According to conventional economic thought, competition should be positive for the market generally and for buyers in particular. That in turn should be good news for asset allocators, who enjoy multiple options in every fund category.
Leaving aside the question of performance – a competitive football league does not necessarily yield an objectively outstanding team – fierce rivalry for investors’ money should at least keep prices low and ensure a high standard of client service.
But alas, two new studies suggest that this is not the case in the fund industry. Take fees first. In 1980, domestic equity funds held less than $26 billion; by 2016, this had swelled by a factor of 264 to $6.86 trillion. Over this time, the average asset-weighted expense ratio increased from 66 basis points to 82 basis points, with the equal-weighted average expense ratio even higher at 1.28%. With US equities having gained 7.5% a year over the past decade, that average fee has eaten almost a fifth of the market return.
Despite some recent consolidation as passive investment has become more popular, this rise in fees has occurred as ever more active funds have been launched. New research by Sitikantha Parida and Zhenyang Tang of Clark University, Massachusetts, explores whether competition is indeed failing to bring prices down, and if so, why.
Parida and Tang began by assessing the competition in a given fund sector through the Herfindahl-Hirschman index, a statistical measure of concentration in a market. Looking at the Lipper subcategories of the US equity universe between 2000 and 2015, they found that funds in areas with above-average competition had expense ratios that were on average 3.4 basis points higher than those in less competitive peer groups.
What’s more, this was principally derived from higher management fees, rather than from greater 12b-1 costs – meaning it was not simply the case that tougher competition compelled funds to spend more on marketing – or from other expenses such as brokerage. Indeed, funds in sectors with above-average competition charged six basis points more in management fees alone than in more monopolistic categories.
How have these funds been able to resist conventional economic forces in this way? One explanation is that investors in competitive sectors don’t care about fees.
‘These findings support the narrative that fund performance and performance persistence decrease in more competitive markets and this drives performance-sensitive investors away, leaving behind less performance-sensitive investors in the more competitive segments,’ Parida and Tang argued. ‘Hence, fund managers operating in more competitive segments take advantage of it by increasing management fees.’
A second recent paper, again by Parida, investigates how competition in a fund sector affects portfolio disclosure. Theoretically, greater transparency should appeal to investors, so enhanced disclosure should be a marketing advantage in competitive segments.
Before 2004, funds were only obliged to reveal their holdings on a semi-annual basis, but could choose to release them more frequently. Parida discovered that from 1999 up to that change of regulation, funds in the most competitive categories were 22% more likely to simply adhere to the minimum semi-annual requirement, rather than being more open.
In 2004 the minimum became quarterly, although funds can still choose to publish their portfolios each month instead. And again, since that year, funds in the most competitive sectors have been 42% more likely to take the quarterly rather than the monthly route.
Put together, then, it seems that competition will not cure what ails asset management. ‘We show that market competition per se may not be sufficient to drive down mutual fund fees,’ Parida and Tang concluded. ‘Regulatory interventions targeted at encouraging competition or lowering barriers of entry may not be effective either. Instead, interventions targeted at making small investors more aware of the fund fees may help as it will make them more sensitive toward the performance of mutual funds after fees are deducted.’