Illustration by Claudio Munoz

ECONOMISTS tend to think that an industry divided between hundreds of players, each with a tiny market share, should be fiercely competitive, with prices cut to the bone. But economic theory struggles to explain the bizarre world of fund management, where the market is fragmented but fees stay stubbornly high.

The takeover of Barclays Global Investors (BGI) by BlackRock, finalised on June 16th, will create the world's largest asset manager. More deals are likely in the coming months. In part that is because banks are keen to shed their fund-management arms, either because they need to raise capital or because they no longer see a business case for combining deposit-taking with portfolio management. In part it is because stockmarket falls in 2008 slashed fund managers' revenues, leaving some groups with broken business models. But the industry remains massively diffuse and has defied past predictions of consolidation. Even the BGI/BlackRock deal will create a fund manager with only 3-5% of the global market. Perhaps the problem is that the industry has difficulty generating economies of scale. Might a few mergers be good news?

Bigger does not necessarily mean better when it comes to running other people's money. True, a bigger group has more money to spend on marketing and can achieve economies of scale in areas such as back-office technology and administration. But there are also disadvantages of scale. Large funds are less flexible and tend to move prices against them when they trade; they also tend to be more bureaucratic and end up alienating talented managers, the ones clients want to look after their money. Luck also plays its part. Fund managers may grow for a while because of superior investment performance. But sooner or later they will be undone by a change in market fashion; their performance will deteriorate and hot money will move elsewhere.

The BGI/BlackRock deal may avoid some of these problems. BGI is one of the two biggest fund managers in the field of index-tracking, one area where having more funds under management does lead to lower costs, which in turn makes it easier for the manager to match a chosen benchmark. But that is something of a special case. The general rule of fund-management consolidations is that they may be a good deal for the companies, but they rarely bring much benefit to investors, for two reasons. First, retail fund managers compete on past performance rather than price. Alas, a good performance one year tends not to be repeated the next; but the fees carry on. Second, because of their inertia, retail investors tend not to buy funds; funds are sold to them. Fund managers must pay banks and brokers to distribute their products, and they claim back that money from investors. As a result the bestselling funds often have the highest charges; other things being equal, they represent the worst deal for investors.

The price is wrong

That second factor helps explain why there is a stark difference between America and Europe. In America, where retail investors are more willing to buy funds directly, the expense ratios of mutual funds have declined for four successive years, according to Lipper, a provider of financial information. But in Europe, where funds are largely sold through banks, annual management fees have steadily risen, from 1.3% in 1994 to 1.6% last year. Retail fund-managers have fed themselves well, but their investors have been left with the scraps.

Even institutional investors such as pension funds and insurance companies, which ought to have the clout to force down fees, are paying more. A survey by Watson Wyatt, a consulting firm, found that the cost of running a pension scheme increased by around half between 2003 and 2008. That was because schemes allocated more of their portfolios to hedge funds and private-equity managers, which charge much higher fees. Chasing performance by paying higher fees might work for individual investors, but in aggregate it is doomed to fail. The return to the average investor is the market return minus costs; if costs rise, returns must fall.

Retail investors, in particular, would do well to learn that lesson, and take responsibility for their own finances. Just as they shop around to find the best estate agent, they can seek out low-charging vehicles such as exchange-traded funds. If enough investors focus on cost, not performance, the fund-management industry will have to give them a better deal.