Fund managers forgo billions in fees in race to the bottom

Asset managers missed out on billions of dollars in fees from US fund investors last year as exchange traded funds ate into revenues from mutual funds, research suggests.

Morningstar’s annual US fund fee study indicates US investors saved nearly $3.4bn in fund expenses last year compared to the previous year as the average asset-weighted expense ratio edged down from 0.37 per cent to 0.36 per cent, continuing a multi-decade downward trend.

The research shows that actively managed funds of all kinds have been the epicentre of outflows in recent years as money has been redirected to cheaper passive funds, driving down average fees. In the past two years alone, passive funds have attracted more than $1.1tn in net new money while active funds shed almost $1.4tn.

However, as the fortunes of Dimensional show — with nearly $740bn in assets under management it is one of the largest US asset managers — the data do not tell the whole story. Its actively managed ETFs have proved wildly popular, albeit at the expense of some cannibalisation of its mutual fund customer base, as the chart shows:

In addition, “the Dimensional data [in the Morningstar chart] is likely to be consistent across the board,” said Todd Rosenbluth, head of research at VettaFi, a consultancy.

“Active managers are being pulled into ETFs and are having success in the ETF space, but part of the money is flowing from their mutual funds,” he added.

He said traditional active managers faced hard choices, “but it’s better to cannibalise their own business than to see the flows into someone else’s business”.

The problem, he explained, is that by entering the ETF market the managers are having to compete for advisers’ and investors’ attention with low-cost index-based products. The result is that actively managed ETFs are charging lower fees than similar or even identical strategies in the mutual fund wrapper.

Fee pressure is evident even for a group such as Dimensional, whose ETFs are largely only marginally cheaper than its comparable mutual funds. This near parity is only the case because it has unveiled several rounds of fee cuts, particularly in its mutual funds, in recent years, coinciding with its entry into the ETF sector.

While the large-scale adoption of actively managed ETFs is relatively recent (Dimensional, which achieved $100bn in ETF assets in September last year, only entered the market in November 2020), the pressure towards ever lower fees is nothing new.

Morningstar noted that demand for the “cheapest of the cheap” has been consistent. Not only have the cheapest 10 per cent of all funds cut their fees almost in half over the past 15 years, but the cheapest 20 per cent of passive funds collected 90 per cent of all inflows over the past two years.

In 2023, $428bn flowed into the least costly 10 per cent of funds while the next cheapest decile of funds lost $25bn.

Research from the Investment Company Institute shows that while active ETFs are beginning to make inroads into mutual fund revenues, most of the damage done to mutual fund market share has come from index funds.

The ICI’s 2024 factbook states that, from 2014 through 2023, index US domestic equity mutual funds and ETFs received $2.5tn in net new cash and reinvested dividends, while actively managed domestic equity mutual funds experienced net outflows of $2.6tn (including reinvested dividends).

Analysis by Elisabeth Kashner, director of ETF research and analytics at data provider FactSet, draws a worrying picture for asset managers. “Asset managers need to manage ever larger pools of money just to break even, at least on the public funds side of their business,” she said.

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“The flight of capital from active to passive strategies has left asset managers in a bind,” she added, pointing out that, even if asset managers tried to compete on performance, research has “shown performance is largely disappointing and generally fleeting”.

However, both Morningstar and FactSet have found signs that fee pressure could be bottoming out, and that some funds are even beginning to raise fees. Zach Evens, one of the authors of the Morningstar report, said in some cases this was the result of outflows triggering automatic fee adjustments.

“I don’t want to call the bottom but I think that we’re getting close,” Evens said. “We’re seeing more reluctance to compete on fees.”