Industry disruption - Adapt or die
Asset managers are being forced to look again at their business models. John Gilchrist, head of customised solutions at Old Mutual Investment Group, discusses the reasons.
We have seen incremental changes in the asset-management industry over the past few years. This adjustment process will accelerate. The rise in indexation/passive investing and a shift towards factor investing/smart beta, combined with increasing demands for responsible investing and a greater focus on risk management, are forcing traditional asset managers to adapt their investment strategies.
This ‘disruption’ presents an opportunity for more progressive investors to capitalise on the changing landscape. There are four key areas:
First, the rise of indexation/passive investing.
Following the global financial crisis, loose monetary policy and a volatile macro-economic environment made for stark reading in the performance of actively-managed funds relative to their benchmarks. The S&P Dow Jones Indices (SPIVA) scorecard indicates that more than 75% of active investment managers in the US underperformed their benchmarks after fees over the past 10 years.
Although historically SA active managers performed well relative to their benchmarks, their performance mirrors the global experience. To illustrate, the average unit trust equity fund has lagged the index by 2,4% pa over the past 10 years.
As with all industries where the profitable incumbents have under-performed or become slow to adapt, the door has opened for disruptive technologies and more innovative cost-effective approaches. The rise of indexation/passive investing is a long-term trend recently accelerated by active manangement’s underperformance.
Research has shown that indexation continues to drive down the cost of investing. Unsurpisingly, indexation is a popular choice for many investors. For example, index funds have grown from 17% of US mutual funds in 2010 to 23% in 2015.
In SA, the change in regulatory requirements is an additional driver. For the institutional market, draft default regulations require pension-fund trustees to consider indexation for default portfolios. For the retail market, the Retail Distribution Review brings improved transparency on costs which drives increased interest in indexation.
Second, factor investing/smart beta.
We have also seen significant flows into factor investing/smart beta. Research is demystifying ‘alpha’ and revealing that much of it is in fact due to factor exposures.
Such factor exposures as value, size, momentum and quality can be accessed through cheaper, systematic ‘smart beta’ offerings. Rather than pay active managers high fees to outperform an index, investors can utilise combinations of smart-beta funds to deliver similar gross returns at lower cost. Globally over the past five years, this has led to a 10-fold growth in smart-beta investing.
There is space for passive investing, smart beta and fundamental active investing. A blended combination of these three approaches should deliver the best net risk-adjusted returns. Blending not only offers lower costs but also creates greater certainty of outcome by reducing the probability of choosing underperforming managers or reducing reliance on active managers delivering on their alpha objectives, and allowing for higher conviction allocations to fundamental managers.
Blending also forces investors to focus more on portfolio construction, particularly on portfolio risks and diversification benefits.
Third, responsible investing (RI).
Launch of the Code for Responsible Investing in SA and revisions to regulations (including Regulation 28 under the Pensions Fund Act) mean that RI is no longer merely a ‘nice-to-have’. Investors increasingly realise that, through their investment choices, they can materially affect company behaviour. This combination of regulations and investor awareness has led to increased demand for investment approaches that incorporate environmental, social and governance (ESG) factors.
Historically, ESG investing was primarily achieved through alternative assets such as infrastructure and renewable energy. Developments in passive investing/smart beta have led to the launch of ESG index funds – low cost and liquid alternatives that invest only in the highest-rated ESG companies.
Although these funds are designed to be similar to the parent index (with minimal sector and country over/under weights), we have seen out-performance from the ESG-cognisant approach: the MSCI World ESG index is marginally ahead of the MSCI World index and the MSCI Emerging Markets ESG index is significantly ahead of MSCI Emerging Markets index.
Fourth, risk management:
Global and local macroeconomic risks appear to have been increasing alarmingly. As a result, there has been a significant increase in demand from investors for risk management that goes beyond the relatively simple diversification offered by a balanced fund. The 2008-09 financial crisis, during which the average balanced fund lost 22%, made it clear that diversification alone is insufficient to protect capital during a bear market.
In this higher-risk environment, the benefits of capital protection – and the significant benefits associated with compounding off a higher base following a period of capital protection – are front of mind.
These trends, and client demands, are forcing asset managers to modernise their offerings. Simultaneously, leading institutional and retail funds are adjusting their investment approach to achieve better returns – with lower risk, at a lower cost – in a way that should positively impact the world in which we live.
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