Passive fees dropping faster than active in RDR wake - Morningstar

Scott Longley

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Fees for passive dropped by more than a third more than those for active funds in the wake of the Retail Distribution review or RDR coming into effect in 2013, according to research from Morningstar published last month.

The not-altogether-surprising findings show that while in the intervening period active fund fees have fallen on average by 18%, the average fee for passive funds has dropped by 28% over the past 4 and-a-half years.

Moreover, in certain areas the difference was even more stark. The Morningstar report shows that passive US equity funds saw their fees fall by 50% over the same period and emerging market equity funds fess were down on average 37%.

At the same time as fees have fallen - and obviously not coincidentally - the amounts being invested in passive funds have ballooned. The Morningstar research shows that 40% of all equity fund investments are now passive while for fixed income the trend is even more obvious with the ratio of active over passive now 50/50 from 80/20 just under five years ago.

The Morningstar team make the point that this can only but be viewed as a good thing. "There is no doubt that the RDR has influenced the marketplace, in a good way," the report concludes. "There is greater transparency of fees for the investor, and this has brought to the fore the issue of the assessment of value at a fund level."

So what's going on?

Part of what is going on is that investors are flocking to passive large-cap US funds. Morningstar points out that assets held in passive US large cap fund quadrupled over the period compared with a 30% rise in active AUM.

As Morningstar says: "That reflects the challenge active managers face in beating the most-efficient equity market in the world and the realisation by investors that, for the most part, they're paying over the odds at actively managed US equity funds for subpar performance."

In other words, as Morningstar goes on to say, as transparency improves on charges, investors are "voting with their feet".

"Passive strategies may only deliver benchmark returns in US equities, but with fees as low as 0.05% for S&P 500 exposure, it becomes an easy investment decision for core exposure when so few active managers can achieve a better outcome than a passive fund," the report says.

When it comes to UK assets, the differences are not quite so stark with active AUM growing by 17% but passive up 60%.

What about fixed income?

Morningstar suggests this is more of a "mixed bag." The report suggests that overall active houses have clearly not felt the need to compete as aggressively either between themselves or versus the "rising tide" of passives.

Here the report notes that fixed income has been a latecomer in the "product-development agenda" for most ETF providers. While before their arrival - and indeed even now - the offerings of traditional index fund houses have rarely ventured away from basic bond exposures.

"Largely thanks to ETFs, the range of passive bond funds has widened significantly, and investors now have access to parts of the bond market that they previously didn't," says the report. "ETFs come with a single, clean fee structure, and for some of our selected categories, they are the overwhelmingly dominant—in fact, for US high yield, the only—passive product type on offer."

But the report adds that in Europe, most assets in bond ETFs are housed with one provider - iShares - so the level of fee competition just isn't the same. Indeed, fee reductions registered by passively managed fixed-income funds over the analysis period in most of the selected categories were in the single digits. The average passive bond fund fee has only come down by 4% in asset-weighted terms, in contrast with a nearly 30% drop for passive equity funds.

Yet, as the report notes, this hasn't proved an impediment for the growth of passive investing in fixed income. "Assets in active fixed-income funds in our sample remained broadly static over the period, whereas they more than tripled for their passive counterparts."

Where does this leave us?

What is interesting from the ETF perspective is the degree to which it is the passive industry which has reacted fastest to the post-RD environment, aided of course by external factors such as the long-running bull market in the US. Notably, there is more to go. The report points out that traditional tracker funds still have a lot of legacy assets in bundled up share classes. "Here, the traditional index fund providers have disappointed, with fees edging up at tracker funds."

Shockingly, the report points out that both the Virgin UK Index Tracking Trust and Halifax UK FTSE 100 Index Tracking Fund are still charging investors 1% compared to the cheapest passive options at less than 0.10%. As the report says, and we would certainly concur, "there's simply no justification for such high fees at a passive fund." Time for a 'rip-off fund fees' campaign, maybe? That would shake things up.


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