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Market View: Sign up to IA principle

Market View: Sign up to IA principle

On April 28 the Investment Association released a statement of principles to which it is asking its members to sign up.

The initiative is a good one and aligns with the stewardship principles that Morningstar has espoused for more than a decade. Both are focused on ensuring that fund investors’ interests come first and that asset managers’ interests are aligned with those of investors.

I would argue this is simply good business. If an asset manager puts its own interests before those of its clients or gives customers a bad experience with its funds, the manager may have near-term success but the durability of the business is questionable.

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Morningstar’s studies of dynamics in the US market show that fund flows to individual firms have a much higher correlation (0.49) with money-weighted investor returns – which reflect the experience of a typical investor in a fund – than with total returns (0.20).

In other words, even if funds did well from a total-return perspective, the money moved to fund houses that offered investors demonstrably better experiences over time.

This was not short-term research as the data covered 10 years through to August 2011.

Furthermore, Morningstar’s flow data shows money is increasingly going to passives in both Europe and the US.

In Europe, for example, although active offerings still dominate in terms of assets under management, growth rates show a shifting field.

The organic growth rate for passives in Europe in the past 12 months is 16.43 per cent, compared with 7.4 per cent for active offerings.

On a more refined basis, equity passives grew at 12.63 per cent, while active equity funds saw outflows shrinking by 0.24 per cent.

Fixed-income passives increased by 32 per cent, while active fixed income rose by just 8 per cent.

It seems clear why investors are turning to passives. Active funds too often fail to deliver given their costs.

Based on a review of UK-domiciled offerings, roughly half or more of active equity funds underperform the index assigned by Morningstar to their sector – for example, the FTSE All-Share index for the UK Large-Cap Blend Equity sector – across the past one (59.4 per cent), three (50.99 per cent), five (49.3 per cent) and 10 years (52.3 per cent) respectively.

That’s not a bad rate and active funds perform better in UK equities than they do in global and US equities, but it still means investors are having a poor experience in a large portion of active equity funds.

Fixed income fares much worse, with clear majorities underperforming the Morningstar-assigned indices across one year (77 per cent), three years (57 per cent), five years (62 per cent) and 10 years (65 per cent) respectively.

In a post-RDR world, interest in funds that outperform and provide value for money is climbing.

We’re seeing it now in Europe and we’ve seen it previously in the US market.

In our view, fund houses that want to build durable businesses would do well to focus on being good stewards of capital, rather than striving for near-term asset growth via product manufacturing and marketing.