What Does Active Management’s Future Hold?

Sanjiv Sawhney

The rise of passive funds has been a constant theme in the asset management industry. According to Morningstar, from 1995 to 2018, cumulative net flows to passive mutual funds and ETFs totaled $4.7 trillion, compared to $2 trillion for active funds. And last year the industry reached an important milestone when the total assets of passive US equity mutual funds and ETFs topped the total assets of actively-managed US equity funds for the first time ever.

Against this backdrop, what are your thoughts on active management’s future?

Robert McKillop

Active management isn’t dead but it is changing. The growth is now coming more from liquid and illiquid alternatives, which are forecast to be over 50% of the industry’s revenue. Much less revenue is forecasted to come from traditional fixed income and equities, which have seen the most competition from the rise of passive. However, it’s not as simple as active versus passive because both play a role in clients’ portfolios. The industry needs to offers a full range of solutions for investors to choose from.

In particular, active management can play a key role in dealing with some of the meta-themes that are emerging. There’s been a lot of focus on the differing tastes of Millennials and their preference for thematic and Environmental Social and Governance products (ESG) both of which require active solutions. However, we should not forget the Baby Boomers who face a very tough challenge to fund their retirements and will require investment solutions.

Another key trend is the emerging middle class in developing countries. They will drive demand for simple, packaged portfolio solutions, likely using passive as key building blocks in their portfolios but also incorporating active elements to help with returns.

Sanjiv Sawhney

I agree the future of active management isn’t as bleak as some would have us believe; but how do active managers need to change in order to compete?

Robert McKillop

Active management can thrive but there are going to be winners and losers. The winners will be those who embrace innovation and execute transformational change.

Product innovation will remain critical and the key in moving your offering to areas of growing client interest, such as alternative and real assets, and something unique that delivers a certain level of pricing power. For example, our new product launches since our merger in 2017 have carried an average revenue yield of above 50bps, compared to our corporate average of just below 30bps. Product innovation can protect margin whilst also delivering volume – those same post-merger products have delivered around £14bn of AUM to us.

Managers should also look carefully at the vehicle they choose to deliver their solutions. Historically, vehicle type has often been an afterthought for many managers. However, between ETFs, separately-managed accounts, and specialist fund structures like the European Long-Term Investment Fund, clients have more choices than ever before. As a result, the wrapper that managers use to deliver their solutions to clients will become a bigger part of the selection process. This means we need to make sure they have the expertise to support these options.

Technology is another important area of innovation. While it is typically viewed as a way to help to drive down the cost of alpha, active managers are actually utilizing data science techniques to deliver more alpha. We are looking at how we use these techniques to drive better idea generation, portfolio construction, and ongoing evaluation of our investment processes to understand where we are adding value.

Sanjiv Sawhney

You mentioned reducing costs and, obviously, fee pressure is a big part of this trend. Often the response to fee pressure is to cut costs, but are there other ways that active managers can look to tackle the issue?

Robert McKillop

Fee pressure is an ever-present challenge for asset managers of all stripes. To combat this pressure firms should look to innovate in their processes and pricing. Innovation in processes can help drive down the cost to serve, especially in low growth areas such as core equities or fixed income. True process innovation entails looking throughout the value chain to see where improvements can be made. This includes evaluating areas that can be automated or outsourced, beyond the traditional back-office functions. Increasingly, we’re relying on our service providers to help co-create solutions that can help us reduce our costs while giving us scalable infrastructure.

Pricing is another area that is ripe for innovation. As an industry, we have been quite sleepy in thinking about how we price our products. Investors and regulators understand the industry’s economies of scale and expect us to share that with the end clients. As the price of beta gets driven towards zero, a potential solution is to look at how we price for alpha. There have already been several models attempted, such as fulcrum and sliding fees, but nothing has really caught on. Nonetheless, there will certainly be further experimentation and the firm that finds the right strategy could transform the industry.

Sanjiv Sawhney

Finally, what do you think will be the to key to success for active managers in the next decade?

Robert McKillop

Active managers should focus on areas where they can truly add value. Private or illiquid markets are an obvious area of focus, especially given the likelihood of a prolonged low-interest rate environment. Clients are attracted by the enhanced yields and diversification benefits and this spans across different investors, including insurers, pension funds, and institutional investors. There’s a massive opportunity for the industry to deliver the benefits of those illiquid strategies to investors who want liquidity.

According to Morningstar, there’s already nearly $1 trillion in ESG funds globally and we anticipate the demand for sustainable products to continue to grow. That demand won’t just be in fund products, increasingly institutional investors are requiring ESG criteria be part of their solutions. To meet this demand, ESG needs to be integrated into the investment processes across the board.

Finally, firms need to focus on delivering solutions because many smaller institutional investors will see managing assets in-house as too complex, costly, or risky and will look to outsource. This will lead to a growth in portfolio solutions opportunities from insurers, pensions, and financial advisers. While the fees will be much lower than traditional asset management, the asset size should be larger and much stickier.

Sanjiv Sawhney

Robert, thank you for your time. I think it’s safe to say that there’s still a place for active management in spectrum of solutions that managers provide to clients. While there are challenges, those who adapt and innovate to meet client demand will be well positioned to succeed. I think it’s incumbent on the entire ecosystem, from service providers to asset managers, to collaborate on how they can better meet investors’ needs. Overall, I think our conversation shows that the future for active management isn’t as bleak as the pundits would have us believe.