A recent investigation into the effect of the government’s Retail Distribution Review (RDR) by financial data provider Morningstar found it has had a significant impact in driving down the cost of actively managed fund costs, but that investors are increasingly turning to ETFs and passive index trackers instead.


A key objective when RDR was introduced five years ago was to stop fund companies incentivising advisers to sell their products by paying commissions; instead, advisers were obliged to have an up-front and transparent agreement with each of their clients detailing the cost of their financial advice and all of the fees they would charge.

The removal of commission payments from fund fees led to the creation of new variants of existing funds, commonly referred to as ‘clean’ share classes- the cost of owning a fund without any ‘hidden’ fees and charges.

‘DIY investors are now much better able to make apples and apples comparisons of funds, and generally the cost of ownership has reduced’

Generally RDR appears to have had a positive influence on the marketplace; DIY investors are now much better able to make apples and apples comparisons of funds, and generally the cost of ownership has reduced.

However, with this new transparency comes the ability to not only compare the performance of funds within a particular sector or peer group, but also the ability to weigh the value add, or otherwise, of active management.

Morningstar has found that investors have increasingly turned to passively managed funds, on the view that not all actively managed funds justify their fees, and advisers are increasingly using passives that they may previously have avoided because they paid low or no commission.


The falling cost of active management


Since RDR came into force in 2013, Morningstar has identified that the average fee for actively managed equity funds has fallen by 18%; almost all new money inflows have been directed to the cheaper clean share classes, but that is not seen as the reason for the fall as there has also been fee compression within clean share classes.

Furthermore there has been competition between fund providers, and investors have apparently discriminated in terms of price and switched assets from expensive share classes to cheaper clean share classes.

Large-cap actively managed equity funds have delivered some of the biggest savings for investors; funds in both the US and UK have seen an average 20% reduction in fees since RDR when looking at clean and bundled share classes combined.

‘funds in both the US and UK have seen an average 20% reduction in fees since RDR’

A UK DIY investor is likely to have a significant allocation of these funds in their portfolio —UK for the home bias and US because it is the largest global economic superpower.

However, whilst the fee reductions Morningstar identified in active strategies are significant, those offered by passives over its study period were even more startling; from an already low base, passive funds reduced their fees by 30% in the UK large-cap equity category, 32% in the Japan large-cap equity category, and by 34% in the European large-cap equity category.

Passive US large-cap equity funds have reduced their fees by an incredible 50%, adding clamour to those that believe that keeping costs down is the key to successful investing; that is certainly compelling when viewed in the context of the record breaking bull run that we have experienced in recent years.


Passive is massive


Now that investors know that the ‘free’ advice they received pre RDR was nothing of the sort, the real cost of active management has become much clearer and many are voting with their feet.

By way of an example, the US has the most efficient equity market in the world, which makes it incredibly difficult for an active fund manager to outperform it; a passive strategy may ‘only’ match the return of the index, but with fees for an S&P tracker as low as 5 bps (0.05%) the net gain to the investor may be better than backing an active manager that even if he does slightly outperform sees his benefit swallowed up in fees.

‘the real cost of active management has become much clearer and many are voting with their feet’

During the period of its analysis Morningstar found that assets in passive US large-cap strategies in its sample quadrupled, whereas assets held by active US large-cap managers grew by 30%, displaying the realisation by investors that generally they could be paying over the odds for actively managed US equity funds with no payback in terms of improved performance.

To highlight the scale of this exodus, in 2013 passive US large-cap equity funds accounted for just over half of invested assets; by mid-2018 that hit 80%.

Morningstar identified that fees for actively managed bond funds, but to a lesser degree – 10% on average since 2013; this could be explained by the relative speed of development of different segments, where there is less competition from passive fixed-income funds.


Active vs passive market share


Morningstar identified that in 2013 passively managed equity funds had around one third market share; today they are approaching parity and set fair to achieve dominance; in large cap funds passives now account for 58% in the UK and 78% in the US.

Fixed-income funds have moved from an 80% in favour of active management in 2013 to 50% now invested in passive funds; passives dominate exposure to UK government bonds where 76% of conventional gilt funds are passive and 59% of inflation-linked bonds.

Outside of these traditional areas, Morningstar identified that ETFs have been a motive force, delivering access to areas such as emerging markets or high yield that had been ignored by the mutual fund index fund industry.


Morningstar concluded that RDR has had a positive influence, delivering greater transparency of fees, and kindled the debate around value for money; generally investors are empowered with better knowledge to understand the cost and relative merits of different investment options, and clean share classes have become cheaper.

However, it believes that despite already having been a cheaper option, passive fund providers have responded better and more quickly to the challenge by cutting fees and launching multiple funds to give access to areas of the market that had previously been inaccessible to retail investors.

Morningstar believes that the industry has responded positively to RDR but that much remains to be done before all retail investors fully benefit from the legislation, and it called upon the FCA to ensure that legacy assets can start to move to clean share classes, in the best interests of investors that may still be paying over the odds.


Leave a Reply