among mutual fund companies.

The onslaught from exchange-traded funds has cut into the traditional open-end mutual fund business. ETFs purport to offer better liquidity and lower costs than open-end mutual funds.

Also, increased regulation has made it costlier to operate funds, and mergers should allow fund companies to cut costs and benefit from economies of scale.

In 2012, the U.S. Department of Labor began requiring greater fee disclosure in 401(k) plans, which has put downward pressure on fees (i.e. fund company revenue). In addition, the DOL’s new fiduciary rule requires brokers and advisers to “act in the best interest of their clients.” This will make it more difficult to sell higher-cost mutual funds to retirement plans. Morningstar expects these regulations to push more than $1 trillion into index funds.

At present, the greatest threat to “actively” managed mutual funds—where investment managers do their own stock picking—is the popularity of “passively” managed index funds that aim to match the return of a market index.

While data has long shown that index funds, with their lower costs, tend to beat the investment returns of many actively managed funds, it wasn’t until recently that a massive shift of assets took place. This year, investors have pulled $166 billion from active mutual funds, while plowing $110 billion into index funds.

Regardless, the actively managed fund industry has proved it is resilient. At the end of June, there were 2,159 actively managed U.S. equity mutual funds. The key observation here is that there are just too many funds, and underperforming funds continue to exist as inattentive or apathetic investors let their money linger.

Some fund firms are in no hurry to close a mutual fund, because even a poor performer can be lucrative for their business as the assets under management continue to generate fees. Other fund companies more actively manage their fund offerings. In the past three years, Legg Mason, with $733 billion in assets, has opened 64 funds, closed 91 funds and merged 10 others.

While index funds are capturing huge cash inflows from investors, they have their own set of problems. The most popular index is the S&P 500, which is weighted by the size of the companies in the index. Apple Computer, being the largest U.S. company, makes up almost 3.5 percent of the index, while News Corp., as the 500th-biggest, counts as 0.008%. So future S&P performance will be dictated, or skewed, by the performance of the larger companies. In rising markets, investors are, in effect, buying a greater percentage of the stocks that have performed the best, a “buy high” phenomenon that usually isn’t a good investment strategy.

Because index funds are in vogue, the stocks of publicly traded mutual fund companies are out of favor and might be undervalued by the market. Considering the prospect of increased merger and acquisition activity, investors might want to research the stocks of fund companies like T. Rowe Price, Franklin Resources, Eaton Vance, Waddell & Reed, Cohen & Steers and Legg Mason, to name a few.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 317-818-7827 or ken@aldebarancapital.com.
 

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