Head Costs matter: Are UK investors voting with their feet?

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1 Head Costs matter: Are UK investors voting with their feet? Vanguard Research September December 2014 Peter Westaway, PhD, Biola Babawale, Todd Schlanger, CFA, Yan Zilbering Recent legislative and policy changes have put fees under greater scrutiny in the United Kingdom. This increased push for transparency has made investors more aware of the importance of costs in the investment decision-making process. For the five-year period ending 31 December 2013, we analysed net cash flows in UK equity and bond mutual funds and ETFs. Our findings include that: 1) The majority of investors cash flows went into the lowest two quartiles of funds by ongoing charges figures (OCFs); 2) This trend was more pronounced in equity than fixed income; 3) This trend was strengthened by the inclusion of ETFs in our sample; 4) The trend was strongest at the broad asset class level, and can be stronger in some categories than others. The trend to lower-cost funds has been driven by investor behaviour, not an across-theboard decline in the cost of investing. In other words, investors are voting for lower costs with their feet. This document is directed at professional investors and should not be distributed to, or relied upon by, retail investors. The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

2 A look at the cost of investing for UK investors As we will discuss throughout this paper, a number of factors have caused investors to allocate a greater share of their assets to lower-cost mutual funds and ETFs. Before discussing the underlying drivers of this trend, it is useful to examine how the costs of mutual funds and ETFs have evolved. In Figure 1, we display the median ongoing charges figures (OCFs) for six categories of investment products over the past five years active and passive equity and fixed income mutual funds, and equity and bond ETFs. The cost of investing in active funds has changed little over this period, falling slightly for equity funds and rising slightly for bond funds. For passive funds, the decrease in costs has been relatively more significant, but it is interesting to see that this decrease has more or less brought OCFs in line with their historically lowercost ETFs counterparts. 1 This is important because, as we discuss the shift to lower cost funds, it can predominantly be attributed to investor behaviour and not an across-the-board decline in the cost of investing. In other words, investors are voting for lower costs with their feet. Retail space: A firm nudge by regulation Financial advisers play a key role in distributing investment products in the UK, with over 80% of retail clients using an adviser. Recent legislative and policy changes targeting advisers have been an important factor in the trend towards lower-cost investing and the adoption of passive investments. These new policies, which form part of the Retail Distribution Review (RDR), aim to make fees to asset managers, financial advisers, platforms and online supermarkets more transparent and fair, both for the investment professional and investor. The first pillar took effect in January 2013 and bans product providers from paying inducements on advised sales. It also compels asset managers and financial advisers to be transparent about their charges for managing assets and providing advice. The second pillar, which was enacted in April 2014, will also force platforms to make their fees more transparent. RDR has placed greater emphasis on fees, making investors more aware of the effect costs can have on a portfolio s performance over time. Indeed, a survey of IFAs conducted by The Platforum found that passive tracker funds, traditionally ignored by many IFAs because they did not pay commissions, have become increasingly popular. Passive funds now make up 10.9% of the market as of October 2014, up from 6.2% in The rising popularity of tracker funds is important because they tend to be lower-cost than their active fund counterparts. For example, according to data compiled from Morningstar as at 31 December 2013, the asset-weighted OCF for an active global equity fund was 1.26% compared to 0.20% for trackers. Figure 1: Median OCFs over time Ongoing charges figures (OCFs) Active equity funds Passive equity funds Active bond funds Passive bond funds ETF equities ETF bonds Notes: Fund and ETF universe includes all those available for sale in the UK from the following Morningstar categories: UK equity flex cap, large-cap blend, large-cap growth, large-cap value, mid-cap, small-cap; Europe equity Europe OE: flex-cap, large-cap blend, large-cap growth, large-cap value, mid-cap, small-cap; Euro zone equity flex-cap, large-cap, mid-cap, small-cap; Global flex-cap, large-cap blend, large-cap growth, large-cap value, mid-cap, small-cap; US equity flex-cap, large-cap blend, large-cap growth, large-cap value, mid-cap, small-cap; Emerging markets equity emerging markets; Europe bond EUR diversified; US bond USD diversified; Global bond global un-hedged bond; UK bonds UK diversified, UK government. Products were then grouped into the six categories above. Ongoing charges figures (OCFs) are from the annual reports as of each calendar year. Source: Vanguard calculations, using data from Morningstar, Inc. 1 We are focusing on ongoing charges figures (OCFs) in this example as a measure of cost. However, it is important to note that the total costs of investing in a mutual fund or ETF are not the same. In addition to OCFs, mutual funds can have sales loads and purchase and redemption fees. ETFs, on the other hand, are subject to bid-ask spreads, premiums and discounts and stock broker commissions. 2 According to data from the Investment Management Association (IMA). 2

3 The increasing popularity of exchange traded funds (ETFs) has also been a driver of the low-cost trend. According to a survey conducted by Morningstar, the low cost of ETFs continues to resonate with investors, with 91% of current ETF investors indicating their low expense as either very important or important in 2013, up from 89% the year before. The same focus is also seen amongst prospective ETF investors. 71% of these would-be ETF investors now cite the low cost of the ETF as very important, compared to 57% in As the advisory landscape continues to adjust to these new regulations, the value proposition for advisers is changing from investment selection to holistic wealth planning services, with low-cost passive investments at the core of portfolios. Finally, a response to the increased transparency around adviser and fund costs has been the rise of do-it-yourself investors, although they remain a minority of fund users at 31% (up from 26% in 2011). 3 The move towards defined contribution and auto-enrolment In the UK, assets in the institutional market are still predominantly held in defined benefit (DB) pension funds where liability matching and the low yield environment remains the main focus of attention. However, with the majority of DB schemes now closed to new investors, the defined contribution (DC) market and new workplace pension schemes are attracting more assets; and this trend is likely to gain further momentum. As a result, cost has become one of the key battlegrounds as providers compete to win new auto-enrolment business from employers who are eager to keep expenses to a minimum. At the same time, more institutional investors are choosing to allocate more of their assets to index-tracking strategies. Indeed, IMA reports have unearthed a trend away from active to passive funds in the pension funds market. In 2009, DB and DC pension funds held 67% of their assets in actively managed funds. By 2013, this share had fallen to 59%. 4 Muted return expectations and an increasingly cost-conscious industry: A testament of our times The financial market environment has also contributed to changing investor behaviour regarding fund expenses. The historically generous stock and bond returns of the 1980s and 1990s probably made cost less of a consideration for investors who were enjoying doubledigit net returns. The combination of investor inertia, satisfaction with high absolute returns and a lack of understanding of expenses helped preserve the status quo. The turnaround in the focus of investors, in particular amongst younger consumers, came after the financial crisis of 2008 and the expectation that future returns are likely to be moderately below long-run historical averages (Davis, Aliaga-Díaz, Thomas, and Patterson, 2014). And, when future returns are expected to be lower than those in the prior 30 years for equities, bonds and other asset classes, even an average OCF can consume a significant portion of returns. Another contributing factor has been investors greater understanding of costs and their impact on long-term performance. This has been aided considerably by improved cost disclosure in shareholder reports and other fund publications and the financial media s greater attention to costs. Investment management firms have also contributed by making available additional lower-cost options including index funds and ETFs and, more recently, by making cost the focus of marketing efforts. A word about our methodology For our analysis, we examined monthly fund-level cashflow data from Morningstar for the five years ended 31 December We used Morningstar data for equity funds and bond funds, including conventional open-ended funds as well as exchange-traded funds (ETFs), but not for funds-of-funds. We excluded funds whose OCFs and assets under management were not reported in Morningstar. We analysed all funds available for sale in the UK regardless of the investment category to provide a full reflection of the investor s opportunity set. Within each category, we grouped funds into quartiles based on their OCFs and calculated the net cash flows for each respective quartile (where Q1 is the lowest cost and Q4 is the highest). For each cost quartile, we also included the median OCF. Finally, to simplify the presentation of our data, we aggregated our results to the broad asset classes of equities and bonds. 3 The Platforum Interim Report to 2014 annual IMA survey. 3

4 Trends in equity funds and ETFs Within equity (actively managed, passively managed and ETFs), over the five years ending 31 December 2013, the lowest expense quartile funds (quartile 1) attracted about 106 billion in cumulative net cash flow (91% of total flows), as shown in Figure 2. Funds with OCFs in the top half (quartiles 3 and 4) suffered net cash outflows of about 13 billion. The lowest cost quartile attracted positive net cash flows in all but one of the 41 categories included in our analysis and was the highest attracter in 20 (49%). The significance of the low-cost trend can be attributed to it being strong in the categories that attracted the largest share of net cash flows. For example, in the large-cap global equity fund category, which attracted the largest total of cash flows at 32 billion (27% of all flows), the lowest cost quartile attracted 19 billion (59%) of all flows. Similarly, in the second-highest attracting category of emerging market equity, which attracted 31 billion in total flows (26%), 21 billion (68%) went into the lowest-cost quartile. In categories where investors were allocating less, such as UK equity, the second-lowest-cost quartile took in the highest percentage of cash flows at 3 billion, with the lowest expense quartile coming in second at 2 billion. Consistent with the broad trend, UK equity funds with OCFs in the top half (quartiles 3 and 4) suffered net outflows of 6 billion. Trends in bond funds and ETFs Within fixed-income (actively managed, passively managed and ETFs), over the five years ending 31 December 2013, the trend to lower costs was generally not as strong as in equity and the quartile that attracted the highest share of net cash flow was Q3, with 72 billion. However, the two lower-cost quartiles (Q1 and Q2) attracted a combined 118 billion (or 52% of the total). Funds with OCFs in the highest-cost quartile also attracted inflows of 35 billion. The lowest-cost quartile attracted positive net cash flows in all but one of the 12 categories included in our analysis and was the highest attracter in seven, an even higher percentage than in equities. We found the trend to be strong in some of the categories that were attracting the largest share of net cash flows, such as high yield, which attracted 61 billion (25% of the total flow). The lowestcost quartile high yield products saw 35% of all flows at 21 billion, followed by the second-lowest-quartile at 15 billion (24% of the total). In other categories, however, such as global bonds, the two high-cost quartiles gathered over 70% of the 43 billion into the category, with quartile three attracting 19 billion (44% of the total). In sterling bonds, the category saw net outflows of 7 billion, with the lowest-cost quartile the primary contributor to outflows with 10 billion, followed by 3 billion for the highest cost quartile. Figure 2: Net cash flows into equity funds and ETFs Figure 3: Net cash flows into bond funds and ETFs Cumulative Net CF ( B) B 23B - 1B - 12B Cumulative Net CF ( B) B 61B 57B 35B Q1 (0.49) Q2 (1.29) Q3 (1.85) Q4 (2.20) Q1 (0.42) Q2 (0.87) Q3 (1.28) Q4 (1.75) Notes: See methodology section for discussion of our quartile ranking process. Source: Vanguard calculations, using data from Morningstar, Inc. Notes: See methodology section for discussion of our quartile ranking process. Source: Vanguard calculations, using data from Morningstar, Inc. 4

5 Conclusion Our study of mutual fund and ETF net cash flows over the last five years clearly demonstrates that low-cost products have drawn significant interest from investors, largely because of the growing popularity of index funds, and particularly index-based ETFs. A similar shift has taken place among actively managed funds. Some of this shift can be explained by recent legislative and policy changes, which have put fees under greater scrutiny in the UK. This increased push for transparency has made investors more aware of the importance of costs in the investment decision-making process. Other factors include a muted return outlook, increasing the share of wealth created eaten up by costs, and an increasingly cost-conscious industry. The trend to low-cost investing has in turn been driven by investor behaviour and, with all of the drivers in place and gaining momentum, it seems set to continue. 5

6 Connect with Vanguard > vanguard.co.uk > Adviser support > Important information This document is directed at professional investors in the UK only, and should not be distributed to or relied upon by retail investors. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments. The information on this document does not constitute legal, tax or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions. The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results. Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority Vanguard Asset Management, Limited. All rights reserved. VAM