£3.6bn stuck in UK ‘orphan funds’, warns report
Research from Morningstar identifies nearly 200 sub-scale funds that can be poor value for investors
Almost £4bn of UK investors’ money languishes in so-called “orphan funds” — sub-scale funds with persistently low inflows and often high charges. Many of these offer such poor value they should be culled from the market, according to a new report.
At the end of last year, UK investors had £3.6bn invested in nearly 200 separate funds that have dwindled in size, according to data company Morningstar.
Morningstar claims these “dormant” funds perform a “disservice” to investors by lingering in the market despite failing to gain traction, and poor economies of scale mean higher costs are often passed on to investors.
“The sheer number of these funds shows the industry has launched far too many funds that are unwanted by investors,” said Jonathan Miller, director of manager research ratings at Morningstar UK. “There are too many funds in the market and our analysis highlights the extent to which small idle ones are surviving.”
Morningstar uncovered 196 UK-domiciled orphan funds in its report.
It defines an “orphan fund” as one that has failed to attract more than €100m (£86.9m) from investors after five years, and has persistently low inflows and outflows. Some of the funds named in its index had as little as £5m of assets at the start of February 2019.
Their small size means that fund charges tend to be comparatively high. For example, the average ongoing charge on “orphan” equity funds was 1.29 per cent, Morningstar found — practically double the 0.67 per cent charged by the average UK-domiciled equity fund.
Smaller funds often have higher cost bases because they do not benefit from the same economies of scale that larger funds command. The level of fees can weigh on performance too.
“Tiny funds are expensive to run, with the costs passed to investors,” said Mr Miller. “Where the past clearly shows there is little hope for the future of such strategies, [fund houses] should be doing the honourable thing and pulling the plug on them.”
Three of the funds picked up in the report — Neptune Quarterly Income, Neptune Global Smaller Companies and Neptune Global Income — all have less than £5m in assets. Of those, Neptune Global Income fund has returned less than half of the total return of the MSCI World index over the past five years.
Neptune founder Robin Geffen said: “Neptune has taken action with regards to all three funds — completely changing the fund type, portfolio and objectives for the Global Smaller Companies fund; changing the manager for the Global Income fund and merging the Quarterly Income fund to drive additional returns.”
He added that Neptune Global Smaller Companies was overhauled from a large-cap to a small-cap fund in 2016, explaining its size, and that Neptune Global Income was taken over by new manager, Storm Uru, in November 2017 when its performance improved.
Meanwhile, Neptune Quarterly Income will be merged into the £203m Neptune Income fund in April, reducing costs for investors.
Investment experts cautioned that small can sometimes be beautiful. Smaller funds can benefit from being more nimble and able to invest in more illiquid assets. But consistent unpopularity can be a bad sign and should prompt investors to work out whether a fund is good value or not, said Ryan Hughes, head of fund selection at AJ Bell.
“We all know there are too many products in the market, but every year we have a net gain of funds,” said Mr Hughes. “If a fund has been small for a long period and really isn’t going anywhere you need to think about it, because at a certain point the fixed costs are just too high and act as a barrier to performance.
“Such funds should be closed or merged into a fund with scale, or turned into something investors want,” he added, “but fund groups have no incentive to do that, as even small funds bring in revenue for the group.”
Investors should act by taking out old paperwork and checking whether their funds are “underperforming and saddled with high fees”, according to Morningstar.
Mixed asset funds of funds — a fund structure made up of a other funds, instead of stocks and shares — tend to be particularly problematic and often charge investors fees “north of 1.6 per cent a year”, the company said.
The analysis follows the introduction of sweeping new European rules for fund managers, known as Mifid II, which force managers to be more transparent about costs and charges.
Morningstar’s research also reveals that there are far more “orphan funds” in continental Europe — where investors typically buy funds through banks instead of independent financial advisers or fund supermarkets — than the UK.
Across Europe, some €80bn (£69bn) of investors’ money — around a quarter of European funds — was invested in orphan funds last year according to Morningstar.
“It remains to be seen if Mifid II can be the driver that brings the issues of orphaned funds to the fore by regulators,” said Mr Miller. “It is evident that investor outcomes are being affected, and this concern should get the wider attention it deserves.”
The cost-efficiency of active management has been a contentious topic in recent years, particularly as the number of low-cost passive funds has grown.
In its sweeping review into the asset management industry last year, the Financial Conduct Authority said asset managers should take more proactive steps to close or merge poorly performing funds.
It said: “While mergers and closures may improve outcomes for some investors, not all persistently poorer performing funds are merged or closed. It can also take a long time for worse performing funds to be closed or merged.”