UK investors seize advantage and feast on bargain passive funds

UK investors have poured 92 per cent of the money they have invested into domestically domiciled funds in the past decade into cheap, passively managed index-tracking vehicles.

In sharp contrast, over the same time period 89 per cent of the new money invested in Luxembourg — Europe’s largest fund industry hub — has been pumped into more expensive actively managed funds.

The findings, based on data collated by Broadridge Financial Services, a fintech consultancy, point, in part, to the impact of differing fee models across Europe.

The UK banned independent financial advisers from receiving commission payments for selling funds in 2013, meaning they have no incentive to sell pricey active funds — most of which underperform cheap passive funds over meaningful time periods. The proportion of new money going into active funds was still 72 per cent in 2014, but has fallen precipitously since.

However, most of the EU has not adopted this model, and much of the retail distribution apparatus is based on banks and insurance companies selling their own, often highly priced, active funds.

“Luxembourg products are sold across Europe, across the world in reality, and in many of these markets they are sold through intermediaries and these intermediaries are still moving money into actively managed funds,” said Devin McCune, vice-president of governance, risk and compliance services for Broadridge’s Distribution Insights business.

“In the UK there are a lot of DIY investors [about 17mn], people who do not use an advice model,” McCune added. “They see passive products as a meaningful way to get diversification in their portfolio without having to do all the hard work and ongoing maintenance that you would with an active product.”

Simultaneously, Broadridge found that fund fees had fallen far more sharply in the UK than in Luxembourg — by an average of 4 per cent a year over the past decade, compared with 2.64 per cent in the Grand Duchy.

Actively managed UK funds had an average total expense ratio of 0.78 per cent last year, compared with 1.03 per cent in Luxembourg — a stark reversal given the UK had higher fees until 2017.

For passive funds, the UK’s average TER is 0.14 per cent, versus 0.25 per cent in Luxembourg.

McCune believed TERs in Luxembourg were likely to remain elevated unless commission payments to intermediaries, otherwise known as retrocessions, were outlawed across the big European markets such as France, Germany, Italy and Spain.

“Without the removal of retrocessions you will not get the steep fall in fees that we have seen in the UK and US,” he said.

In the US, where fee-based, non-commission advice is also the norm, TERs are lower still at 0.44 per cent for active funds, on average, and 0.11 per cent for passive ones, Broadridge found. The US is another market where inflows to passive funds, be they mutual or exchange traded funds, now dwarf those to active ones.

McCune argued that additional regulation, over and above the Retail Distribution Review that outlawed commissions, had played its part in lowering fees in the UK.

In particular, he cited the Financial Conduct Authority’s Assessment of Value regulation, which requires fund managers to conduct an annual review to assess the overall value delivered to investors, and its Consumer Duty, which requires them to put their customers’ needs first.

More broadly, he believed larger asset managers were using their economies of scale to drive fees down, “which creates challenges for medium and smaller-sized managers”.

However, McCune believed that fees in both the UK and the US were now as low they were likely to go.

“There has been a levelling-out of fees in the last year or two, a realisation that there is a minimum cost that is needed to run a product. Regulation, especially in the US, is very mature,” he said.

Moreover, new products particularly in the US, increasingly tend not to be plain vanilla funds that can be replicated easily by a passive ETF, allowing issuers to charge higher fees.

However, in Luxembourg and Ireland (Europe’s second-biggest fund hub, where active fund fees average 0.6 per cent and passive 0.19) McCune believed there was still scope for fees to go lower if the EU were to introduce tighter regulation.

Kenneth Lamont, senior fund analyst for passive strategies at Morningstar, believed this should happen.

“RDR was an extremely positive move. There are fewer corners for intermediaries to tuck away fees and kickbacks, which clearly favour higher margin products,” he said.

“[The Broadridge data] shows that the regulation is working. Our own research has shown that in most cases it’s extremely difficult [for active managers] to outperform the broad market benchmark over long periods of time. I think the European regulators should be looking at it.”

Even without that, McCune believed UK regulation was pressing Irish and Luxembourg funds to consider lowering prices in order to remain competitive, given that the FCA’s Consumer Duty regulation applies to all funds sold into the large UK market, irrespective of domicile.

The strong bias towards active flows in the Luxembourg market is not entirely due to intermediaries’ remuneration, however, but the corollary to Ireland having emerged as Europe’s go-to hub for passive funds, particularly ETFs.

“If [intermediaries] are looking for passive products, they are choosing an Ireland domicile. Ireland got there first,” McCune said.

As a result, with passive funds constantly increasing their market share, he feared “the Luxembourg fund industry is going to face challenges. We see it in all markets with active managers. You really have to create a differentiated product.”