An Industry in Transition
The investment management industry has enjoyed rising revenues and attractive profit margins. Investment firms benefited from the accumulation of assets from the baby boomer generation and from rising markets that created a multiplier effect for asset and revenue growth. However, it’s no secret that the investment management industry is in the midst of significant fundamental change. Greater recognition of the connection between costs and investor outcomes is an important catalyst, as is the disappointment of many investors in the results from actively managed investment products.
Speculation about the future of investment management is common. Unfortunately, far too many forecasts are slanted to favor the business interests of the commentator. Passive managers often discuss a future in which index or factor-based investments predominate, and are critical of the performance track record and fees charged by actively managed strategies. Active managers often highlight active management successes or speculate about doomsday scenarios in which the demise of active management causes a breakdown of the price-setting mechanism of markets.
Hedge funds are frequently a target of misleading attacks. A recent commentary published in a San Francisco newspaper suggested that pension plans should cease investing in hedge funds because the average hedge fund has trailed the Standard & Poor’s 500 index for eight consecutive years. Most hedge funds aren’t trying to beat the S&P 500, so the comparison was misleading and based on a false premise. There may be reasons to criticize pension fund investments in hedge funds, but underperformance relative to the S&P 500 isn’t one.
The Portfolio of the Future
My firm invests in both passive and actively managed products, and I have extensive background with hedge funds and private investments. Consequently, I think I have a well-informed and reasonably unbiased perspective about the future of the investment management industry. Index and factor-based funds should continue to gain market share, but active management will still play a meaningful role in investor portfolios. Many investors will gravitate to portfolios that include core investments in low-cost index or factor-based funds, supplemented by active funds in selected asset classes. This “core/satellite” approach is already widely used by advisors and institutional investors, and may become the norm for a growing share of the investor population.
Index or factor-based strategies are likely to dominate ultracompetitive asset classes such as large-cap equity, providing low-cost, tax-efficient market exposure. Active strategies may thrive as satellites around a core allocation to index or factor-based strategies, providing return enhancement or risk management benefits.
Actively managed strategies may provide return enhancement opportunities in asset classes in which skilled managers can develop a sustainable edge and provide superior risk-adjusted performance. Despite the many negative headlines about active management, active managers have enjoyed success in asset classes such as international small-cap equity and core fixed income.
Actively managed strategies may also be used in asset classes in which indexes are flawed or are highly fluid in nature. For example, high-yield credit indexes are dominated by the companies that issue the most debt, a structure that can lead to unintended and undesirable consequences. High-yield credit indexes may not be completely investable or may carry very high trading costs, demonstrated by significant differences in performance between passive high-yield funds and their benchmark index.
Actively managed funds may also be used by some investors to invest in emerging markets, as today’s indexes may not represent tomorrow’s opportunities given the transition of many emerging markets from commodity to consumer-centric economic models. Global equity, particularly “go anywhere” strategies, may also be winners as investors abandon the rigidity of the “style box” system previously favored by many. Hedge funds and other alternative investments may have a role in larger portfolios, providing either returns that are less correlated with stocks and bonds, or taking advantage of potential return premiums associated with illiquidity or concentration.
Firms That Will Win Under the New Industry Paradigm
According to Morningstar, passively managed funds collected more than $1.5 trillion in net new assets over the last three years. Passively managed funds and low-cost institutional share class funds are the beneficiaries of the increasing attention paid to investment costs. Actively managed funds are losing assets at an accelerating pace, with the pain felt most by higher-priced funds. Firms that specialize in high-priced, index-hugging funds face existential challenges.
Vanguard and BlackRock dominate indexing with an estimated market share of 67%. Given the importance of scale to indexing, it is likely that the index segment will be dominated by a small number of competitors. Charles Schwab is one of the most creative innovators in the index arena, leveraging the Schwab brand and resources to become a credible challenger to the index leaders. The creator of the first (and largest) ETF, institutional indexing powerhouse State Street Global Advisors, is also a contender for a meaningful share of the index market.
Scale is also important in the factor-based segment of the market, despite the proliferation of “me-too” products from aspiring “smart beta” providers. Early innovators in factor-based investing benefited by commercializing academic research into factors such as style, size and momentum. As factor-based investments become far more crowded and it becomes harder to generate incremental returns relative to traditional indexes, research capabilities and implementation skill will increasingly differentiate the contenders from the pretenders. Among the likely winners in factor-based investing are Dimensional Fund Advisors, AQR and Research Affiliates.
Some of the most interesting equity investment opportunities are in segments of the market in which investment capacity is limited or specialization and a long time horizon is required. Size is often the “enemy of investment success” in equities, and winners in a world that gravitates to core/satellite approaches may include high-quality investment boutiques such as Matthews Asia, Baron Capital, Harding Loevner and Cohen and Steers, as well as multi-boutiques such as Artisan Partners and Affiliated Managers Group.
Fixed income may provide a different set of lessons, as actively managed strategies are likely to maintain a higher share of fixed income allocations than passively managed strategies. Scale can be a benefit in fixed income, as identifying relative value is much easier for firms with the resources to cover a wide array of bond sectors while evaluating fiscal and monetary policy developments that influence interest rates and currencies. Access to new issues is also an important component of bond investing, and larger firms may have an advantage. Firms renowned for thought leadership and deep investment teams, such as Pimco, DoubleLine, TCW, BlackRock and JP Morgan, are well-positioned to thrive in a core and satellite environment, though there is also room for highly-skilled specialty managers to thrive.
The investment industry is evolving at a rapid pace, disrupted by changing consumer preferences, demographics and the pervasive influence of technology. Investment management firms must resist the urge to protect legacy business models, and must evolve to meet the demands of an increasingly well-informed audience of consumers and advisors. Price competition and performance transparency are not going away, and investment firms must provide a value proposition in which performance and cost both meet increasingly demanding expectations. A limited number of investment firms are likely to thrive in the future, and firms that fall short are likely to disappear.