It may only take two to make a market, but it costs a lot more to market a fund.
According to a new paper by Nikolai Roussanov and Hongxun Ruan at the University of Pennsylvania and Yanhao Wei at the University of Southern California, the fund industry spends more than a third of its $100 billion in annual revenues on marketing, primarily through sales loads and 12b-1 distribution fees.
‘Is marketing a purely wasteful rat race, or does it help imperfectly informed investors find attractive investment opportunities more easily?’ the academics wondered. ‘Does it enable capital to flow toward more skilled managers or, instead, distort allocation of assets by channeling them toward underperforming funds?’
Roussanov, Ruan and Wei looked at 2,285 actively managed US domestic equity mutual funds between 1964 and 2015, investigating the relationship between their reported distribution costs and other characteristics such as performance and size.
They modeled the industry through a system developed by the University of California’s Jonathan Berk and Carnegie Mellon University’s Richard Green to explore how assets would be rationally allocated between funds in a more efficient marketplace – one without frictions such as search costs.
As you might expect, this model revealed that fund assets are inefficiently distributed: The vast majority of strategies were too large relative to their performance, while the top performance decile held fewer assets than it should given the alpha it generated.
Could the billions spent on fund marketing account for the spread of assets between strong and weak managers? Roussanov, Ruan and Wei reckoned so. ‘Our estimates imply that marketing is relatively useful as a means of increasing fund size,’ they reported.
Indeed, they discovered that on average an increase of one basis point in marketing expenses led to a 1% increase in a fund’s size. All strategies benefited from this trend, regardless of their performance. The single extra basis point in marketing fees prompted a 1.15% increase in assets under management for funds with the best returns, but even for those with the lowest returns it boosted a fund’s size by 0.97%.
‘We find that marketing expenses alone can explain 10% of the variation in mutual fund size,’ the authors summarized. ‘This explanatory power is comparable to both fund manager skill and fund price.’
While that may be encouraging for asset managers, the news is less good for clients. Roussanov, Ruan and Wei also calculated that the search costs incurred by the average investor through these fees were equivalent to around two thirds of the mean annual gross alpha produced by funds in their sample.
That is evidently not a desirable outcome for investors, so what if marketing and distribution charges were banned? In the researchers’ model, three things happened in this scenario.
First, the mean expense ratio in their sample dropped from 160 basis points under present fee schedules to just 83. Intriguingly, this reduction of 77 basis points was greater than the average observed marketing cost of 62 basis points in the cohort of funds.
‘This result indicates that preventing funds from competing on non-price attributes such as marketing significantly intensifies price competition,’ Roussanov, Ruan and Wei argued.
Second, the total market share of active managers in the fund industry slipped from 74% to 68%, with more investors moving to passive options in the no-marketing environment. And third, this shift from active to passive was accompanied by an increase in the average active fund’s performance as measured by mean gross alpha.
This could be as a result of weaker active managers leaving the industry as passive gained market share, or because of performance being buoyed by the smaller average fund size in the absence of marketing incentives – given the well-documented tendency of larger funds to underperform smaller ones – or maybe even both effects operating at once.
‘Thus, in the aggregate, marketing reduces welfare,’ Roussanov, Ruan and Wei concluded. ‘The reason for this inefficiency is that funds engage in a wasteful arms race as they compete for the same pool of investors via marketing.’