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According to Lipper, European equity mutual funds have now seen outflows for three years in five, suggesting growing investor disillusionment with this type of savings vehicle.

(See our blog from last week for more details of the Lipper survey)

Though there may also be economic and demographic trends at work, an increasing perception of the poor value of fund management services is undoubtedly causing such large-scale investor withdrawals. With stagnant or falling returns from equity markets over the last decade, the share of those returns being absorbed by costs has gone up sharply. This is a topic that’s unsurprisingly attracted a great deal of mainstream press attention in recent months.

“3.2 percent in fees are being siphoned off each year from pension plans,” yesterday’s Daily Mail reported. Investment industry insiders may quibble about some of the measurements used, and many of those attacking fund costs have their own commercial interests to promote, but you can’t dispute the frightening effect of compounding percentage charges in a low-return world.

But it’s not just high-cost active managers who are under fire. Even though ETFs have continued to record net positive sales, the passive funds industry can’t be complacent, either. 2011 was the year in which one of the leading ETF issuers in Europe, Deutsche Bank, admitted in a research article that providers make as much on the side from “ancillary” activities like stock lending, trading and derivatives provision as they do from fund fees.

Other observers have added weight to arguments that you can’t take passive funds’ headline expense claims at face value. For example, the Bank of England suggested in its summer Financial Stability Report that notionally lower fees on synthetic ETFs may disguise higher and unadvertised risks.

It’s worthwhile remembering the original aim of mutual funds—of which index funds and ETFs are one type. First developed on a large scale in the 1920s in the US, such investment vehicles were designed to offer easy and diversified equity and bond market access to the masses. Open-ended mutual funds became popular after the 1929 Wall Street Crash discredited the previously popular (closed-ended) investment trusts, many of which had become highly leveraged pyramid schemes that ended up losing all their investors’ money.

Reinforced by better post-crash regulation, the US mutual funds industry took off in the 1950s and 1960s, while indexed funds added a formidable new strand to the business from the 1970s, one that continues to gain market share. The move towards defined-contribution pensions in several Western economies greatly reinforced the demand for such pooled savings vehicles.

Mutual funds haven’t stayed immune from the conflicts of interest that beset the broader financial services industry, though. Some of the leading names in the business—Strong, Putnam, Invesco, Prudential—were caught up in the 2003 late trading and market timing scandals in the US. The increasing use by mutual funds of “heads I win, tails you lose” hedge fund-like performance fees is another, more recent cause for concern.

And now, as we have seen, there’s ever more attention to costs and the extent to which the guardians of investors’ money are really working on their clients’ behalf. An increasing number of observers are asking a simple question: why have average fund expense ratios gone up during a decade of poor returns and when computerised trading has greatly decreased the costs of accessing those funds’ underlying investments?

Perhaps a new bull market is around the corner, something that would probably divert attention from nagging questions about fund expenses. Until then, the extent to which the interests of management companies, fund directors and investors are truly aligned will be the standard by which fund viability should be measured.

Unless the asset management business can address the conflicts of interest to which it seems prone, expect ever more investors to ditch funds altogether and buy equities and bonds directly. Let’s hope that, helped by sensible changes in regulation, 2012 will be a year in which steps can be taken to restore pooled fund investing’s original goal of mutuality.

The increase in the minimum free float required for eligibility for FTSE’s UK index series, announced this week, is undoubtedly a reaction to growing concerns over corporate governance. FTSE has been careful to appear as neutral as possible in making the rule change: consulting a broad range of clients before increasing the minimum float level, while also making it clear that the consultation process itself came in response to requests from those index users.

As a result of the change, UK-incorporated companies seeking to gain entry to the index provider’s UK index series must have a minimum 25% of freely traded share capital. Before, a free float of as little as 5% would have been sufficient for some larger-capitalisation companies to gain inclusion in the FTSE All-Share and FTSE 100.

According to a report in today’s Financial Times, the changes haven’t gone far enough for some investors. The UK’s National Association of Pension Funds, which represents funds with collective assets of £800 billion, says that the minimum free float threshold should be set at 50%. If this higher free float minimum were imposed, says the NAPF, minority shareholders would be able to block a majority shareholder’s resolution (assuming they all voted together).

This response reveals that what appears to be quite a technical issue has much wider relevance than we might imagine. Let’s try to spell out some of the conflicting economic interests at play.

First, FTSE’s role in developing and maintaining indices is not necessarily aligned with the incentives of its new owner, the London Stock Exchange (and the same goes for other exchange-owned index providers). FTSE promises to compile benchmarks objectively and without bias. Creating the index rules, however, means setting some minimum standards on tradeability.

The LSE, on the other hand, is interested in obtaining revenue from listings and therefore has a natural bias to encourage as many foreign companies as possible to have their shares traded in London. The UK regulator, the UK Listing Authority (UKLA), has also so far taken a liberal view on listing requirements, presumably because it takes a similar view and wants to encourage companies to shift their headquarters to the UK.

“Isn’t it odd that FTSE now sets a higher minimum free float requirement than the regulator?” Mark Makepeace, FTSE’s chief executive, was asked on a conference call yesterday by a journalist. “You should ask the UKLA,” Makepeace responded. Makepeace also insisted that FTSE’s policy committee, which sets index rules, will remain completely independent from the LSE.

Second, there’s an obvious conflict between the interests of companies looking to gain index access and attract capital from the growing pool of tracker funds (i.e., to sell their shares for as high a price as possible) and the interests of investors buying those funds (who want to buy as cheaply as possible).

Whether or not a small free float contributes to greater potential price distortions as a result of index inclusion is an important additional question, and a difficult one to answer. In principle, the free float adjustment which most index providers now use as standard (reducing the weight of a company in the index by a factor reflecting the proportion of that company’s share capital that is not traded) counteracts the natural supply/demand imbalance that would occur if you had a lot of index funds chasing a small number of liquid shares, forcing up prices.

On the other hand, the lower the absolute level of free float, the greater the chance of “accidents” occurring, even if indices are adjusted to reflect the number of their constituents’ shares that are tradeable. This is particularly true when changes in economic interest can easily be conducted behind the scenes and via derivatives contracts. The massive short squeeze of 2008 in Volkswagen shares, which severely distorted the DAX index and which involved both a small float and derivatives-based buying, is an obvious case in mind.

It’s important not to be naive about companies’ motivations for wanting index inclusion. Of course they want to boost their share prices, even if only on a temporary basis (to allow some shareholders to cash in). And it’s not just a question of nefarious oligarchs from the former USSR seeking access to the pool of capital widely tracked indices can guarantee, even if that makes good headlines and many companies from that region cite this as a key motivating factor for listing in London.

Given the importance of passive investing, while index providers go to great length to compile benchmarks that can actually be tracked, they do not provide any assurances about the quality of the companies they are admitting, something it’s easy to forget. Remember Polly Peck, Maxwell Communications, Baltimore Technologies, Marconi, or RBS? All are one-time FTSE 100 companies that soared and then crashed. The fund managers buying those companies and getting burnt were the ones at fault for not doing their homework, not the index provider.

But passive investors are unable to make judgement calls of this type, since they buy all the index shares as a matter of course. Those investors should take particular care, in other words, and not just buy index funds or ETFs blindly because they appear cheap on a headline basis. The portfolio of shares or bonds you’re accessing via an index should make sense as an investment in its own regard. You mustn’t let the index tail wag the fund management dog.

ETFs in Europe have had a tough year, with an onslaught of critical comment and difficult markets causing the industry's growth rate to come to a halt. But active managers are doing much worse.

As we reported earlier this week, citing the latest figures from Deutsche Bank, Europe's ETF market has seen a notable slowdown, following several years of rapid growth.

Barring a Santa Claus rally, assets in European ETFs may end the year slightly down from 2010 levels, the first absolute annual decline in the market's history. For the five years to end-2010, by contrast, they grew at a compound annual rate of 40%.

The halt in asset growth masks continuing inflows to European ETFs. Falling market values have counteracted net new cash flows of €17 billion, says Deutsche Bank's Christos Costandinides, measuring the state of play at the end of November. BlackRock, the ETF market leader, has been the overwhelming beneficiary, garnering over 60% of investor inflows, we calculated a few weeks ago.

It's hard, though, not to draw some connection between regulators' spring warnings about ETF risks, rising bank default risk, and the slowing in the ETF market's growth. Counterparty and collateral risks are on the rise and have clearly had some impact on the growth of the synthetic ETF business.

MF Global's failure and the disappearance of investors' money from supposedly safe client accounts have also drawn attention to the risks involved when assets are lent out under repurchase agreements. MF Global's losses apparently relate to the rehypothecation (re-pledging) of the collateral placed with the firm by customers.

UCITS, the regulations governing most European ETFs, do not allow the pledging of non-cash collateral taken under securities lending agreements. Here, for example, are the rules for securities lending and repo transactions currently applicable to UCITS domiciled in Ireland.

But that doesn't necessarily remove all risk. As one correspondent told me this week, "Even when UCITS do not repo their assets directly, it remains to be seen how many of them formally prohibit their depositary bank to use their assets for repo. My guess is that up to now only a small proportion do so. This is a particular concern if the asset manager and the depositary bank belong to the same financial group."

Investors would therefore be well advised to check the small print of their fund managers' custodial arrangements.

But if ETF issuers have had a difficult year, it's been even worse for those managing active funds.

The latest Lipper fund flow figures show how actively managed equity funds have started to haemorrhage cash again, after a better couple of years in 2009 and 2010. For the third year in five, active funds are seeing tens of billions in investor withdrawals.

Net Sales Of European Equity Mutual Funds (€ million)

Source: Lipper, a Thomson Reuters Company

Growing investor disillusionment with managed equity funds is unsurprising, given the multitude of recent studies showing that a high proportion of investor returns is eaten up by fees.

As David Norman, author of one of the studies, put it, "In the current low return environment costs take on an ever more important role in fund returns; high costs mean investors are effectively trying to walk up the down escalator – a sure-fire way to get nowhere fast."

Some active managers have responded this year, launching low-cost fund variants to counteract the competitive pressures being posed by index trackers such as ETFs.

But as another year in the markets draws to a close, competitive pressures in the asset management business are clearly intensifying. ETFs have been in the headlines in 2011, but it's the active fund providers who face a wholesale reevaluation of their business models.

What’s the common theme linking the following: Fidelity’s recently announced plans to expand its US ETF range; BlackRock’s August application to the SEC to develop its own indices; MSCI’s launch of a new strategy index range; the lawsuit filed last week by Robert Arnott’s Research Affiliates against WisdomTree; a less-publicised spat between French research institute EDHEC Risk and Arnott over alternative index methodologies; and a reported move by “a cabal of active asset managers” to fight back against the growing uptake of passive funds?

All are signs of an intensifying fight over the middle ground of fund management, where active and passive strategies are increasingly converging. There’s a battle of the bulge, as it were.

The traditional passive fund management business—tracking indices like the S&P 500, MSCI World or MSCI Emerging Markets—is likely to be won by Vanguard, one head of a European ETF business told me this week. Noone else can really compete with that firm’s scale and low costs, he explained. For its part, Vanguard is sticking to the replication of large, liquid, capitalisation-weighted benchmarks, whether via ETFs or index funds, fitting the bill.

Everyone else—including other ETF providers and passive fund managers, active fund operators and now also index providers—is now involved in a scramble to establish competitive advantage in slightly higher-margin areas. The emphasis is on establishing and protecting intellectual capital, a tough job given the commoditisation of many parts of finance.

The rewards on offer are potentially huge. “This is the biggest inflection point in the fund management business since the 1970s,” the ETF head commented.

The battle of the bulge raises interesting questions about governance and fiduciary duties. Should index providers be involved in fund management? This is effectively what’s happening when you start introducing factor tilts and embedded strategies into benchmarks. Should a fund manager be creating its own benchmarks, given the importance of an independent measurement of performance?

These questions will be resolved in time. But for investors, dividing fund providers into “active” and “passive” no longer makes sense, if it ever did. As quantitative investment models proliferate, the emphasis will be on evaluating investment strategies in a holistic, understandable way—a tough task, given some of the complexities involved in fund and index design. There will be a need for a range of new fund comparison tools. And those answering to investors—fund board directors—will have a whole lot of extra homework to do.

According to Richard Comotto, tutor on this week’s International Capital Market Association course on the repo market and collateral management, you should “only do repo (secured finance transactions) with those counterparties to whom you would lend on an unsecured basis”.

Why? Lending and taking a pledge of collateral in return is clearly less risky than lending without security. But it’s easy to become too casual when lending is collateralised, said Comotto.

The experience of US mortgage lenders over the last few years gives some indications why.

Banks lending against the value of US real estate were collateralised, but lenders had made a series of miscalculations: they lent to the wrong counterparties (via NINJA or “liar loans”); the collateral risks were vastly underestimated (it was assumed that housing prices couldn’t fall); haircuts on loans were too small (loan-to-value ratios reached or exceeded 100 percent); loans were not documented properly, incurring unforeseen operational risks; and legal risks materialised when judges ruled widely that lenders couldn’t foreclose when mortgage holders stopped paying their debts.

In theory, said the ICMA’s Comotto, secured lending in the financial markets is good because you have so-called “double indemnity”. If your counterparty fails, you can sell the collateral. If the value of the collateral you hold falls, you can call on your counterparty to top it up. But if there’s a linkage between the behaviour of your counterparty and the value of collateral, then you’re less protected. At worst, you’re effectively lending unsecured.

An example would be conducting a securities loan with a Spanish or Italian bank and then taking a selection of other Italian or Spanish bank shares as collateral. If your counterparty defaults, how much is the collateral going to be worth? Avoid such “pig on pork” deals, or “wrong-way risk”, Comotto said. Keeping the correlation between counterparty and collateral as low as possible is crucial.

There are also legal and operational risks involved in secured lending, said Comotto. Having a pledge of collateral is riskier than taking title to (ownership of) the collateral. But even if there is a transfer of title, if it hasn’t been recorded properly you could still end up as an unsecured lender in the case of a default. And there’s also a risk of running into an unsympathetic judge who doesn’t allow you to net out obligations in the case of a bankruptcy, particularly in some jurisdictions. While the European collateral directive has greatly improved the consistency of close-out netting provisions across the region in the last decade, it hasn’t really been tested in a crisis.

You could also run into conflict of laws problems if you are operating cross-border, said Comotto. Imagine a fund domiciled in one jurisdiction, contracting with a derivatives counterparty in another country and holding collateral in a third. Which country’s legal system holds sway in the case of a bank failure? In theory, it’s the country where the bank is domiciled, but will judges play ball in those countries where the fund is domiciled and where the collateral is held?

Finally, said Comotto, if your secondary defence in a secured lending transaction is the collateral, your primary safeguard is the creditworthiness of your counterparty. It’s better, for that reason, he explained, to take poorer-quality collateral from a safer counterparty than to take top-notch collateral from a poor-quality counterparty.

For this reason, he concluded, you should only choose as a secured finance counterparty those firms to whom you would lend on an unsecured basis.

But if that’s our criterion for selecting counterparties, we’re talking about a very rapidly shrinking pool of acceptable names.

There’s a buyers’ strike in the market for senior bank term debt, for a start. Investors don’t want to lend on an unsecured basis to many banks at any price in the current market, except perhaps at very short maturities. The current all-time highs in the Markit iTraxx Europe financials indices provide ample evidence of their reluctance.

Credit default swap spreads, which serve as a measure of counterparty risk in bilateral transactions, have doubled or trebled this year for the vast majority of banks involved in writing derivatives in the ETF market. This isn’t just a European issue. In fact, some of the banks with the largest percentage rises in CDS spreads this year are US and Asian names: Morgan Stanley, Bank of America, Goldman Sachs, Nomura. For the majority of the banks writing derivatives with European ETFs, it now costs over 3 percent a year to insure against default on senior unsecured debt, a meaningful sum.

For those bank borrowers approved earlier this year by iShares as counterparties in securities lending operations, things are no better. Five of those twelve names—Bank of America, Santander, Goldman Sachs, Morgan Stanley and Unicredit—have senior debt CDS spreads of over 4 percent a year.

Not all European ETFs use derivatives and securities lending, and not all ETFs involved in lending lend out significant proportions of their holdings. Some of the funds involved in lending offer additional safeguards like indemnities. And these questions are not specific to ETFs; they apply to all funds engaging in similar activities.

But—taking Comotto’s point—if you wouldn’t be willing to lend unsecured to the banks involved in repo-like activities with the majority of the ETFs in Europe, should you be buying the ETFs that trade with those counterparties at all?