PERFORMANCE ANXIETY SEEN INCREASING AS INVESTORS ZERO IN ON FUND EXPENSES

A day of reckoning is coming for money managers, as investors begin to fixate on escalating management fees while the vast majority of those managers continue to underperform the market.

That’s the message of a new report by the Advisory Board Co., a Washington-based market research group, presented at the American Bankers Association’s recent trust marketing conference in San Francisco.

The mutual fund industry — one of the most profitable around — still markets itself largely based on its results vs. well-known benchmarks like the Standard & Poor’s 500 stock index.

“And when investment performance fails, we trumpet our relationship with the client,” says Michael P. Kostoff, executive director of the firm’s VIP Forum/Insurance Advisory Board, who presented the report.

telltale signs

“Our industry has been able to charge premium prices forever,” Mr. Kostoff adds. “(Today) the whole industry benefits from the ability of a few funds to beat the market.”

That’s going to change, though, particularly when returns settle to a more normal level than the roaring bull market is providing today.

The signs already are apparent.

For instance, more investors are turning to index funds, as active management struggles to beat the indexes — particularly after accounting for fees, taxes and trading costs.

Index funds now account for a deceptively small 6% of the assets in mutual funds, but last year passive management drew 20% of the net flows into mutual funds. Mr. Kostoff estimates that up to one-quarter of assets will be in index funds in a few years.

As actively managed funds fight over a smaller pie, then, expense ratios will come down from 81 basis points (Lipper Inc.’s average for equity, bond and money-market funds) to between 45 and 67, VIP Forum estimates.

“Fees paid for active management are not a good deal for investors,” Mr. Kostoff says. “And they’re beginning to realize it.”

Not all agree that fees are such a big issue yet.

“There’s a long way to go before this issue comes home to roost,” says Mark Balasa, a principal at Schaumburg, Ill., advisory Balasa & Hoffman. “Investors are more interested in cachet and sizzle than in fees. If you’re making 18% and you’re paying a point, who cares? If you’re making 4% and paying a point, that’s a different thing. But we’re not there yet.”

feeding the frenzy

Mr. Kostoff, however, maintains the industry is feeding the coming price rebellion by focusing nearly all its marketing efforts on performance.

And investors are reacting accordingly. He points to a recent survey of affluent investors showing that 37% switched money managers for performance-related concerns. The next most commonly stated reason for changing — dissatisfaction with the level of service — was given by 7%.

To address this problem, fund firms might want to begin changing the subject, comparing their performance to individual investors’ goals rather than the market. For instance, the industry could concentrate on whether returns are sufficient to provide investors’ needed cash flow over their expected lifetimes.

“We change the nature of the game,” Mr. Kostoff says. “We educate clients. We change their perception. We will redefine performance around the customer.”