Morningstar - Q3 2023 - 8

Dispatches
Three Strikes Against
Active Management
How the industry
undermined
its own credibility.
PHILLIPS CURVE
Don Phillips
Great investors like Ralph Wanger or Warren
Buffett have noted how a handful of
shrewd decisions can have a profound impact
on long-term results. Sadly, the same works
in reverse. A handful of bad decisions can
undermine a portfolio. It can also undermine an
entire industry if those choices tilt the odds against
investors. This is seen in the steady erosion
in public esteem for actively managed
mutual funds. I believe that you can trace the
demise of the goodwill once accorded
active management to three bad decisions.
The first was adopting 12b-1 fees. Personal
finance writers had created a mantra among
individual investors that they should only
buy no-load funds. Of course, the brokers
could not sell their clients these funds. But by
shifting the broker's compensation from
a front-end load to a higher ongoing expense
ratio, the industry was able to create the
impression that it offered commissionless funds
while still amply rewarding salesmen.
This looked like a magic solution, but it had
devastating consequences.
For one thing, it created the impression that
professional investment advice could be
had for free, thus undervaluing in the public's
mind the very professionals the industry relies
upon. Moreover, it enabled the creation
of a morass of share classes, undermining the
simplicity and " mutual " spirit of funds.
It also tarnished perceived performance by
replacing front-end loads, which were typically
8
Morningstar Q3 2023
omitted from performance calculations,
with higher expense ratios that were embedded
in returns. Moreover, higher expenses specifically
lowered yields, as yield calculations are net
of expenses, thus pressuring many managers to
take added risks that led to a slew of ugly
blowups. An ethical line had been crossed:
Investment decisions were increasingly influenced
by distribution costs. The fiduciary duty to
clients was subverted by the asset-gathering
desires of management.
Index funds and fund companies that competed
mostly on cost were less likely to embrace
12b-1 fees, but most active funds opted for them.
Salesmen soon demanded these fees not only
on new share classes designed to resemble
no-load funds, but on traditional A share classes
as well. In return for a modest drop in the
front-end load, 12b-1 fees were added to the
expense ratios. This may have been an innocuous
change for future shareholders, but consider
those who had already paid 8.5% to get in. In 1978,
an investor in the Templeton Growth Fund
TEPLX paid an expense ratio of 0.70%. Today the
fund carries an expense ratio of 1.05%, despite
a more than twentyfold growth in assets.
Loyal shareholders saw the economies of scale
diverted away. In time, this lack of loyalty by
the industry to its best clients would morph into a
lack of loyalty from clients to active managers.
The second great sin was paying for shelf space.
Fund supermarkets were a boon to small shops
struggling to compete with juggernauts like
Fidelity. Initially, supermarkets charged funds 25
basis points, and insiders claimed privately
that that fee would drop as assets grew. Instead,
the charge generally rose to 40 basis points.
Fund companies used 12b-1 fees to pay for part
of this cost, but they often had to cut into their
own take. Historically, it had been typical for
a fund manager to offer shareholders breakpoints
on their management fees, charging one fee
on, say, the first $100 million under management,
but lowering the percentage as assets grew.
The supermarket fees, however, did not decline
as assets grew, which led to situations
where much, if not all, of the management fees
on future assets would be going to the
platform, not the manager. Funds responded
predictably: Many altered their prospectuses
to eliminate future fee cuts on their funds.
Again, the economies of scale the industry once
shared with shareholders were usurped
by distributors. And paying for shelf space had
another ugly consequence. Investors now
had to consider whether a fund's availability from
their broker or in their 401(k) plan owed
to merit or to its willingness to pay to play.
The third great sin was allowing hedge fund
managers to market-time public mutual funds. The
market-timing scandals of 2003 not only cost
many fund leaders their jobs and reputations, but
they led to an opportunity cost. Just before
the scandal broke, senior industry leaders were
planning to petition Congress for better tax
treatment for fund shareholders. The U.S. is one
of the very few countries to tax fund shareholders
not just when they sell their investment, but
also when funds declare distributions-even if the
investor keeps the money on the table via
reinvestment. This gives passive funds, which
make fewer distributions, a profound advantage
over active funds, locking many investors into
passive funds for tax reasons. Unfortunately for
active shops, the industry's credibility was
shattered by the timing scandals and any attempt
to lobby for tax changes was squandered.
In pursuit of asset gathering, active managers
have repeatedly compromised their fiduciary
responsibility to shareholders. In the process, they
undermined the simplicity and elegance of
mutual funds, thus further tilting the playing
field toward passive funds and setting the stage
for the migration to ETFs. An industry whose
claim to fame was once giving ordinary investors
access to investing legends like Peter Lynch,
Michael Price, and John Neff morphed into a
processing service led by marketers. The
reputations of both mutual funds and active
management have fallen precipitously.
Today's active managers pay a heavy toll for the
sins of their predecessors. K
Don Phillips is a managing director at Morningstar. He is
a member of the editorial board of Morningstar magazine.
The views expressed here are not necessarily those
of Morningstar.
https://www.morningstar.com/funds/xnas/teplx/quote https://www.morningstar.com/funds/xnas/teplx/quote https://www.morningstar.com/authors/286/don-phillips
Morningstar - Q3 2023

Table of Contents for the Digital Edition of Morningstar - Q3 2023
