Top 400: Business models - No turning back
Familiar set-ups in asset management are becoming obsolete in the face of Darwinian forces
- Passive strategies are harder to beat and the industry is concentrating.
- Artificial intelligence is disrupting the value chain.
- M&A must deliver value-added beyond scale efficiencies.
- Managers should become trusted advisers and improve client experience.
“BlackRock chooses wires over wizards to pick stocks” ran a headline in The New York Times back in March. On the same day, Bloomberg reported that the legendary John Paulson, who made billions from the sub-prime crisis, was slashing bonuses at his hedge fund after a dismal 2016. Such headlines are common.
The number of asset managers that can deliver market-beating returns has fallen to its lowest level since at least 1998. But that’s not all. First, passive is in the ascendancy. Over the period 2008-16, the share of active core strategies in the global investable universe declined from 86% to 76%, while that of passive funds (including ETFs) increased from 14% to 24%, according to estimates compiled by CREATE-Research. As markets have become deeper and more liquid – especially in the US – they have become ever harder to beat.
Second, fund management is turning into a winner-takes-all game. The world’s ten largest managers – measured by net inflows in Europe and the US over the past 15 years – have captured over 75% of net new money in motion.
Third, investors continue to have unrealistic expectations. Average returns (net of fees) targeted by European pension investors, for example, are around 6% – a near impossibility, since quantitative easing has already borrowed future returns for most asset classes.
Fourth, regulators are cracking down on fees and charges. In the UK, for example, the Financial Conduct Authority has gone a step further by overtly advocating passive funds for less informed investors. Fee compression is the norm and profit streams are becoming more volatile.
Finally, artificial intelligence is already disrupting every area of the value chain. Not only it is industrialising the craft of alpha generation, as illustrated by the BlackRock example. It is also disintermediating the value chain by promoting direct selling channels. Most of all, it is forcing asset managers to shift from selling what they have to selling what their clients need. The industry is no longer supply-led.
M&A is not a panacea
Consolidation is inevitable. Two recent large scale mergers – between Henderson Global Investors and Janus Capital, and between Aberdeen Asset Management and Standard Life Investments – herald a new wave. There are plenty of players who are either too big to be small or too small to be big. Managers caught in the ‘mid-tier trap’ will have to shape up or ship out.
Big can be beautiful, but only if scale delivers either lower unit costs, investment capabilities that deliver multi-asset class products, global footprints that penetrate new markets or a technological edge that delivers better value for clients. However, size does not ensure success, according to various M&A deals that I have studied since 2000.
In hindsight, crunching businesses together has proved mission impossible because of five constraints: internal politics, unrealistic expectations, excessive hype, the us-and-them syndrome and the lack of management bandwidth to do the necessary slash and burn. After acquisition, the whole has to be worth more than the sum of the parts. That has happened in around a third of the deals, thanks to savvy execution.
The rest have suffered from an empire building syndrome, best exemplified by Gartmore Investment Management. It was sold to Banque Indosuez in 1989, which sold it to NatWest in 1996, which sold it Nationwide Mutual in 2000, which sold it to the private equity firm Hellman & Friedman in 2006, which listed it on the London Stock Exchange, only for it to fall into the rescuing arms of Henderson Global Investors. Until then, on each occasion, what was reported as industry consolidation was just a merry-go-round.
Hence, M&A is not a one-size-fits-all solution. There is ample scope for doing old things better as well as doing new things.
Doing old things better…
At a time when markets are so disconnected from their fundamentals, investing has also become a loser’s game: one where the winner is the one not with the best strategy but one who makes least mistakes. It’s all about winning by not losing. How clients behave, therefore, has a major impact on their investment returns.
Asset managers need to step up to the plate and aim to become a trusted adviser for their clients – in the inner circle of confidants and open about the promises and perils of investing today. That means decoupling marketing from thought leadership by seeking three sets of step-improvements.
The first set seeks to improve client focus. This involves understanding clients’ dreams and nightmares, avoiding unrealistic claims about returns, soliciting new ideas, managing expectations, raising awareness, and avoiding panic buying and selling.
The second seeks to improve investment capabilities. Innovations are essential in investment processes to recognise that investment returns are turning into a monetary phenomenon, influenced more by politics than economics.
New lenses are needed to look at markets from perspectives as diverse as politics, psychology and philosophy. Financial theories alone can no longer be relied upon to influence investment decisions.
The third seeks to promote a better alignment of interests by replacing the age-old ‘heads-I-win, tails-you-lose’ fee structure with a more equitable sharing of pain and gain; avoiding me-too products not tested by time or events; and offering proactive investment ideas.
…and doing new things
The most obvious action is to widen the scope of the existing business.
To start with, new expertise is needed to invest in less efficient markets where pricing anomalies are ripe or diversify into areas – like long/short funds, multi-asset funds or alternatives – which are likely to grow over the rest of this decade.
Furthermore, new channels – like discretionary and defined contribution – remain to be exploited, as personalisation of risk spreads to all pension markets. Finally, new client segments – like insurance companies and sovereign wealth finds – need to be nurtured, as they seek to outsource a raft of investment strategies like real estate, credit and emerging market assets.
Improving client experience in this digital age is also emerging as another priority. Clients increasingly want a one-click, hand devise-based advice and execution, with complete transparency around fees and charges. They also want jargon-free educational tools that help to counter clients’ behavioural biases like herding and market timing.
With total separation of alpha and beta, fee pressures will intensify. To contain them, significant investment in digital technology will be inevitable in order to automate routine operations, improve customer service and improve investment performance by harnessing the power of big data and machine learning.
In the past, when faced with existential challenges, asset managers have relied on market recovery to bail them out. On this occasion, this is unlikely since markets are already trading at unsustainable multiples and clients are rapidly developing zero tolerance for mediocrity.
As Bill McNabb, CEO of Vanguard, recently warned: “The change in the economics of the investment management business is pretty profound.”
Amin Rajan is CEO of CREATE-Research