Passive funds an active threat for Europe's fund managers

Reuters - UK Focus

(Repeats Sunday's story without changes)

* Warren Buffett flags support for 'passive' investing

* Post-crisis focus on cost driving increase in demand

* Many more expensive 'active' managers facing squeeze

By Simon Jessop and Nishant Kumar

LONDON, Aug 31 (Reuters) - Warren Buffett built a fortune ofnearly $60 billion from astute stock picking, but when the83-year-old dies, the vast majority of the money he leaves hiswife will be parked in a fund that simply moves in step with anindex.

The afterlife plans of the man nicknamed the Sage of Omaha,revealed in a letter to his investors earlier this year,underline a sea change afoot in the investment industry.

Fed up with high fees and poor performance, investors areincreasingly shunning active fund managers who promise to beatthe stock market in favour of cheaper, passive funds, whichsimply track it.

Such funds account for about a quarter of the money investedin the UK stock market, up from 15 percent a decade ago. Theswitch is accelerating, with index funds attracting inflows of$3 billion in the first half of this year, while activeUK-focused funds saw $4 billion leave, a Reuters analysis ofdata from fund tracker Lipper showed.

The passive wind blows even stronger in the United Statesdue to years of underperformance by active funds, which has ledto institutions parking half of their equity allocations inindex trackers, according to data from State Street.

And the shift is spreading to other parts of the world,putting at risk revenues earned by money managers, banks andbrokerages that service funds and more than half a million jobsrelated to fund management in Europe alone.

Industry experts expect Europe, where active mutual fundsare still the dominant force, making up 80 percent ofallocations, to move more in sync with the United States,following the lead of Britain, the region's top capital market.

"It's only a surprise that investors have taken this long torealise that the puffery around long-term outperformance, starmanagers, etc., is just that ... puffery," said Peter Douglas,founder of investment consultancy GFIA.

NICE N' EASY, TILL NOW

Patchy economic recovery since the 2008 crisis and increasedregulation, such as a proposed clampdown on a fund's activitiesin times of a crisis to ensure stability, have hampered activemanagers' ability to outperform.

Weak gains have already made it harder to justify fees thatare sometimes 10 times or more than the cost of a passive fund,which in the case of the most liquid exchange-traded funds canbe less than 0.1 percent on a headline level, before factoringin brokerage, transaction and tax costs.

While some active funds have cut their charges or introducedcheaper products in response to the threat, the gap is stilllarge.

Leading index fund providers such as Vanguard, Deutsche Bank (Xetra: 514000 - news) and BlackRock (NYSE: BLK - news) have cut fees this year to grab market share,putting further pressure on the active managers to do more.

"You can't charge what you could in the past," said ChrisIggo, chief investment officer for fixed income at AXAInvestment Managers, which manages 582 billion euros.

"In a way it's a good thing. For many years the fundmanagement industry had it easy ... Return on capital in fundmanagement has been very nice."

Vanguard, whose S&P 500 index fund Buffett favoured in hisletter to investors, and BlackRock have taken in thebulk of new money to European fund houses since the summer of2013.

The biggest equity fund investing across Europe, VanguardEuropean Stock Index Fund, managed $22.4 billion at the end ofJuly, more than twice the size of Fidelity Funds-EuropeanGrowth, the biggest actively managed fund for the region.

The growth in passive funds is reflected in the industry'snet revenues, which have remained flat globally for the lastfour years, according to the Boston Consulting Group, even asfunds under management hit a record $69 trillion in 2013.

ADDED VALUE?

The biggest problem for active fund managers charging morefor their services is consistently beating the market.

A study of fund returns in local currency over the last 10years using data from Lipper shows only 35 percent of the fundsinvesting in Britain have outperformed the FTSE All Share TotalReturn index, which includes dividend payouts fromconstituents.

That percentage declined to 29 percent in the first half ofthe year.

Active funds investing across continental Europe, meanwhile,have performed even worse, with just a fifth of them gainingmore than the MSCI Europe Total Return index since 2003.

The star managers that do manage to beat the crowd oftenfail to maintain their outperformance.

Of the 107 top quartile funds, or those ranking among thetop 25 percent by gain from investing in British stocks in 2013,only 18 managed to repeat the feat through June-end this year.

Two of them held that spot for the previous five years, andnone managed to achieve the feat over the last 10 years.

A similar pattern is found when looking at other regionsaround the world, Reuters data showed.

For Buffett, this meant one thing for the average investor.

"The goal of the non-professional should not be to pickwinners - neither he nor his 'helpers' can do that - but shouldrather be to own a cross-section of businesses that in aggregateare bound to do well. A low-cost S&P 500 index fund will achievethis goal," he said in his letter to investors.

The struggle to pick a winner consistently has led someleading institutional investors to change how they invest, withsome of them putting the bulk of their funds, as much as 70percent in some cases, in passive investments, said LaurenceWormald, head of research at Sungard APT.

Money managers of all stripes are also developing newproducts to offer cost-conscious investors a middle groundbetween the pure passive and active. So-called "smart beta"funds track a bespoke index that has been tweaked to weight itin different ways, using factors such as stocks' cheapness orprice momentum.

Net flows into U.S.-based smart beta equity funds stood at$234 billion in the first seven months of the year, alreadyexceeding the total inflows of $208 billion recorded last year,according to data from BlackRock.

In spite of the strong demand for low-cost passive funds,active fund managers will continue to play a key role in theglobal investment industry because the possibility of higherreturns is always attractive, particularly in a low yieldenvironment.

In addition, there is only so far the market can go passivebefore the price of a stock - still the most popular asset classfor passive investing - becomes detached from fundamentals,thereby allowing an active manager to profit more handsomely.

The ability to profit in such as manner has been evidencedmost recently by firms such as Glaucus Research and Gotham CityResearch, who have spotted corporate fraud through a deepinvestigation into company accounts, such as at Gowex.

"Passive investing is obviously at the mercy of thesefrauds," said Michele Gesualdi, chief investment officer ofhedge fund investor Kairos.

"If you are with a long-only active fund or a hedge fund,then certainly you have a chance to avoid these frauds or maybefinding them as shorts," he added, referring to short-selling,the ability to sell a borrowed stock and profit when it falls.

Still, some 3,200 money managers in Europe will need tobroaden their expertise across asset classes and develop newproducts to reassure investors they are adding value.

"That's the acid test," said Thomas Ross, head of Europeandistribution at U.S. money manager William Blair, which manages$62 billion, largely for institutions.

"Can you beat the benchmark after fees? If you can, you'llfare well, and if not, the market will move against you andyou'll be indexed." (Editing by Carmel Crimmins and Will Waterman)

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