When Seeking to Reduce Fees Marginal Gains Matter

Cyclists

How do you reduce fees without compromising your core strategy? This age old commercial challenge is one now facing the asset management industry. Study after study has shown that funds with the lowest fees consistently outperform those with higher fees, and are attracting more inflows as a result.

Asset Managers Revisiting Securities Lending as Fee Pressure Bites 

In the last year alone, investors have withdrawn $259 billion from active equity funds while investing $185 billion in ETFs and other low cost passive products.1 Morningstar research has shown that 95% of all flows over the last decade have gone to funds in the lowest cost quintile.2 And if competitive pressures weren’t tough enough, regulators across the globe are issuing proposals and rules that emphasize product costs and shareholder fees. In the U.S. the Department of Labor’s Fiduciary Rule is likely to drive advisor managed retirement assets to lower-cost products and in Europe, the U.K. regulator will soon deliver its report on competition in the asset management industry, with one of the stated aims to “map out charges across the asset management value chain.”3

A level playing field? 

The challenge for active managers in particular is that the core components of their strategy simply carry more cost than their passive equivalents. By its very nature, active management requires more investment expertise that needs to be paid for. On top of that, portfolio turnover is often far higher for active managers, with the increased amount of buys and sells representing 10-20 bps4 of cost ‘drag’ alone to the average active fund according to Morningstar.

While these costs can always be managed, there is realistically little room for most active asset managers to do so without compromising their core strategy. There are though some other steps active managers can take and still stay true to their core approach. These are not in the portfolio management process itself, but in the post trade, operational domain where techniques such as efficient FX execution, portfolio hedging, and securities lending can help active managers keep more of the performance they are generating, and reduce fees.

Marginal gains matter.

Often overlooked by active managers as either ‘not worth it’ or potentially detrimental to their investment objectives, securities lending can generate a valuable revenue stream to offset some of the higher management fees and trading costs associated with active management.

Consider the Vanguard Small Cap ETF and the iShares Russell 2000 ETF, which have generated more income from lending (27bps) than they charge investors (20bps). In other words, investors are effectively “paid” to own the ETF by fully collateralized loans of securities. Even if the average return for most funds is closer to 5-10bps, this, like the impact of higher turnover, compounds over time into real money. Because of this, securities lending has become central to the low cost passive approach with 95% of the lowest cost ETFs engaging in the practice.5

Why then would active managers still be reluctant to engage?

Not built for me? 

Active managers that have felt securities lending isn’t designed for them are right – it mostly isn’t.

85% of securities on loan are sourced from sovereign wealth funds, banks, pension plans and insurance companies, with surprisingly only 15% from asset managers.6 Consequently, most securities lending programs have not been designed to cater to the needs of asset managers, who because they make the ultimate investment decisions, tend to pay closer attention to the potential impact of lending. If asset managers are going to embrace securities lending more widely, they need a different approach to the standard offering, which all too often seeks to maximize total returns through large balances on loan combined with a flexible collateral policy.

Tailor for best effect

Most equity funds can generate the majority of their lending revenue from less than 2%-3% of their assets (by comparison, some industrial scale programs may put over 50% of a portfolio on loan). By focusing on lending a handful of high-fee loans, the potential for operational disruption is reduced substantially and because the intrinsic value of the loan itself is adequate enough to generate an acceptable return, taking further credit risk with the collateral is unnecessary.

Also, the industry is now more transparent, with better data, and more flexible technology than ever before, allowing managers to address the question of whether lending will conflict with their core investment objectives. The short answer is that it should not if constructed correctly. An agent specialized in servicing asset managers will be able to lend within detailed specified parameters and if even more control is required, pre trade tools can be made available which allow managers to selectively approve individual loans based upon the estimated revenue potential, as well as the broader considerations of that loan. Examples of such are the manager’s position versus the overall availability of assets in the lending market, and the correlation between securities on loan and share price. In other words, asset managers no longer need to accept a choice of either handing over their portfolio to an agent to lend at their discretion, or not lending at all.

Conclusion 

Securities lending is not of course a singular solution to the challenges of fee compression. No asset manager lends securities because the revenues are large enough to correspond to those of a well-executed investment strategy. Lending returns will always be incremental rather than game changing. However, asset managers who lend would all agree that lending revenues are a vital component in off-setting costs and enhancing investor returns, as evidenced by the largest ETF managers who employ lending today. We will give the last word to the CIO of one the world’s largest and fastest growing asset managers….

“We believe in alpha (outperforming the market through active management) as well as beta (tracking the market through passive management). But we have delivered alpha because we have low fees. I don’t care how good you are, it is difficult to produce alpha with high fees”.

And in this respect, marginal gains matter.

– John Wallis at john.wallis@bbh.com

 

1 Twelve months through February 2016. Source: Morningstar Direct. 

2 Morningstar, 2015 Fee Study: Investors Are Driving Expense Ratios Down, April 2015 

3 FCA Asset management market study, Terms of Reference. November 2015. 

4 Kinnel, Russel. “It’s Flowmageddon!” Morningstar.com. 7 Apr 2016. 

5 Predictive Power of Fees, Why Mutual Fund Fees Are So Important, May 2016 

6 ISLA SL report 9th April 2015 Distribution copy 1.0