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Is the golden era for active fund managers ending?

Woody Allen observed that 99% of life is showing up. Despite belief in their unique skill and perspicacity, fund managers have been the fortunate beneficiary of a confluence of events.

The industry has benefitted from the favourable economic and financial environment for the last three decades.

First, rapid growth in wealth and mandatory retirement schemes increased assets under management (AUM).

Second, deregulation and globalisation of financial markets and the economy created attractive investment opportunities. Privatisation of state assets and the opening up of emerging markets, for example, broadened investment choices.

Third, high average returns, in part underpinned by structural asset inflation, reinforced expansion.

Revenues, which rely substantially on fees based on the size of funds, was aided by AUM growth. This was reinforced by strong returns as around 50% of AUM increases is due to rising asset values. Incentive fees from strong market performance boosted earnings.

AUM has tripled globally over the last two decades to over US$100 trillion. Asset management revenues have also grown three-fold to around US$400 billion. Australian superannuation assets now total over $3.1 trillion and generates around $30 billion per annum in fees for the industry.

Are these influences sustainable?

AUM is unlikely to grow at historical rates. Fund outflows will increase as retirees draw down investments to finance post-income lives. Replacement inflows may not compensate for losses. Younger workers have lower savings due to stagnant incomes and discontinuous, precarious employment. Their investment habits and attitudes to money reflect lower trust of financiers and traditional investments.

Sponsored retirement schemes may change. Government tax incentives, seen to be favouring the wealthy, may be withdrawn or reduced in a period of strained public finances. In an environment where fewer people can retire due to insufficiency of savings and income support, formal retirement savings arrangements become redundant. Governments may phase out compulsory schemes to increase disposable incomes and economic activity. Allowing workers to draw on their retirement schemes during the Pandemic provides an interesting precedent. These factors will all reduce inflows.

The range of investments is likely to diminish. Systematic privatisation of markets is under way with smart money moving away from public equity and debt markets. Drivers include the increased availability of funding from high net worth investors and the cost, disclosure and regulatory burdens of public issues. Central bank buying of debt and (in the case of the Swiss and Japanese central banks) equities also reduces available stock.

Controls on free movement of capital and cross-border investments as well as re-regulation are likely to constrain investment choice or increase risk. The Chinese government’s ambivalence towards foreign investment or overseas fund raisings by its companies may be copied by others. Sanctions and other protective measures by various countries, as they shift towards autarky, will further limit opportunities. Climate emission tariffs or promotion of ‘national champions’ may become another impediment to international investment.

These developments are likely to diminish trading depth and liquidity affecting investment opportunities and implementable strategies.

Future returns not as promising

Adequate post-fee returns are needed to attract investors. Future gains are likely to be lower across asset classes affecting both AUM and fees. The higher the price paid for an asset today the greater likelihood of lower future returns and higher the risk of loss. When returns are 10%, a fee of 1% is begrudging acceptable. If returns decline to 2%, an equivalent fee may be problematic.

High current returns, especially from equity and property markets, are misleading. They are driven by low rates, central bank asset purchases and artificial suppression of volatility. This market regime favours short term momentum trading. The dominant investment environment becomes RORO (risk-on/ risk off).

It lends itself to low-cost passive ETFs or specialised quantitative trading techniques. Over time, AI’s role may become important. The gamification of markets, exemplified by Robinhood meme investors, supports direct investment bypassing professional fund management. Vicarious pleasure where someone invests your money does not work for YOLO (you only live once) investors.

The consistent failure by many seasoned asset managers to outperform the broad equity market highlights the difficulties. The decision by many storied veterans to close their funds to external investors is testament of the challenge.

These influences collectively place pressure on fund managers’ margins, currently 25-40%, and the trickle-up rewards for many investment professionals. The industry’s profitability globally has been largely flat or in decline over the last decade.

Some fund managers are responding

Heeding General Norman Schwarzkopf‘s warning that the unwillingness to change means irrelevance, some fund managers have responded. They have introduced index tracking funds and quantitative strategies, such as factor investing. Alternatives and new ‘virtue signaling’ ESG funds are now fashionable. Many have expanded into private equity and debt. Some are rolling out post-retirement income arrangements. The aim is to maintain AUM and also target higher fee products.

But the changes create new issues. Some new markets lack invest-ability for asset managers geared to traded and liquid financial securities. Many necessitate offering greater liquidity to fund investors than that afforded by the underlying investment itself. Others lack scale, being too small and uneconomical for traditional funds. The skill set required for some investments is scarce.

Ultimately, these measures cannot increase returns for all. Financial markets are zero sum games where no value is created with wealth being transferred between participants. Not all fund managers can be above average.

History is replete with industries disrupted or superseded often rapidly. Assuming that asset management can prosper in its current format may not be realistic.

 

Satyajit Das is a former banker and occasional author. His latest book is A Banquet of Consequences – Reloaded (Penguin March 2021), which updates the 2015 edition with 150 new pages covering MMT, PPT (plunge protection team otherwise known as central bankers), the Trump/Johnson ascendancy, the climate emergency, accelerating resource scarcity, and, of course, Covid19.

© 2021 Satyajit Das All Rights Reserved

 

6 Comments
SS
October 21, 2021

This message will fall on deaf ears of the financial ‘know-it-alls’.. Upton Sinclair was right when he said that you can’t get a man to understand something when his salary depends on the opposite.

CC
October 21, 2021

small caps fund managers have a long and strong history of outperformance in Australia and I own several that do. also when future market gains are said to be lower, it seems a contradiction to say that passive investing will be better. financial markets a "zero sum game" ? I don't think so !

Jason
November 08, 2021

Agreed 100%.

Steve
October 21, 2021

Looks like this is a US centric article as it misses one of the main problems active managers have in Australia which is industry super funds. Lower fees and equal or better performance and scale to match many active managers is one of the main reasons active managers in Oz are going backwards.

Jerome Lander
October 21, 2021

Yes, the industry and investors need to adapt. One way to do this is become more focussed on managers who are genuinely client centric in their approach and who use markets to achieve client objectives rather than simply tracking them and being asset gatherers and marketing experts. Alternatives and alternative approaches more broadly are becoming more valuable to investors, and there will always be room for active managers that add genuine value. We haven't seen risk management be very rewarded in the speculative markets we've had and one can also expect that to change as broader market returns become more challenged. There's an incredible range of opportunities for good active management today and we are possibly heading into a golden age for active management again, particularly for the small minority of managers who put their clients' interests first and who add genuine and meaningful value to clients.

CC
October 21, 2021

Jerome, they'd also do better if made themselves available to ordinary investors, not just wholesale/ institutional

 

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