Professional buyers have backed active fund management to find favor again with investors when markets turn.
But they believe managers will have to live on thinner margins in the future and change the way they operate.
Active management has not had its best year in terms of flows. Every day it seems there is a new set of data and accompanying articles highlighting huge outflows from active funds and a corresponding swing to passives.
Active management’s obituary has been written more than once in 2016, but investment gatekeepers at major advice firms and broker-dealers believe this is premature.
An active future
These gatekeepers control some $13 trillion of assets, according to data collected by Citywire. We asked them about the shift to passives and the future of actively managed funds.
Raymond James and Dynasty Financial Partners said the move to passives had been driven by the equity bull market in the US and a move to active would come as investors seek downside protection.
The S&P 500 index has really dominated active large blend/core and most other asset classes over several years,’ said Tom Thornton, vice-president and head of manager research at Raymond James Asset Management Services.
Fees lowering is great, but some passives may be bought without the downside protection of active managers, at the wrong time.
Tom Thornton, Raymond James Asset Management Services
Scott Welch, chief investment officer at Dynasty Financial Partners, shared the sentiment. ‘You don’t pick an active manager to outperform in a bull market; that’s very difficult to do consistently. You pick an active manager to preserve capital in a bear market.’
Of the $50 billion overseen by Thornton and his team, $44 billion is in long-only active funds, with $5 billion in traditional exchange-traded funds (ETFs) and $1 billion in liquid alternatives.
Moody’s Investors Service also estimated that passives only have a one-third market share in the US, so active is far from extinct.
Back to life
That is not to say, of course, that the pressure to reduce fees will ease.
‘Even if active management came into favor, I don’t think the message that fees matter is going to reverse,’ said Michael Iachini, managing director of mutual fund and ETF research at Charles Schwab Investment Advisory.
‘I think the trend toward lower-cost investments is here to stay,’ agreed Tim Clift, chief investment strategist at Envestnet, adding that this applied to all products rather than only signifying continued growth for passives.
Even if the active industry is far from dead, it could still take steps to improve its health.
One step would be to consolidate. Moody’s Investors Service counts around 10,000 mutual funds and another 10,000 hedge funds available to US investors. Clift expressed an interest in seeing funds simplify their ranges of share classes too.
Welch hoped to see asset managers refocus on concentrated and high-conviction portfolios, but doubted that large fund groups could embrace their inner boutique.
‘At the end of the day, this remains a distribution game. That is the primary advantage of the monster asset-management firms: they know how to sell.’
A more ambitious, or defeatist, approach for active shops would be to harness passive by building or buying ETF businesses.
Plenty already have: Janus and VelocityShares, Legg Mason and QS Investors, Columbia Threadneedle and Emerging Global Advisors, among many others.
What most of these have in common is an emphasis on smart beta; they are not an attempt to challenge the incumbent giants of Vanguard, State Street and BlackRock, whose combination of low fees and high liquidity would be difficult to overcome for mainstream indices.
To the extent smart beta cannibalizes cheaper traditional trackers, rather than taking market share from active strategies, it could boost industry profits.
The smart-beta raft is unlikely to be large enough to fit everyone, however. ‘We think there is going to be a proliferation of strategies in the beginning, but then competition and survival of the fittest will winnow it down over time into a handful of successful strategies,’ said Stephen Tu, senior analyst at Moody’s Investors Service. He added that smart-beta fees would also face compression while being ‘anchored’ by index trackers charging single basis points.
More fundamentally, Welch challenged the smart beta tag for implying that it was a better way to invest; rather than being a ‘panacea,’ he countered, specific betas would only work in specific market environments and certainly did not guarantee outperformance.
Taking advisors' turf
With their own field looking trampled, could fund groups eye a move onto advisors’ turf?
They could, for instance, repackage current active strategies – or passive products – inside multi-asset funds, as an outsourced proposition for advisors or private investors.
Multi-asset was indeed a winner in a Casey Quirk survey undertaken by consultants Casey Quirk by Deloitte and McLagan. It attracted 24% of all net new money last year, up from 18% in 2014.
For Iachini, however, asset-allocation funds are more a product for 401(k) investors than high-net-worth individuals.
The all-in-one fund has a role, but I would be surprised if that became a giant growth area for the industry.
Michael Iachini, Charles Schwab Investment Advisory
Jeffrey Levi, principal at Casey Quirk by Deloitte, nevertheless felt that fund groups would indeed need to ‘embrace asset allocation as a core competency’ and market that to the segment of advisors happy to outsource portfolio decisions.
‘When you look at who has the greatest skillset in terms of asset allocation, asset managers are right at the top,’ he said. ‘They have demonstrated that their ability to generate outperformance through asset allocation is actually quite strong.’
They do lack the holistic capabilities of turnkey asset management providers, however, such as custodian functionality.
As with smart beta, asset managers can and are buying into this market, most visibly at the moment in the robo space: BlackRock and FutureAdvisor, Invesco and Jemstep, Fidelity and eMoney Advisor, and so on.
Equally, the convergence can be driven from the other side: Edward Jones developing proprietary fund propositions, for instance, or Charles Schwab integrating vertically.
Liquid-alternative funds, particularly those with a low-volatility mandate, could also be marketed as solutions. This would be highly profitable for asset managers: McKinsey has estimated that alternatives command a revenue margin twice that of target-date funds and four times greater than ETFs.
There would be obstacles to selling liquid alternatives more widely, of course. ‘They are complex, opaque, may involve leverage and are relatively new as well, so how much risk is the advisor taking in selling something like that?’ Tu said. ‘And on top of that, the fees are higher.’
That cuts to the heart of the issue for the active industry: is it developing products that advisors can use? To ensure the answer is yes, asset managers will need a multi-pronged response: consolidation and self-improvement; developing a quantitative or smart-beta business; and establishing themselves as outsourced investment partners.