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Review of the KiwiSaver Fund Manager Market Dynamics and Allocation of Assets

4 Economic Efficiency and Competitiveness of Fund Manager Market

The market for fund management services for KiwiSaver members is examined in the following section. We have addressed the structure of the market, including an analysis of concentration levels. The dynamics of the market are reviewed with reference to the role of the different sub-markets of default and non-default providers and major banks, market power of individual managers, barriers to entry and the trend of market consolidation. Based on limited data, we reviewed the profitability of fund managers in comparison to domestic and international fund managers. We conducted statistical analysis of the determinants of fund success to test the trends observed. Price-based competition is also reviewed with regression analysis of the determinants of fees reviewed. Non-price based competition and switching rates rounds out the review with a qualitative review of non-price based scheme features such as customer service and product innovation, and a look into the levels of switching in the KiwiSaver market.

4.1  Assessing the Efficiency of the KiwiSaver Fund Manager Market

The theoretical perfect market with optimal consumer outcomes in funds management would feature workable competition between managers with respect to fees, customer service and investment performance combined with fund managers who have reached a large enough size to take advantage of economies of scale and pass on these cost savings to members. We briefly outline the theory and evidence for both competition and economies of scale in the economics of fund management.

4.1.1  Competition theory

Economic theory suggests that in a market for funds management with perfect competition and perfect information about fees and risks of investment, the level of fees would reach market equilibrium where the supply curve for funds management services meets the consumer demand curve. However, the funds management industry has a number of unique features which differentiate it from such a theoretical model. Firstly, the consumers of funds management services do not have perfect information because fee information is often very opaque with fee levels often only calculable on an ex-post basis. Secondly, consumers do not typically possess optimal financial skills to assess risk and potential return profiles of different managed fund products, which are not homogenous. Furthermore, investment funds are close substitutes for one another but they are not perfect substitutes due to differences such as fund structure, fees, and investment objectives. Nevertheless, we do know that funds compete with one another for customers on the basis of fees, performance and other factors such as history and stability, despite this competition being less than perfect. A more sensible method for evaluating competition is to assess the extent of workable competition and contestability which is the method applied in this paper.

4.1.2  Economies of scale

Theory of the economics of firm size also suggests that in a competitive environment, a fund manager's administrative costs per customer should decrease with an increase in the size of the fund due to economies of scale until the point at which the marginal cost of an additional customer is equal to the marginal revenue. This is because many production inputs and expenses are fixed and are typically large investments (physical establishment, registration, legal and regulatory compliance, marketing platforms and networks). Variable costs should in theory be relatively small as these mainly relate to account management and reporting which can be automated and replicated. In theory, therefore, as KiwiSaver fund managers grow by attracting customers and consolidating via mergers and acquisitions, lower fees for individual consumers should result. Furthermore, as outlined in section 3 above, fees are generally split into a fixed dollar amount and variable amount based on funds under management. Variable fee revenue should therefore grow as a function of fund asset size, while costs should increase at a lesser rate.

Previous assessments of KiwiSaver by MED (2010) and PwC (2008) only reviewed the state of competition in the market and did not evaluate the existence of economies of scale nor the impact of economies of scale on the firm dynamics and profitability of KiwiSaver fund managers. Therefore we have focussed attention on the effects of economies of scale as well as competition in the market.

Empirical evidence of economies of scale in funds management

Empirical literature suggests that economies of scale do in fact exist in funds management, including in highly competitive markets. The U.S Security and Exchange Commission (2000) found that as assets increased, the operating ratio declined; funds that are part of large fund families tended to have lower management expense ratios than funds that were part of small fund families; and finally there are differences in economies of scale for different asset classes. This is supported by LaPlante (2001), which controlled for numerous factors and found a negative relationship for expense ratios and fund size for equity and bond funds. Collins and Gallagher (2011) analysed the trends in the expenses and fees and fund size of mutual funds over the preceding two decades also finding a negative relationship which was smaller for equity funds but larger for bond and money market funds. Malhorta et al (2007) found differences in cost efficiencies in the mutual fund industry from 1998 to 2003. Economies of scale varied greatly and did not remain the same year to year. Conversely, Indro et al (1999) found that an optimal level of assets that minimises expenses to investors exists for US equity funds – for the years 1993-1995 this was US$ 3.5 billion.

Latzo (1999) also confirms the existence of economies of scale from a cross-sectional sample of 2,610 mutual funds. Schaefer and Maurer (2013) found economies of scale for German investment management companies and that the average investment management company faces an increase in costs of 0.71% for a 1% increase in assets under management. The ratio is greater for small to mid-sized firms. Economies of scope are more pronounced for large investment management companies, in particular between different types of retail security fund.

Banko et al (2010) also established that costs to investors are reduced by the economies of scope for fixed-income investors associated with large-asset managers, who supervise many funds over multiple fixed-income investment styles. However, they found no evidence of economies of scope for equity funds.

These findings are supported by Zera and Madura (2001), Bikker (2013) and Bikker et al (2010). The latter carried out a cross-country comparison of Australia, Canada, the Netherlands and the United States for the period 2004-2008 and found evidence of economies of scale (confirming earlier studies) noting that a 1% increase in customers would result in an increase in a fund manager’s costs of 0.76%. Likewise, Agostini, Saavedra and Willington (2012) found that the Chilean pension funds market possessed significant economies of scale. In the Australian context, Bateman and Mitchell (2004) reviewed the 1998-1999 annual reports of all 1,920 Australian superannuation plans under APRA’s jurisdiction found that a 1% increase in assets resulted in an approximate 0.5% increase in costs.

The literature is very clear on the relationship between increases in mutual fund size and costs. As funds grow in size, the costs increase at a lesser rate, which confirms that economies of scale do exist in funds management and this should also hold for New Zealand KiwiSaver funds. Economies of scope also exist. As funds under management in KiwiSaver funds grow, the overwhelming evidence suggests that average costs per customer should reduce.

4.1.3  The structure-conduct-performance framework

In this section 4 we utilise the structure-conduct-performance framework to analyse the fund manager market. The framework is a standard tool in industrial organisation theory. This enables us to form an initial view of the performance of the KiwiSaver market and the potential benefits to consumers and the advancement of public policy goals. The structure of the market is the set of variables which affect the behaviour of the sellers (fund managers) and buyers (members, customers). This includes the extent to which supply is concentrated, the extent of competition and barriers to entry. The conduct of fund managers and members amongst themselves and each other examines strategic behaviour such as pricing, investment, marketing and other non-price factors. Performance of the fund manager market reviews the profitability as a proxy for efficiency and the dynamics of member and fund movement within the market.

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