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As investors move away from actively managed funds to passive funds and ETFs the industry is expected to shrink much like how Napster and iTunes revolutionized the music industry
<p>As investors move away from actively managed funds to passive funds and ETFs, the industry is expected to shrink, much like how Napster and iTunes revolutionized the music industry.</p>

The Financial Industry Is Having Its Napster Moment

Since the beginning of 2015, about $250 billion has moved out of actively managed mutual funds and into passively managed index funds and&nbsp;ETFs.

(Bloomberg) -- Has the music stopped for the financial industry?

Just as record companies in the early 2000s had to deal painfully with the digitization of music courtesy of Napster and Apple Inc.'s iTunes, many asset managers are now facing a similar situation as more investors make the switch from high-priced, actively managed mutual funds to passive, low-cost, exchange-traded funds (ETFs) and index funds. When the dust settles in this sea change, the financial industry may be half of what it once was, simply because its revenues will be half of what they once were.

This trend may be accelerated because of proposed new “fiduciary rules” issued by the Department of Labor, which will require brokers to (gasp) put clients' interest ahead of their own when it comes to customers' retirement investments. In other words, no more putting grandma in a pricey active mutual fund just because you get a commission, or "load" in industry jargon.

The rule, which is set for a vote in 60 days and would be phased in over the next two years, is predicted to be a boon for ETFs and index funds, the vast majority of which already pass the fiduciary rules and are the vehicles of choice for advisers currently abiding by this standard. Rule or no rule, however, the trend toward passively managed investing has been slowly blooming for more than a decade, as seen in the chart below from the Investment Company Institute, which looks at this trend within equity funds.

Since the beginning of 2015 alone, about $250 billion has moved out of actively managed mutual funds and into passively managed index funds and ETFs. For investors, this has been a way to save costs and increase returns, but to asset managers—and many of their stakeholders—this represents a direct hit to revenue and a frustrating new reality.

The reason for this dynamic is simple: ETFs and index funds produce far less revenue for asset managers compared with actively managed mutual funds.

Consider that ETFs have $2.1 trillion in assets and their asset-weighted average fee is 0.27 percent. This produces about $5.5 billion a year in revenue. Traditional index funds have 2.1 trillion in assets but have an asset-weighted fee of just 0.10 percent, producing $2.2 billion in annual revenue. That’s a total $7.7 billion in revenue earned by passive vehicles.

In contrast, active mutual funds enjoy an asset-weighted average fee of 0.72 percent, three times that of ETFs and seven times that of traditional index funds. With $10.4 trillion in assets under management, active mutual funds produce a collective $74 billion in annual revenue for large asset managers.

Money Shift

Assuming current trends hold, asset managers will see about $1 trillion defect every four or five years. Some 40 percent of the money is forecast to go into index funds and 60 percent to shift to ETFs. That money will go from being charged 0.71 percent in fees to approximately 0.20 percent. That's a 70 percent loss in revenue every time money moves over.

In other words, about $2.5 trillion in assets could migrate out of active mutual funds over the next decade. That money will shift from producing $18 billion in revenue to producing just $5 billion. That’s $13 billion less in revenue in the next decade and upward of $30 billion over the next 20 years. All this could be expedited by the new fiduciary standard—as well as a parallel trend that sees institutional funds moving toward passively managed investments, too. Add all that up, and that's how you get to an industry half the size it used to be.

If that sounds familiar, it's because it has happened before. In 2000, record companies enjoyed revenue of $13 billion a year, largely from compact discs. Then Napster and eventually iTunes arrived. Over the next 15 years, revenue dropped precipitously. Today, revenue from music sales totals $7 billion a year–chopped almost exactly in half in just over 15 years, according to data from Bloomberg Intelligence.

Shrinking revenue won’t necessarily put asset managers out of business, but it will force them into something potentially unsavory: self-cannibalization. Many of these large asset managers offer both active and passive products. Such firms as Blackrock Inc., State Street Corp. and Pacific Investment Management Co. could in theory see their ETF or index fund business boom yet their revenues shrink. That might help explain why Blackrock announced last week that it is cutting 400 jobs despite the fact that the company has been leading the U.S. in ETF flows for two years running.

The secondary effects of this—whether it happens slowly or quickly—will also be painful. For instance, much less money will be spent on trading since ETFs and index fund portfolio managers don’t actively buy and sell anything beyond an occasional rebalancing. This is bad for big Wall Street banks' trading revenue.

It's worth noting here, however, that while ETFs are themselves passively managed, many investors use them very actively, and as such they will still bring in trading revenue of an estimated $7 billion to $9 billion a year for marketmakers on Wall Street based on the asset-weighted trading spread of an ETF. So while traditional index funds—which can't be traded—are like garlic to a vampire when it comes to Wall Street, ETFs are more of a mixed bag revenuewise.

And if asset managers are making less, it means less money available for the entire financial ecosystem that feeds off them, including back-office providers, lawyers, public relation firms, and of course, the brokers who will lose a big chunk of a $100 billion pool of juicy commissions.

All in all, most asset managers and much of the ecosystem they support will likely survive.

But just as the music business showed in the past decade, it won’t be a pleasant transition.


Eric Balchunas is an exchange-traded-fund analyst at Bloomberg. This piece was edited by Bloomberg News.

To contact the author of this story: Eric Balchunas in Skillman at [email protected] To contact the editor responsible for this story: Tracy Alloway at [email protected]

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