Moody’s Investors Service has downgraded its outlook for asset management firms from stable to negative, citing in part the added pressure on mutual fund fees expected after the Labor Department’s fiduciary rule is implemented.
Between 2007 and 2015, the rotation of assets into passively managed mutual funds and exchange-traded funds vastly outstripped flows into actively managed mutual funds, which yield fund companies higher fee revenue.
Over that period, $1.5 trillion flowed into ETFs, and $700 billion flowed into passively managed mutual funds. Just over $400 billion flowed into actively managed mutual funds during the nine-year period ending in 2015, according to Moody’s.
The ratings agency expects that trend to continue, saying in its 2017 outlook report that performance of active management “continues to underwhelm” and that investors will remain cost-conscious in a low-return environment.
The fiduciary rule, which requires investment advisors to act in the best interest of investors in IRAs and 401(k) plans, will accelerate flows into cheaper passively managed investments, according to Moody’s outlook. Moody’s and other analysts expect the fiduciary rule will encourage an industry-wide transition to fee-based advisory services, which in turn will incentivize the recommendation of lower-cost investments.
Investors can also expect to benefit from increased competition among passive fund managers, which will continue to drive down the cost of passive investments.
Moreover, the size of passive funds — the average passive fund is triple that of the average actively managed fund, says Moody’s — will also create management cost efficiencies that puts downward pressure on fees.
Neal Epstein, a vice president and senior credit officer at Moody’s, says the fiduciary rule will flip the balance of power in the investment management industry as advisors adopt a fee-based model of compensation.
“The rule is trying to align the interest of investors and advisors, and that will put more control in the hands of advisors, who used to be influenced by fund wholesalers,” said Epstein in an interview.
Going forward, fund companies will have less ability to impact the funds advisors recommend. “That’s going to be a big change,” said Epstein. “Manufacturers won’t be able to influence the sale of their funds like they once could. Active funds are going to have to prove the performance and value of their funds with analytical reasons.”
Speculation that the fiduciary rule will be dismantled or delayed under the Trump administration is not slowing efforts to comply with the rule among the investment management companies tracked by Moody’s. The first implementation date is April 10, 2017.
“All managers are adapting because they have to,” said Epstein. “Even if the new administration takes a stand against the rule, the deadline will be a matter of weeks away once Trump takes office. Once the rule is adopted and industry makes its adjustments, I don’t think firms will want to un-adopt the rule.”
Moody’s expects a dramatic decline in actively managed funds’ market share—the 70 percent claimed in 2015 is projected to be less than 45 percent by 2025. For investment management companies, the bottom line is that there is currently too much capacity for all mutual funds, says Epstein.
But not all is lost for proponents of active management. Moody’s says rising interest rates will impact asset prices, and create capital hurdles that will separate strong companies from weak ones.
That will give active managers the opportunity to distinguish better performing assets—something index funds cannot do, notes Moody’s report.
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