The history of financial markets has more wild plot twists, temper tantrums and triumphant comebacks than a daytime soap opera — or a US presidential election for that matter. Even by Wall Street’s standards, 2020 has been exceptional, yet for some active asset managers it offered the promise of salvation of sorts.
Over the past two decades there has been an epochal shift of power from the pedigreed stockpickers and bond kings who have straddled markets, to the cheap, passively-managed index funds now in the ascendancy.
In the past 10 years, passive equity funds have enjoyed inflows of more than $2tn, even as traditional, active ones have suffered outflows of over $1.5tn, according to data provider EPFR. There is now over $12tn in index funds globally — either passive mutual funds or the increasingly popular exchange traded funds — according to Morningstar.
This underestimates the heft of passive investing, as many big pension plans and sovereign wealth funds now manage index-tracking strategies internally. “In many ways it’s now the default,” says Christopher Harvey, a senior analyst at Wells Fargo who covers the investment industry.
Traditional money management groups have long argued — particularly loudly in the past decade — that they would prove their worth in the next downturn. The coronavirus-triggered mayhem of 2020 has been a perfect opportunity to demonstrate the merits of human “active” management, while staunching the outflows or even beginning to reverse them.
“It’s markets like this . . . where active managers get to show outperformance,” Jenny Johnson, chief executive of Franklin Templeton, told analysts in April. “And as you have outperformance, the flows will follow.”
In contrast, the weaknesses of index funds would be revealed, some industry executives predicted. “The shortcomings of mechanised trading, better known as passive trading, will come into sharper focus,” Peter Harrison, chief executive of Schroders, wrote in the FT in March. “The answers will not be conjured up by arms-length algorithmic investment management.”
Yet, despite such predictions, 2020 looks like it will end up as another muddled year for active management. With a few notable exceptions, the results have mostly been mediocre, with problematic consequences for the industry. “It will further accelerate the demise of traditional active management,” says Yves Bonzon, chief investment officer at Julius Baer, a Swiss private bank.
Asset management executives and analysts expect this to speed up consolidation in the industry, as investment companies seek out the shelter that size offers them. There has already been a spate of deals in recent years. But with the promises to outperform in downturns once again unfulfilled, and likely to reinforce investor scepticism of active management, the battle for market share is set to become even more ferocious.
“Buoyant financial markets lifted asset levels over the past decade, but masked underlying challenges and deteriorating fundamentals at asset managers,” Michael Cyprys, an analyst at Morgan Stanley, said in a recent report on the industry. “We expect the implications of the crisis to have a lasting impact on the industry, accelerate existing trends, and motivate managers to take strategic decisions faster than anticipated.”
A better environment
The investment industry dealt well with many aspects of the Covid-19 pandemic. Shifting thousands of portfolio managers, traders, analysts, risk managers, fund accountants and compliance staff out of the office — at a time when financial markets were in a tailspin — without any major mishaps was an under-appreciated achievement.
“The resilience was a big success,” says Keith Skeoch, chairman of the Aberdeen Standard Investments Research Institute. “Not only did business get done, but liquidity kept flowing . . . A huge amount of money has been raised in the bond and equity markets. The industry continued to fulfil its role in transforming savings into investments.”
However, when it comes to the primary job of a money manager, the record is more blemished. Analysts slice and dice the overall performance of active funds in different ways, which can lead to differing results. Yet one of the most comprehensive, regular snapshots — the S&P Dow Jones Indices’ “Spiva scorecard” — makes unhappy reading for anyone seeking evidence that active management is having a bright 2020.
Only about a third of US equity funds beat the broader market in the year to the end of June. The longer-run Spiva — the S&P Indices Versus Active — results are even grimmer, with under 13 per cent outperforming over the past 15 years. The story is broadly similar for bond funds, despite fixed income markets generally being considered less efficient and therefore offering more opportunities for skilled money managers.
Nor has the third quarter helped much. Bank of America estimates that 40 per cent of US equity funds have surpassed their indices in the first nine months of the year. This is narrowly ahead of the 36 per cent long-term average since 1991, when its data began, and the turbulence around the recent US presidential election may have helped. But it means a majority of funds still underperformed their index even in a supposedly better environment and is unlikely to alter the entrenched trend of outflows affecting the industry.
“This has been anything but a normal bear market,” says Michelle Seitz, chairman and chief executive of Russell Investments, pointing to extraordinary central bank stimulus and the dominance of big technology stocks in the subsequent recovery. “I don’t know how valid it is to look at a cycle like this and try to draw too many conclusions from it.”
There are important nuances, for example, that active managers generally perform better in certain markets, such as international equities; or in smaller stocks that are less well covered by Wall Street’s army of analysts. “Active is not dead,” says Nicolas Moreau, chief executive of HSBC Global Asset Management. “The more the market is inefficient, the more active management is important.”
Higher returns also mean the sensitivity to performance can be diminished. Investors are unlikely to dump funds that focus on racier “growth” stocks just because they have narrowly trailed behind their benchmark.
Nonetheless, the overall shift into index funds has continued apace — with another $375bn going into passive vehicles in 2020, according to EPFR.
The main driver is the fact that fixed-income ETFs — which some analysts had warned would prove to be fragile in a downturn — performed better in the coronavirus market tumult than many investors had feared, says Sheila Patel, chairman of Goldman Sachs Asset Management.
“A number of institutional investors say they were pleasantly surprised by the liquidity and functionality of using ETFs in March-April,” she says. “So I definitely think it’s cemented a place on the fixed income front.”
Stock market underperformance
Equities remain the hardest area for asset managers to retain investors, and the hurdle is getting higher. In the 1990s the top six deciles of best-performing funds saw inflows, while in the 2000s only the top three deciles did so. In the past decade only the top-decile funds enjoyed positive flows, according to Morgan Stanley.
Even Fidelity’s Contrafund — the world’s biggest actively-managed equity fund — has suffered steady outflows in recent years, despite its manager William Danoff beating his benchmark by an average of over 3 percentage points a year over the three decades he has managed the fund.
Underscoring how far the pendulum has swung in favour of passive investing, this summer Coloradan industrialist Clarence Herbst sued the state university’s foundation — which he had previously chaired and donated to — for eschewing index funds in favour of pricier, poorly-performing active funds. The case was thrown out by a Denver judge in October on the grounds that Mr Herbst had no standing to sue, but the fact that it was filed was emblematic of the shifting views of investors.
Tellingly, the shares of most big investment groups have underperformed the broader stock market this year, falling by an average of 2.4 per cent compared with the S&P 500’s 10 per cent gain. Over the past decade BlackRock — the world’s biggest provider of ETFs — is the only US asset manager whose shares have beaten the S&P 500.
Industry executives are aware of the unfavourable data on their overall performance, and know that for a durable active asset management comeback this will need to change. But there is cautious optimism that the coming decade will prove more fertile for their stockpicking stars and bond kings.
Given the prospect of more market volatility, lower overall returns that necessitate a more aggressive approach and widespread economic disruption, the future of active management is brightening, Mr Skeoch argues.
“It’s up to active management to show that it can deliver . . . But I would argue the environment is going to be materially different,” he says. “The opportunity is there, we’ll see if people step forward and take advantage of it.”
Consolidation picks up pace
Staunching the industry-wide outflows matter because scale is becoming increasingly important for asset managers. Many big institutional investors are trimming how many employees they hire, while wealth brokerages are also culling how many mutual funds they make available to retail investors. Size both means that an asset manager has more sway with potential clients, and that they are better able to pay for their rising costs.
Analysts argue that the turbulence triggered by the pandemic is more likely to shift money between active managers — with those that prove their mettle winning business from underperformers — than arrest the ongoing shift into passive investment vehicles. Morgan Stanley’s Mr Cyprys, estimates that the churn between active managers is actually nearly three times greater than that between active and passive.
As a result, there has been a spate of mergers and acquisitions. The latest deals involved Franklin Templeton buying Legg Mason for $6.5bn in February; and Morgan Stanley paying $7bn for Eaton Vance to combine it with its own money management arm. The deals catapulted both buyers into the club of groups with $1tn of assets under management.
The former deal in particular represented a doubling-down on a bet that active management is on the cusp of a comeback, according to Ms Johnson. “If you’re driving a car down a well-paved road you don’t need a lot of the safety features. But if you’re going to head to the mountains and you get a snowstorm you’re going to wish you had those safety features,” Franklin Templeton’s chief executive told CNBC in a recent interview. “And that’s what active management is.”
Adding to the sense of an industry shake-up, activist investor Nelson Peltz has taken big stakes in both Invesco — which is still digesting its 2019 purchase of OppenheimerFunds — and Janus Henderson, itself a product of a 2017 merger of Janus Capital and Henderson Global Investors, and is clamouring for further consolidation. At the same time, Société Générale, Bank of Montreal and Wells Fargo are all reportedly looking to sell their asset management arms.
There is plenty of scope for consolidation. Morgan Stanley analysts point out that the 10 biggest investment groups control just 35 per cent of the $90tn industry, making it the most fragmented sector outside of the capital goods sector. They predict that the Covid-19 crisis will further accelerate its consolidation.
“M&A is not a panacea. But strategically combining firms to meet the needs of the capital markets, to meet the needs of the clients and to adapt to the changing landscape is absolutely vital. Every CEO should stay open-minded,” says Ms Seitz, whose company is one of those said to be up for sale by its private equity owner TA Associates.
In addition to bulking up, investment groups are exploring other ways to future-proof their businesses. These efforts include investing heavily in technology to both improve the performance of their fund managers and to cut costs, expanding internationally — with Asia particularly high on the agenda — and accentuating their credentials on environmental, governance and social issues, as ESG considerations become more important to clients.
Yet increasingly, size is seen as the most important imperative.
“The ones with the most amount of assets are going to survive and thrive,” Mr Harvey says. “But if you’re not a behemoth already, it will be tough to become one.”