PCG | Pacific Consulting Group

Structural Changes in the Funds Market

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The funds management industry is undergoing fundamental structural change, not just in Australia but also on a global basis. The key structural changes impacting at present include the move away from Australian equities into alternative investments, the in-sourcing of investment management capability by large funds, significant management fee reductions and the increasing competition in the industry from new fund managers and new products such as Exchange Traded Funds (ETFs).

These structural changes have come about due to the maturing of the funds industry, the crash in equity prices in 2007 and 2009, and the increased competition in the mid to large sized superannuation funds.

The industry has grown on the back of large increases in superannuation savings, high fees and inexperienced investors. As a result, large profits have been generated and, in turn, this has attracted new entrants into the industry.

At the same time, Funds have grown in size and are now in a position to exert significant power in the marketplace by actively demanding reduced fees from the funds management industry, building their own in-house management and also competing directly with fund managers with their own investment manager, Industry Funds Management (IFM).

Concurrent with these changes has been a lack of confidence by investors in both the share-market and fund managers, leading to substantial outflows from equities into 'safe investments' such as short-term deposits.

Main structural changes

One of the major impacts on the funds management industry currently is the cyclical and structural move away from equities, particularly Australian equities. Wholesale funds and retail investors have been overweight to equities and equity related investments and, as a result, have suffered poor performance since the global financial crises.

The realisation that many of the investments in multi-sector portfolios were highly correlated to equities has led to a move to reduce the core equity exposure and diversify into investments with lower correlations to core equities.

This has meant an increase in exposure to alternative investments including diversifying assets such as hedge funds, infrastructure, distressed debt, private equity, natural resources, gold and commodities, real estate, debt and equity emerging market, high yield and small cap equities strategies.

The Future Fund, the largest fund in Australia, has 6% invested in infrastructure and timberland and 6% in private equity. Alternatives in the Future Fund are mainly hedge funds with strategies such as multi-strategy, relative value, macro-directional, distressed event driven and commodity orientated.

Australian Super ($45 billion) has 18% in infrastructure and private equity and is looking to further increase its exposure to alternative assets in the future.

Most funds are diversifying their portfolios with funding coming primarily from a sell-down of the Australian equity weighting. Historically, the home bias has led to a high relative weighting in Australian equities. As a result of this down weighting, funds flow in Australian equities has been negative.

In the retail market the low returns and concerns of macro impacts have led to flows out of equity related products being parked mainly in cash and fixed income investments.

Another impact on managers of Australian equities is the move by the larger funds to take investment management in-house. A few of the larger funds have built or are building in-house management capability in an attempt to lower costs and gain more control over their investments.

It is recognised in the industry that once a fund's size is $15 billion or more it becomes economical to start to replace external mangers. Australian Super ($45 billion) spent over $200 million in external management costs last year.

Industry funds are also competing against managers by setting up their own stand- alone manager, IFM. IFM now has $36 billion in funds under management and is owned by many of the industry funds, including smaller funds, and offers funds management across all investment sectors.

This is a very efficient way for the industry funds to control their investments. This development should not be dismissed, as the large retail funds have been very successful in implementing this strategy and have attracted high calibre investment talent to manage the business.

It is evident that in the future a large portion of the moneys managed in Australia will be handled in-house by these large wholesale and retail funds.

Funds are competing in the market by offering low cost products and have focused on reducing the costs associated with their products. This is unfolding in a number of ways.

Firstly, funds have become far more aggressive in negotiating fees with fund managers resulting in a significant lowering of fees for mandates. The funds are in a strong position to negotiate, as the funds management industry is highly competitive.

Secondly, they are changing the manager mix and risk profile within their Australian equity exposure. Funds are reducing their exposure to active managers and increasing their exposure to passive, lower cost investments.

One model that is getting attention is to have a 50% weighting to passive exposure and 50% to active, thereby reducing the fees/costs on half the portfolio but keeping exposure to the equity market.

The downside in this strategy is the reduced outperformance that can be generated via active management. To compensate for this, funds appoint more aggressive managers for the active component, increasing the potential to outperform and compensating for the fund's 50% passive exposure.

The other main influence on costs and fees is the Gillard government's MySuper initiative to introduce low cost funds to the superannuation market.

Under MySuper, super funds are required to offer a low cost balanced fund with fees much lower than those currently on offer. This is already having an impact on fees in the industry, with a retail fund already offering a no fee balanced fund.

While these structural changes are taking place the market remains intensely competitive in Australian equity products, particularly in the 'core' equities product offering where approximately 55 companies are vying for Australian equity mandates.

In addition there is increased competition in the market with new equity products that can be traded on the stock exchange. These Exchange Traded Funds (ETFs) have been popular internationally and are gaining favour in the Australian market.

The market for ETFs has grown by 25% in the last year and now totals $6 billion with 84 ETFs. This means that the funds management pie will continue to be cut into smaller pieces.