This is a watershed moment for the asset management industry. New technologies are reshaping the sector, forcing incumbents to sharpen their value propositions. And although the industry still enjoys growth in assets, the future is likely to become increasingly turbulent to players ignoring structural changes.
The asset management industry is at a tipping point. New technologies and new Fintech entrants are commoditizing large parts of the value chain, forcing incumbent players to sharpen their value propositions to end clients. At the same time, clients are also advancing new demands with respect to the immediacy, connectivity and ubiquity with which they interact with their providers. Moreover, regulators are doing their best to prevent consumers from being sold inappropriate products, which are often the most lucrative for providers. As a result, regulatory costs continue to climb during a time in which fees are falling and a veritable battle to claim ownership of the client relationship has erupted. These structural changes are being driven by 5 trends already challenging the industry.
1. The inexorable rise of passive products
Investors continue to flock out of active into passive products. Clearly, this trend is not new. Since 2007, the penetration of passive products in the equity space has nearly doubled in all parts of the world, reaching 46% in Asia, 27% in Europe and 43% in the US. The narrative is only slightly different in the fixed income space: since 2007, the penetration of passive products in the US has also practically doubled to reach 28%, although penetration in Asia and Europe is lower, continuing to hover around 10%.
The drivers of this flight to passive products are threefold: first, significantly lower fees. Fees for passive products make up just a third of the fees charged by active managers, on average. A second driver for the flight to passive products is the difficulty active managers have in exceeding their benchmark returns. The third driver for the flight into passive products is regulation. Directives like MiFID II incentivize greater price transparency, thus reinforcing the demand for simpler, more cost-effective passive products.
2. Costs, costs, costs
Costs matter. The implication of the shift to passive products is that investors have become increasingly cost-conscious. In fact, according to data collected by Morgan Stanley, price competitiveness became the primary determinant of reallocations between managers in 2016 and 2018, surpassing even performance. Clearly, this increased cost sensitivity is being driven by the proliferation of low-cost alternatives, the elusive quest for alpha, and, of course, the low-yield environment.
But this story should not be reduced to active vs. passive. It is a story about low-cost vs. high- cost. Since 2014, active investors have been voting with their feet by withdrawing vast amounts of money from the more expensive active funds, while low-cost active funds continued to see net inflows. This data suggests that the proliferation of passive funds, but also the underperformance of active funds relative to their benchmarks, have effectively lowered investors’ willingness to pay for expensive active fund management.
3. The rise of smart beta
Active asset management is certainly not dead. In fact, actively managed assets still account for no less than two-thirds of total assets invested on a global basis. But alpha has become more elusive as more active managers struggle to outperform their benchmarks in a context of falling fees and shrinking margins. This challenge of generating alpha – or achieving returns in excess of the market - has become particularly acute in a low-yielding environment. To defend against this challenge, many managers are turning to “smart beta” strategies to enhance their returns.
“Smart beta” products employ passive index-following strategies, but use alternative index construction rules based on factors such as size, dividends, value, low volatility, momentum, and quality. The goal is always to achieve alpha, but also to lower risk, and to do this in a cost-effective way. As such, smart-beta typically costs less than any active strategy, but a little more than a traditional market-cap weighted index strategy. In short, smart beta offers investors an inexpensive, easy, and transparent way to target alpha generation.
4. MiFID II – a watershed moment for the buyside industry
The list of regulatory changes being implemented in Europe is long and varied, but MiFID II stands out as one of the most disruptive pieces of regulation ever to hit the industry. The directive fundamentally reshapes the distribution model for asset management in two fundamental ways: first, the regulation will effectively ban commissions, incentivizing a structural shift to fee-based services; and second, the directive enforces rigorous requirements to provide independent advice in the interest of the client with increasing cost transparency. As such, MiFID II represents are watershed moment for the buy-side industry. The requirements force fundamental changes to the way products are distributed, business models are run, and to the pricing and cost structures of incumbent players. And, as fee structures become explicit, high-margin products could suffer. Moreover, stricter laws and limitations are likely to limit the scope of available product offerings, while also forcing up compliance costs across the industry.
5. Artificial Intelligence as a catalyst for innovation
Everyone is talking about the Artificial intelligence (AI). AI is a technology cluster that includes Machine Learning, Robotic Process Automation, and a variety of other tools used to automate or intelligently perform various activities. Such technologies will be able to augment or exceed human cognition, resulting in a change to the economics of expertise and judgement in the asset management space. As AI becomes more capable, the technology could soon be able to replace complex human activities across the front, middle and back office. For example, Robotics are also revolutionizing the entire operations value chain to aggressively manage costs, increase productivity, streamline processes and replace manual actions wherever possible. As this happens, many of the competitive advantages firms have derived from excellence in execution are set to subside, increasing the incentives to externalize parts of their value chain.
These 5 trends suggest that the threat of disruption in the asset management industry is imminent. In short, the ongoing industry‐wide automation and externalization of middle and back offices are commoditizing large parts of the asset management value chain. This makes scale key to thriving in this new environment. This quest for scale is likely to see a wave of disruptive acquisitions and strategic alliances with tech companies shaking up the market in the coming years.
Looking ahead, the asset management firms set to thrive in this dynamic environment are those with 3 key characteristics: First, those focused on enhancing the client experience that clearly differentiates itself from one focused on pushing products; second, those using AI to enable mass customization of the service offering; and finally, those operating businesses with a clear purpose-driven culture are set to thrive in the age of commodification and disruptive change.
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While the asset management industry is still growing, the future will be turbulent for those that do not adapt to powerful structural changes. Investors are flooding from active products into passive products such as ETFs. Costs are under pressure as investors become reluctant to pay for expensive products that do not perform well. Smart beta products offer an inexpensive way to generate alpha. In the EU, the MiFID II regulation changes distribution rules, limiting the scope of offerings and pushing up compliance costs. AI can be a catalyst for necessary innovation. Asset managers must focus on a differentiated client experience, mass customization and purpose-driven cultures.