Would the launch of another active fund without distinguishing edge succeed? The active managers are facing increasing pressures from the unprecedented rise of passive products and fee cuts. The recent publication of the Assessment of Value (AoV) reports of several large UK asset managers reminded us of the regulatory scrutiny on the active fund industry. These AoV reviews have led to multiple fund closures and funds “to be monitored” based on a combination of 7 criteria: quality of service, performance, management costs, economies of scale, comparable market rates, services and classes of units.

Despite the increasing competition and complexity of the active fund industry, we still see some contrarian trend of new fund launches with little seed money, poor pedigree of portfolio managers or team culture, non-evidence of credible track-records, expensive fee structures or a combination of these factors. It is crystal clear that these launches will not be successful in the long run, but if this trend continues to exist, it is because some asset managers take advantage of the naivety of non-professional investors by providing little or non-factual information. Fund selectors have more urgency than ever to protect investors’ interests by conducting deep-dive due diligence to eliminate these funds. A strong corporate governance of investment platforms also plays a key role in the consolidation trend of the active fund industry.

The below lists some major challenges that the active managers face these days:

• The extended periods of low volatility and lack of dispersion in the markets before the worldwide Pandemic did not provide a favourable hunting ground for active managers for many years. Coupled with the extremely low interest rates in developed markets, the only “music” in town has been active funds with strong “quality growth” bias almost everywhere in the world. In contrast, funds with a value style or more diversified sector allocations have suffered from a relative standpoint.

• The “crowding effect” of active fund managers’ portfolios. If we take the billion dollar club of global equity funds with a fundamental stock picking approach in distribution in the UK, we observe a “crowing effect” in the top holdings which are populated with FAANG stocks alongside Tesla, Zoom, Mastercard, Microsoft and Paypal. This trend has been particularly reinforced since the Covid 19 crisis during which the e-commerce and online communication themes have continued to benefit from a positive tailwind unsurprisingly. It is difficult to criticize these smart stock pickers who seem to share a consensus in terms of their top holdings, especially if these companies fit in their investment criteria of being the innovative technology disruptors with high ROE and free cash flows. One argues if it is worth of paying the expensive ongoing charges (sometimes up to 1.8%) for these actively managed portfolios compared to thematic ETFs.

• The Woodford scandal was a severe blow to the traditional active management with a fundamental stock picking approach and “star culture”. However, what went wrong in Woodford’s case was his lack of discipline by investing into illiquid and “unquoted” shares outside of his original circle of competence. It has been a permanent conflict to resolve between a fund’s outperformance and capacity, especially for one which invests a non negligeable portion of its portfolio into small and mid-cap stocks.

I always admire fund managers who take a prudent approach to manage their funds’ capacity by soft closing it ahead of the curve to avoid being a victim of their own success. It is arguable whether a “sole portfolio manager” culture is better or worse than a “committee-driven” decision making process. The key is to assess the consistency of the manager’s investment process, any missteps of style drift or lack of discipline.

• The increasing popularity and sophistication of passive products. Passives are no longer dominated by simple replication of large cap indexes. Even in the most popular ESG areas, we start to see an increasing number of passive products which offer some degree of exclusion and inclusion ESG criteria at more attractive costs. In this unprecedented greenwashing process, fund selectors need to separate a real ESG active fund from one being greenwashed by marketing labels.

From the performance perspective, the fact that a significant portion of active funds underperform their respective indexes, start to raise alarm of their long-term benefits to investors after fees over an observation period of more than 5 years.  

I believe that the active fund industry will self-regulate to consolidate towards winners which become bigger and bigger. The funds without long-term alpha generation or sufficient scale, and those charge inadequate fees will lose out in this process. The FCA’s pressure on UK asset managers to release the Assessment of Value (AoV) is certainly a necessary and healthy push in this direction.