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Crowd control

UK retail investors are faced with an enormous choice of unit trusts and Oeics. Bloomberg identifies more than 2,100 funds in the UK managed by over 135 asset managers with some £240bn of funds under management in 2003.

These funds range in size from the top 30, with between £1bn and £5bn under management, all the way down to the bottom 40, each of which has less than £1m under management. So what?

Consumer choice is generally a good thing, with competition helping to keep prices down and ensuring efficiency for consumers, right? Not in this case.

More than almost any other sector, asset management should benefit from huge underlying economies of scale. The costs of managing a fund do not vary much as the fund grows although it obviously requires investment to capture those inflows in the first instance.

Mercer Oliver Wyman estimates that the average fund should have fixed costs of around £400,000 a year, plus an extra £260 a year to manage each £1m of assets. So a £200m fund should cost about £25,000 more to run than a £100m fund while producing an average of £1.5m in additional income.

Obviously this varies according to asset class, geography and other factors but the point is clear – size obviously matters.

Looking at the UK mutual fund industry as a whole, these economics produce an average manufacturing cost of 37 basis points, giving a cost to income ratio in the 25-30 per cent range for manufacturing alone, excluding the cost of marketing and distribution.

But the scale curve is steep. Funds under £25m in size will have costs greater than annual fees and therefore should make a loss unless other cost-cutting measures are employed. Generally, funds will struggle to deliver profit at less than £40m in funds under management.

This group of sub-scale funds includes nearly 1,200 funds – or more than half the UK total – of which we estimate some 285 have succumbed to the size trap as a result of falling markets over the last three years.

Fund manufacturing costs v size of fund

To put this into perspective, the average fund size of over half of the parent companies is below the £40m threshold, suggesting a strong case for fund manager consolidation. Even among the top 10 managers, an average of 30 per cent of funds are sub-scale by this definition – a further argument for fund consolidation.

What can fund managers do?

There are a five main ways for fund managers to address this problem.

•Ignore it, arguing that most funds start off small and uneconomic and grow to profitability through new fund inflows and/or market appreciation. But market appreciation will not save the smallest 700 funds unless stock values return to 1999 levels.

•Cut costs by combining multiple funds under a single manager or team. This may be good for the operational economics of the asset manager but retail investors might reasonably take issue with having their money managed on a “part-time” basis.

•Eliminate the majority of the costs by moving to passive indexing. From an operation viewpoint, this is a logical step for the average manager, who on average fails to beat the index anyhow. But it has considerable knock-on effects in terms of promoting the fund and pricing.

•Adopt a semi-passive approach. This involves reviewing the fund constituents less often and in less depth, so that for much of the time the fund is passive rather than actively managed. Retail investors might again be concerned.

•Close smaller funds. Such a move may well improve the asset manager&#39s economics but will not be popular with retail investors or their advisers.

The incentive to close funds will be significant. To assess the scale of the savings, consider a world in which fund consolidation has already driven out smaller funds, which have either closed, had management subcontracted to a more efficient player or had their management rights sold.

If this limited the industry to a maximum of 100 funds in each sector – hardly a loss of competition – we estimate that industry operating costs could be halved. The saving would rise to 67 per cent if the number per sector was limited to 50 or 80 per cent with a maximum of 20 funds per sector.

The latter situation would still present the retail investor with over 260 funds to choose from while asset management companies would see an average improvement in the overall cost to income ratio of 20 per cent. If even a portion of these savings were passed on to investors, overall returns, after adjusting for costs, could improve dramatically.

What does this mean for IFAs?

Although IFAs should review clients&#39 needs and fund firms&#39 product offerings on a case-by-case basis, there are three main issues to bear in mind.

Consider client positions in smaller funds. Funds under £40m may be uneconomic for their managers. There is a chance that these funds might be rationalised in the future, particularly if they have existed for some time, and advisers should consider how such fund rationalisation might affect their clients.

If the average fund in a manager&#39s portfolio is less than £40m in size, there is a chance that the manager might be less profitable than others or that they might be forced to use fewer or less expensive management resources to run the funds. Consider the potential implications of this, as well as how actively managed these funds are likely to be.

Revisit fee rebates and commission with bigger managers and funds. Big funds are inherently more profitable than smaller funds so there is more scope for managers of big funds to pay more to distributors.

Regulatory developments in the UK look set to release independent distributors from the need to distribute products from every provider. This will accelerate the need for manufacturers to demonstrate value to distributors and the retail investor.

Forward-looking manufacturers, such as Isis Asset Management, are already reviewing the future of smaller uneconomic funds that will not contribute in the world of the near future.

Fund consolidation will be one outcome of this trend. Forward-looking IFAs need to consider the size of funds and managers as an important dimension of how they form relationships with these manufacturers.

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