Review of BCG’s Asset Management Survey

We had a chance to take a look at the Boston Consulting Group’s annual asset management survey which landed on our desks last week. Each summer the consultancy takes a fairly deep dive into the industry’s overall state of health and reviews its overall performance, as well as discusses emerging products and competitive trends. A few things we found particularly interesting:

  • For the first year since the 2008 financial crisis, revenue earned by asset management firms fell globally in 2016 along with profits. The biggest squeeze in margins come from those ‘in the middle’ i.e. from asset managers without large scale or a niche focus.
  • Global assets under management increased by 7 percent to $69 trillion, however most of that growth came from rising markets rather than new inflows which held steady throughout the year.

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  • One area of growth area that particularly stands out is China, where the asset management industry is still relatively underdeveloped. The country’s assets under management increased 21 percent in 2016, mostly driven by net new inflows. Rising levels of household wealth, along with the development of insurance companies and pension funds, offer the potential for further gains in the coming years. Foreign companies, for whom the barriers to entry to the Chinese market are gradually disappearing, could stand to benefit from this trend.
  • Passive strategies were the largest driver of net fund flows in the US, where the industry is dominated by a few large players (the top 10 firms captured almost all of the inflows). This ‘winner takes all’ trend was less pronounced on the active side of things, where the 10 top firms captured 58% of net inflows.
  • Despite the faster growth of AuM in passive products, passives’ contribution to managers’ revenue pools “remains small.” Revenues from passive mandates grew from about $6 billion in 2008 to $14 billion in 2016, which only represents 6% of the industry’s global revenues. Even though various forecasts suggest passive investments could overtake active by 2021 (in terms of AuM), revenues will likely only reach around 7% of total revenues during the same period.
  • The asset class that has proved to be the most stable during the last few years is alternatives. Even though alternatives only accounted for 15% of AuM in 2016, they made up 42% of total revenues. The next two strongest contributors were active specialties as well as solutions and multi assets.

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The survey concludes that growth in the industry is still possible, however only through a combination of M&A, cost management, and crucially, technology innovation.

Understanding Active ETFs 

In previous Closir blogs we’ve discussed at some length a number of trends relating to ETFs and their impact on today’s fund management landscape. The increased interest of institutional investors, combined with an already strong retail uptake, has helped ETFs to grow further in popularity during the first few months of the year. In recent weeks, a number of large players known more for their active management, including Fidelity, Pimco and Eaton Vance, have launched or are planning to launch active ETF funds.

A quick recap:

  • Assets Under Management in ETF form now stand at over $2 trillion dollars, representing a ten-fold growth over the last decade. In terms of equity, ETFs make up around 25% of mutual fund size, and up to 30% of all daily trading volume on US exchanges. Turnover of actively managed mutual funds is on average 10x that of passive funds.
  • Perhaps surprisingly to some, active managers are amongst some of the largest users of ETFs, utilising them for hedging, cash management and to achieve ‘instant’ exposure to sectors and geographies in which they are underweight, or lack sufficient stock picking expertise.
  • ETFs are still very US equity-centric, with 56% of the global total focused on broad US coverage and roughly 20% US sector-focused, with only about 17% covering global equities.
  • The number and scope of Emerging Market ETFs has also expanded over the last three years, despite volatility and recent outflows. In the first quarter of this year,  Emerging market equity ETFs saw hefty redemptions of $12.6bn in the first quarter amid concerns that any further rise in the US dollar will hurt future returns. The largest two are Vanguard Emerging Markets ETF and iShares MSCI Emerging Markets Index Fund.
  • There is a direct correlation between market volatility (as measured by the VIX index) and ETFs as a percentage of total trading volume.
  • The growth of the ETF industry has given birth to new products and investment strategies, as well as a new set of industry jargon, including Actively Managed ETFs, Smart Beta and Robo Advisors.

Actively Managed ETFs

The easiest way to think about active ETFs is as mutual funds wrapped in an ETF structure, allowing investors to trade intra-day and pay lower fees. There are approximately 125 actively managed ETFs (with AUM of $19bn), with the majority focused on fixed income and macro asset classes. There are 45 global (i.e. non-US) active ETFs. The numbers are still fairly low, relatively speaking, and advisors are questioning whether it’s the wrapper, the fees, or the performance of the ETFs themselves which are most to blame.

Active ETFs are designed to offer investors the benefits of ETFs, which include continuous trading, a low expense ratio and a number of tax advantages, while adding an active management component. The goal of an active ETF is to outperform its index.

One of the key differences between mutual funds and active ETFs is transparency. Unlike mutual funds, active ETFs are required to reveal their holdings on a daily basis.

This has been a concern to traditional equity managers, who prefer to keep their buying and selling intentions shielded from Wall Street traders. Publicising trades to the market can allow other market participants to front-run trades and erode returns.

The SEC is considering whether or not to allow actively managed ETFs to keep their trading secret, and has already allowed Eaton Vance to launch a series of non-transparent products that will mirror the firm’s mutual funds. Additional structures are proposed in the market which we will cover on another occasion.

Another key difference is the flexibility of the product and ability to hedge. Active ETFs can be traded at any point in the day, mutual funds only at the close. ETFs also offer investors additional ways to generate yield, returns and hedge. For example, unlike mutual funds, ETFs allow investors to short shares, buy on margin, lend and include options such as buying calls or puts.

Active ETF fees are higher than for traditional ETFs, but still lower than for mutual funds. This is because many mutual funds have distribution and service fees, and transfer agency fees, as well as trading costs associated with inflow/outflows. Active ETFs may also continue to put pressure on active mutual fund fees going forward.

Top 15 actively managed US ETFs with over $100m in Assets

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While actively managed ETFs present some new challenges for the market, they undoubtedly offer new opportunities for diversified investment. For IR teams it is a space worth carefully observing.

Sources: Institutional Investor, Goldman Sachs Research, ETF.com

ETFs in 2020

A comprehensive paper published by PwC last month entitled ‘ETFs in 2020’ paints a very detailed picture of how the Exchange Traded Fund business is likely to evolve globally over the next five years. According to the analysis, the market will double to $5tn by 2020, and its impact has the potential will be felt much more widely within our industry than previously imagined.

A few takeaways from the report we found particularly interesting:

  • Despite fragile economic growth in developed markets, the global AM industry is predicted to grow at a healthy pace. Having doubled over the past decade (to $70tr), PwC predicts professionally managed financial investments will grow by 6% per year , due to both asset inflows and value appreciation. The US & Europe will dominate asset flows in absolute terms, but the highest rates of growth are likely to come from developing markets. Passive funds currently account for around 35 per cent of all mutual fund assets in the US.
  • New types of indexing (also referred to as ‘smart beta’) are perhaps the most important area of innovation within theproduct class. As they continue to evolve, a growing number of investors are likely to opt for index weightings based on factors other than market capitalisation, which by itself can lead to overly concentrated exposure to certain markets, sectors, or securities. The size and scope of actively managed ETFs are also set to grow (there are currently 55 actively managed ETFs listed in the US with AUM of $9.6 billion).
  • The regulatory environment in the US and Europe is expected to have a significant impact on the evolution of ETFs. New regulations could spark further growth if they permit further product innovation or lower distribution barriers, but they could also dampen demand, particularly if new tax rules make ETFs less attractive or convenient. For instance, MiFID II could be a game changer in Europe, where the adoption of ETFs by retail investors significantly lags behind the US.
  • Firms offering ETF products to investors will need to consider rapid changes to the way asset management services are created and consumed, with the most dramatic changes enabled by technology.

If the predictions do come true, they will no doubt have an impact on a future shareholder register structure and consequently on corporate IR strategy.

A few questions for companies to consider:

  • Do I monitor my shareholder register on a fund level, for the activity of the largest three ETF fund providers: Vanguard, Blackrock (iShares), and State Street (SPDRs)?
  • Am I familiar with which are the largest and most active ETFs in my asset class? I am aware of key trends and drivers of their growth?
  • Do I know which indices is my security a constituent of?
  • Am I staying on top of developments in the active ETF space?

Top 10 Emerging Market ETFs

Name of Fund Assets Average Volume 2015 Performance
Vanguard FTSE Emerging Markets ETF $46,331,830 13,908,497 +4.40%
iShares MSCI Emerging Markets Index Fund $31,702,630 55,250,906 +3.51%
iShares Core MSCI Emerging Markets ETF $6,254,856 2,344,426 +3.91%
iShares MSCI India ETF $2,822,917 1,059,985 +10.02%
WisdomTree India Earnings Fund $2,308,956 4,828,908 +8.34%
WisdomTree Emerging Markets High-Yielding Equity Fund $2,256,093 914,679 +5.69%
iShares MSCI Emerging Markets Minimum Volatility Index Fund $2,093,439 446,303 +4.36%
Market Vectors Russia ETF $1,610,733 20,284,920 +23.38%
WisdomTree Emerging Markets SmallCap Dividend Fund $1,470,268 273,755 +3.34%
Schwab Emerging Markets Equity ETF $1,182,924 536,871 +4.23%

Sources: PwC, ETF Database. To download a copy of the PwC paper visit: www.pwc.com/etf2020

Activist Investor’s influence on Passive Funds

The cover story from this week’s Economist caught our attention, particularly as it relates to a number of IR themes we have been observing closely. Academic literature* examining the recent track record of US activist investors concludes that despite their reputation and short term focus they are more often than not a force for good, at least in terms of driving greater operating performance and shareholder returns.

The article draws attention to a polarity in today’s average shareholder structure, one that is particularly evident in the US. On one side of the spectrum is ‘lazy money’ which comprises a growing number of computer-run index tracking funds, ETFs and mutual or pension funds, which generally prefer not to get too involved in radically altering the strategic direction of the companies they invest in. On the other are large funds which buy entire companies, often taking them private and actively dictating strategy.

Activist investors can fill a key corporate governance void by influencing passive funds and ‘lazy money’ to take an interest and support either the activist investor or management’s chosen course of action. The long-only funds holding the majority of the free float generally assume the role of ‘blocker’ or ‘enabler’ for activist campaigns so the more involved they are the better. This involvement looks set to increase as activist funds grow in popularity. In 2014, a fifth of flows into hedge funds went to activist investors, resulting in their AUM rising from $55bn to $120bn over a 5-year period.

The two largest providers of passive products, Blackrock and Vanguard, have already pledged to work more towards ‘long term interests’; this will inevitably include increased contact with company boards. Company management and IR teams may also make a more proactive effort to establish relationships with passive managers, something which was not really considered as recently as a few years ago.

The final angle of the debate centres around the potential for transferring the US-style activism model across the Atlantic, particularly given the arguably limited opportunities in the US (only 76 companies in the S&P 500 registered a poor 5-year Return on Equity and only 29 trade below their liquidation value). European investors will argue that they already have more say than their American counterparts on corporate governance issues such as renumeration and board appointments, and differences in culture as we move east mean that many activist fund demands are often settled discretely and diplomatically.

* Long Term Effects of Hedge Fund Activism, Lucian A. Bebchuk,  WSJ

Active encouragement for fund managers

A number of eye-catching recent statistics have reignited the ongoing debate around active vs. passive investment. Passive funds now account for 35% of all mutual fund assets in the US, up from just 2% 20 years ago. As illustrated in the Financial Times charts below, in 2014 less than 15% of US large-cap mutual funds outperformed their benchmarks, marking a low point for an industry under increasing scrutiny. 

 

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When even Warren Buffett is telling his wife to put 90% of his fortune into an S&P 500 tracker fund after he dies, it’s difficult not to pay attention.

Morningstar recently posted an interview discussing some of the key reasons behind the growth of passively managed funds during the last 12 months. The 3 main themes highlighted are:

  • Lower-cost products
  • Wider choice of index funds
  • Strong global index performance

To a certain extent, these themes go hand in hand – the better the main indices perform, the more interest passive funds generate and the more products are tailored around them. With returns under greater scrutiny than ever, the cost advantage to index investing from a fund management point of view looks increasingly attractive to investors.

Vanguard’s own blog puts the role of these costs into perspective. Given the small margins, reducing the execution cost of the actively managed fund significantly increases the likelihood that it will outperform the benchmark. In fact, for funds with a cost lower than 50 bps this number rises to 39%.

 

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Perhaps inevitably, 2014 saw a substantial increase in the prevalence of alternative investment strategies such as smart beta. These strategies are a logical half-way house, offering investors the lower-cost security of index investment with the flexibility of an active weighting strategy. It may be too early to evaluate the long-term success of this approach, but after such a difficult year in the press, active fund managers are increasingly taking advantage of the additional opportunity to demonstrate that skill still has a huge role to play in chasing alpha, even if this does herald a more general trend towards cost reduction across the investment management industry.

Closet tracking

Many have pointed to the dubious practice of ‘closet tracking’ as a drag factor on active investment return figures. Closet trackers are actively managed funds which track the index either entirely or to a significant extent, meaning that investors lose out on both counts, as they are charged high fees for what are effectively passively managed funds. In fact, Informed Choice point out that over three quarters of the IMA UK All Companies sector funds correlate with their benchmark index to a degree of 90% or more. An FT article recently highlighted that as much as a third of actively managed UK funds can be classified as such. Some correlation is probably a good thing, particularly given index performance in 2014, but given the higher fees there comes a point where it makes more sense for investors to bypass the middleman and go straight for the index.

The case for active management

Active and smart beta funds still offer some obvious advantages over their passive counterparts. A Times article published on Saturday cites a study by HFM Columbus which suggests that active funds in the UK have actually prospered during the last 12 months, although the study does not take into account the execution costs of the respective strategies.

The article highlights the fact that control over investment provides protection against macro industry trends such as the falling oil price, as the performance of companies like BP and Royal Dutch Shell drag indices down and provide the active fund manager with an opportunity to outperform. The strong performance of small- and mid-cap stocks in 2014 also offered investors a good alternative for getting ahead of the market. Skilful fund managers continue to exploit this opportunity to good effect to stay ahead of their benchmarks. As the Novel Investor chart we posted up over the weekend shows, emerging market equities are the other big performers as an increasing number of active fund managers look internationally for value. Opportunities are often found within segments of the market not covered by mainstream research analysts. 

The wider performance margins emerging markets and SMEs offer can reduce the impact of execution costs for high return funds (the impact of macro trends can be similarly amplified). The higher volatility of these stocks coupled with a more lenient disclosure environment and an often unpredictable economic or political climate means that it’s particularly important for investors to be actively engaged with the companies in their portfolios, and to stay on top of and react to the latest developments to maintain an edge over their passive rivals.

If they can manage this, 2015 may yet be the year of the active investor.