Asset management: Actively failing

 17 July 2016

By Stephen Foley, Source: 

To an audience of financial advisers who had come to hear the hottest stock tips from the big stars of the fund management industry, it was a startling thing to say: "If somebody asked me to make the argument for active management, I would find it difficult given the statistics."

The speaker, Dennis Lynch, is stockpicking royalty. The son of the founder of Lynch & Mayer, a pioneering money manager from the 1970s, has his own $3.4bn mutual fund - the Morgan Stanley Institutional Growth fund - which has put money into the likes of Twitter, Netflix and Tesla. It has outperformed the S&P 500 by more than 2 percentage points annually for the past decade, putting him in the top 6 per cent of his peers and accumulating substantial extra profits for his investors.

But active managers, those whose funds must try to beat the market rather than simply track the index, are facing something approaching a crisis.

A majority fail to beat the index over any significant period, and most of those that do ultimately find their outperformance to be fleeting. New competitors are claiming any insight they actually possess can be replicated by a computer. Clients are shifting en masse to index-based funds - active funds have lost $213bn in assets in the year to the end of May, Morningstar says, while passive funds took in $240bn. Profit margins, traditionally among the best in the finance world, are under threat and it seems only a matter of time before there is pressure on managers' pay. Sporadic lay-offs at some money managers this year may be a harbinger of more to come, say consultants, especially if a newfound willingness to discuss mergers triggers a wave of cost-cutting deals.

The panel at the Morningstar Investment Conference, held in Chicago last month, was titled "Ultimate Stockpickers", but it began with a challenge to participants to, in effect, justify their existence. Mr Lynch said that perhaps only 15 per cent of active managers are persistent market-beaters.

"The managers that tend to outperform have certain characteristics in common," he said. "They tend to be longer term in nature, not traders. They are willing to be different to the benchmark. Most importantly, they also tend to have a lot of skin in the game."

Some see the changes as an opportunity. Stephen Yacktman, another second-generation fund manager on the panel, who runs Yacktman Asset Management in Austin, Texas with his father Donald, said talk of the death of active management "makes us smile". With mediocre managers driven out, and investors piling into passive funds, there will be more opportunities for those who go looking for under-appreciated stocks.

The comments are a reminder that stockpicking as a career has always required an uncommon degree of self-belief. Never more so than now. Clients have imbibed the evidence of studies such as the latest annual Spiva survey from S&P, which shows that 83 per cent of US mutual funds and 86 per cent of European funds have underperformed the market over the past decade, and Morningstar's own work suggesting that today's top performing managers are no more or less likely to be among the top performers of the next few years.

The result: index-trackers already account for 40 per cent of the $9tn in US equity mutual funds and exchange traded funds, and the shift is accelerating.

Savers who have paid high fees and failed to get even market returns will hardly be upset if the industry emerges from a period of upheaval with fewer businesses, lower profits and fewer people, if they end up paying less and getting better returns.

There are debates, however, about whether fair prices for assets can be discovered if too high a proportion of the money is simply tracking the index. And active management remains a large employer, running and supporting 100,000 mutual funds around the world and countless more portfolios for institutional investors - a veritable Lake Wobegon of practitioners who all believe they are above average.

As Will Riley, portfolio manager at Guinness Asset Management in London, puts it: "You have to believe [when] getting out of bed that you have a chance of outperforming, otherwise you wouldn't bother."

Asset management remains an uncommonly profitable business, with operating margins of 37 per cent in 2015 and profits that topped $100bn globally, according to Boston Consulting. But growth appears to have stalled. The ultra-low fees on passive funds do not make up for the outflows and fee cuts on the active side.

Managers have been keeping a lid on costs by limiting the growth and pay of sales forces and cutting operating expenses. But Brent Beardsley, Boston Consulting's senior partner, says the squeeze could soon start to affect the portfolio managers themselves.

A year ago, Johnson Associates said the average US equity fund manager could expect to earn about $690,000 a year in pay and performance bonuses, but it predicts industry pay could fall by between 5 and 10 per cent in 2016. That sort of downward pressure has been felt in investment banking since the credit crisis, but asset managers' pay had only been going up until last year.

Pimco, BlackRock and GMO have made lay-offs this year, and although most of the cuts were sales or back-office staff, Pimco also dropped some fund managers in its equities business.

"Firms will keep a sharper eye on where there are products and areas where they are sub-scale, and think whether they should close them, since they will not see the same margin or the same upside now," Mr Beardsley says.

The open question is whether the industry will respond with mergers and acquisitions aimed at cutting costs faster. Chief executives have traditionally scoffed at the idea of megadeals, saying it is important to preserve unique cultures. However, there has been a notable change of tone among some industry leaders. Greg Johnson, chief executive of Franklin Resources, whose funds have suffered some of the heaviest outflows of the past year, says consolidation is coming, echoing comments by BlackRock boss Larry Fink.

Joe Sullivan, chief executive of Baltimore-based Legg Mason, predicts that retail and institutional investor specialists could merge, while managers with a US focus could acquire those with big overseas operations.

"This is as disruptive a time as I have seen in this industry. Every CEO has to take a step back," he says. "There are a lot more conversations out there about what could happen than has ever been the case. This is an industry that arguably has excess capacity, particularly when the performance of active management has been inconsistent."

Much will depend on the attitudes of shareholders, and whether they are willing to tolerate lower margins in return for higher dividends and share buybacks, or whether they will force companies to keep profits up.

"We all have to try to protect our margins, but the reality is they [margins] are going to come down," Mr Sullivan says. "Stack up those margins against industrial companies or service companies. Asset managers have margins in the 30s or low 40s. Really? How many businesses do you know that throw off those kinds of margins?"

Money managers are still willing to invest in areas where they see growth opportunities. These are often one stage up from the traditional fund level, however. Instead of touting individual products, they approach clients offering to use their funds as building blocks, charging them instead for asset allocation expertise, risk management consulting or other services.

David Hunt, chief executive of PGIM, the asset management arm of New Jersey insurer Prudential, says that instead of trying to eke out a little outperformance against a benchmark such as the S&P 500 - outperformance that is known as "alpha" in the industry - managers will be expected to make bolder bets, going big on fewer stocks. Their "active share", the amount of the portfolio that deviates from the benchmark, will need to be higher. "The link between pay and performance will continue to be very close," he says.

Standing out from the human crowd is one thing to worry about. Another is the race against the machine. Even alpha- or at least a good deal of it - can be replicated by computers, academics claim. The analytical work and gut instincts of the consistently successful stockpickers might actually boil down to simple bias for value stocks, momentum investing or one of the other factors that have been proven to outperform market capitalisation-weighted stock indices.

The "quants" - who build investing algorithms rather than form opinions on company prospects - are as bullish as the traditional active managers are nervous for their futures.

QMA, a quant asset manager, uses the latest issue of the Journal of Portfolio Management to publicise its own research on what it calls "closet quants", active managers whose outperformance can be explained by mathematically proven market factors: "Why choose a closet quant fund, when you can have the real thing, an actual quant fund?"

While insisting on great respect for active managers, some fund management groups have gone down this route themselves. Janus Capital has distilled its active small-cap equity strategy into a mathematical formula and launched it as an ETF. Franklin Templeton has launched a similar range of what its billboard ads proclaim to be "ETFs built on the most important factor: the human factor".

For the humans, it can be an exhausting race up the value chain. Marketfield Asset Management's Michael Aronstein, who this year marks 30 years as an active fund manager, has often invested more like a hedge fund manager, running a mutual fund with the ability to bet against stocks as well as buy them. Taking bold bets is hard, and the bigger prizes are in hedge funds proper, where clients are more willing to accept the risk than mutual fund investors.

"You could be betting your career, and the bias in our industry is that there is very little incentive to do that," he says.

Mr Aronstein's fund has seen bouts of strong performance and huge inflows and, more recently after mistakenly predicting global inflation, weak performance and outflows. But he remains indefatigable. "Investing methods that were obscure back in the early days, such as distressed debt investing or convertible arbitrage, are now well known. With the amount of data available, the idea that there is a particular insight that is not already incorporated by the market is pretty difficult."

This may be the new lot of the active fund manager, driven to take more concentrated risks. It is what successful stockpickers like Mr Lynch may already be familiar with, but for others it will be uncomfortable territory.

As for the investors, there are no guarantees that results will end up being any better on average, and every chance that the ride will be scarier for them, too. Ironically, just before its conference this year, Morningstar stripped Mr Lynch's fund of its gold rating - because it was more volatile than its peers.

Passive funds are "boring", says Tim Guinness, the founder of Guinness Asset Management, a boutique fund manager managing $1bn from a townhouse in London's Westminster. "What do people want to own? If your portfolio is constructed so that it can never outperform, that is less attractive than one that can."

The industry veteran, who sold his first company to Investec in 1998, is still so bullish on asset managers that he even runs a little fund which invests in their shares - and he does not shy away from active managers. In fact, his fund buys shares in firms whose funds have seen strong performance, on the belief that client inflows, and higher revenues, will soon follow and boost the share price.

What is it that gives Mr Guinness a spring in his step, despite talk that active managers like him could be replaced with robots? "What makes me look forward to it every day is [that] I'm curious, I'm interested," he says. "Being a fund manager and trying to do well is rather like doing the crossword."

Will Riley, Mr Guinness's protégé and lead manager on the asset management sector fund, highlights "the intellectual challenge of putting together an investment process you think is repeatable and can give you an edge through the cycle".

He does not doubt that stockpicking success will be rewarded. "When do people buy funds? When they have a track record that is better than the next guy's," he says. "For all the academic studies that say past performance does not equal future performance, I don't think that aspect of human nature is going to change."

Additional reporting by Robin Wigglesworth and James Fontanella-Khan

Copyright The Financial Times Limited 2016

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