The Coming Catastrophe For High Fee Active Managers

by: Cullen Roche

Back in 2009, I wrote a very critical piece on mutual funds, basically calling them antiquated products that do the American public a disservice.¹ My general message wasn't to bash active management. After all, I agree with Rick Ferri here - there's no such thing as passive investing. There are only degrees of active investing. But there are smart ways to be active and very silly ways to be active. Mutual funds are usually a silly way to be active, as they sell the low probability of market-beating returns in exchange for the guarantee of high fees and taxes.

What I pointed out back in 2009 was that the mutual fund industry was bloated with closet indexing funds - funds that essentially track an index and charge a huge premium for it. I said this had to end. And thankfully, it looks like the mad rush for the exits is beginning. This isn't only true for mutual funds. This is a trend that will span all of the high fee management space. And I suspect it will go a bit like this:

  1. Mutual funds will become an increasingly antiquated product as investors realize they lack many of the advantages of ETFs and other product wrappers. Some will thrive (such as Vanguard's low fee funds); however, the majority of the space will continue to dwindle as investors realize that most of the space is just bloated fee-sucking closet index funds. What assets they do retain will be primarily legacy assets in 401(k) plans that have failed to update their fund options.
  2. Hedge funds will do better retaining assets, primarily due to strategy differentiation. Thanks to greater legal flexibility, many of these funds will continue to thrive, and AUM could even increase as the migration from alpha-searching mutual funds bolsters the hedge fund space. Guru worship and alpha chasing (both misguided pursuits, in my opinion) will be tailwinds. Hedge funds, on the whole, will not be able to justify their high fees, but the chase for market-beating returns will always leave the hedge fund space with a clientele to embrace and shower with high fees. See also: Why Hedge Funds are Sucking Wind.
  3. Fees in the advisory space will come under fire as RIAs adopt index funds and "passive" strategies, but also continue to charge the same 1% fee under the guise of an "advisory fee" instead of an expense ratio. Investors will slowly realize that their advisor charging 1% per year is doing just as much damage as the old mutual fund that charged 1% for a closet indexing approach. See also: Indexing Doesn't Win When it's Implemented Through a High Fee Advisor.
  4. Assets will pile into low-cost ETFs and other low fee platforms as investors realize that they can't control the returns of the financial markets, but they can control the amount of taxes and fees they pay.

Dan Loeb is right. A catastrophe is coming. The end of an era is here. And the American public is going to be better off because of it.

¹ - I was generalizing, of course as there are some fine mutual funds out there, however, as a generalization I think it's pretty fair to say that the vast majority of mutual funds are closet indexing leaches that do no one any good (except for the management companies who charge the high fees).