Asset management is one of hundreds of industries that finds itself under profound disruption. In the first article on this topic, I explored the roots of modern asset management, noting that during the 40-year stretch from the late 1950s through the 1990s when things were working quite well thanks to the 60/40 model, the industry had no need to change.
Then, with the dot-com bubble and subsequent tectonic shifts in both demographics and the economy, it slowly shifted to take a more stratified, defensive position in the financial landscape in reaction to slashed assets-to-liabilities ratios and, frankly, consumer demand. Defined benefit pension funds shifted to defined contribution; investing shifted from active to passive; and, where we left off, low-fee index funds and ETFs emerged front and center. Now, I’d like to delve into the move toward beta returns, the increasing difficulty of generating alpha, and the innovative thinking that will be required as the industry reinvents itself.
Data Levels the Playing Field, Disrupting Again
It’s not much of a stretch to say that the roots of most disruption lie in the proliferation of information, access to which has exploded since the advent of the Internet, which has disintermediated the exclusive, proprietary nature of most industries. Chances are, unless you’re maybe a 5th-generation shoemaker in a tiny Italian town, your field’s language, processes, and information no longer have a sheen of exclusivity. Everyone with a smartphone now has the ability to quickly assess where the market stands on any given subject. In asset management, this has meant the shift from alpha to beta returns, as the free flow of information allows few players an edge. When everyone knows everything, it’s much harder for anyone to get a leg up.
As you are no doubt aware, beta returns are at market level, while alpha returns are above the market. It’s become increasingly difficult to generate alpha returns. In the days of Wolf of Wall Street-type traders, there wasn’t an oversupply of information—but we now have a plethora, leveling the playing field. More people can understand stocks, bonds, and how to generate returns through portfolios—including the 60/40 model, style boxes, indexes, and exposure to different geographies.
With this new era of information comes a corresponding new management trend: factors. This model holds that if you understand the quality, value, and momentum of a stock via different underlying metrics, you can determine fairly accurately which stocks are likely to perform better than others. Once you understand these factors, data and technology allow you to layer algorithmic trading on top of that. And when that happens, asset managers homogenize. A set number of algorithms feed on the same degrees of factors and available information. This drives the entire industry further toward sameness, toward market—in short, toward beta returns.
Passive Investing and the Barbell
Two industry trends have emerged from this movement. First, as we’ve mentioned, there’s been a shift from active to passive investing, or else toward more outcome-based returns. Second, companies are looking for different sources of profit. There are massive ‘beta factories’ that churn out beta returns through index funds, ETFs and trackers. In order to do this profitably, a company has to be big enough to take advantage of economies of scale, otherwise they can’t keep their costs low enough to remain profitable.
To give some sense of the relative scale here, a firm that has less than $500 billion in assets under management carries costs that are twice as high as a $500 billion-plus asset manager. Indeed it’s reported that, while the top 500 global asset managers grew their assets by 15.6 percent last year, the top 20 firms’ assets under management grew by 18.3 percent.
This is called the barbelling of the industry, which results in weighty segments on either side of a thin bar–in other words, if you’re in the middle, it’s hard to survive. On one end are the global mega-players that are hoovering up more assets under management, and quicker, than their peers, making huge profits. Data indicates that if you’re a top ten asset manager, it’s easier to get more assets under management because economies of scale kick in and you can lower your charges and fees. The top five—Vanguard, Blackrock, etc.—are accelerating even faster still, and threaten all others with getting left behind.
On the other end, there are small firms that specialize in active management; but these are niche players. While it’s getting more difficult to generate alpha, these houses are still making a decent amount of profit despite their relatively small size, because they have chosen to keep investing in a few select, very specialized areas. In the middle, you’ve got all the asset managers that are being squeezed on both profit and outflows.
Asset managers are now starting to look for different types of alpha, different ways to generate above-market returns. The first type was illiquid assets, like real estate, but now they’re starting to look at other sources of alpha, such as small and medium enterprise (SME) level private equity deals and venture capital (VC) investment in startups. We’re seeing an alternative asset in private debt, as well.
Still other alternative investment strategies are coming to the fore. One company might be an alpha shop, one side of the barbell—a niche-type asset manager—for which investment expertise and multiple management disciplines are required. Another company could be a beta factory, generating returns in line with the market, but leveraging economies of scale, liquidity, and a global product pipeline to maximize profit. In the case of the largest global players, it’s possible to combine the best aspects of scale and niche by investing in regional SMEs and other specialty investment shops and leaving their processes largely untouched.
Another option for asset management companies is to become a provider of outcome-based solutions such as total returns and liability-driven investments. If a pension fund or institutional client has a particular set of goals—whether it’s a particular risk profile, or limiting their exposure to certain geographies or industries—it’s possible to build a bespoke solution. This type of investing can be done across different asset classes, but it’s necessary to have a wide selection of products and asset classes and strong expertise in constructing a portfolio.
Top asset managers are capable of delivering all three of these models. They are a solution provider, beta factory, and they also do a significant amount of alpha—active investment management. Where asset management appears to be heading, it seems increasingly necessary to be able to give clients the full spectrum of risk solutions, from the simple passive, hands-off approach—you give us your money, and we’ll manage it on your behalf—to full fiduciary responsibility, where the asset manager takes over full ownership and running of the pension.
Next time we’ll talk more in depth about the massive movement from defined benefits, which have become unsustainable, to defined contributions—a shift that puts much more onus on the individual to take ownership of their own financial future.
About the Author: Martijn Moerbeek is group director of Digital Strategy & Innovation at Legal and General, a forward-looking, UK-based financial services and insurance firm managing over $1.4 trillion in assets. He can be reached at [email protected]