OpinionMay 2 2018

Only managers willing to invest in alpha capabilities will survive

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Only managers willing to invest in alpha capabilities will survive
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At the end of the 1990s, asset managers were coming under immense pressure from clients to keep up with indices.

Having sold funds on the basis that they would continuously outperform, they then failed to do so when the tech bubble took hold. 

Eventually, managers either capitulated and indexed, or came close to failure.

Arguably, active management became a vehicle purely there to deliver high fees.

Fast forward to today’s environment and the failure of yesterday’s model, built on promising consistent incremental outperformance from a semi-active process, has left many funds unable to achieve enough alpha to sustainably offset high fees.

Shareholder expectations have also played a role in restricting the long-term success of active management.

For too long, managers were building up excessive amounts of assets while, at the same time, severely under-investing in their own investment capabilities.

The race to the bottom creates a self-fulfilling cycle where fees are cut, the investment capability is starved of investment and assets bloat in periods of aberrational performance.

Professional fund investors, however, are more aware of this than ever before, and it’s becoming increasingly difficult to justify high fees on this basis.

What active managers could do is invest more in their ongoing alpha, cap their strategies (possibly even returning assets where they have over-raised) and educate their clients as to what reasonable expectations are.

Unfortunately, any course of action which puts the high margins and earnings at risk is not going to be an easy sell to corporate shareholders even if it is the right thing to do for clients. 

Another option is to use the cashflow from existing strategies to invest in speculative new products, or spend money to reduce the cost of active management through AI and data strategies.

The reality though, is that these approaches rarely provide the expected cost savings and may struggle to compete with the quality of processes of early entrants in those markets. 

So, does active management still have a future?

We certainly believe so. But only within certain structures.

There needs to be absolute alignment between clients (the “asset owners”) and the people who invest their money. This includes both the asset owners and the investment manager having reasonable expectations in relation to capacity, costs and fees.

Without this, the race to the bottom creates a self-fulfilling cycle where fees are cut, the investment capability is starved of investment and assets bloat in periods of aberrational performance.  

Asset managers also need to be clear on where the value comes from.

If the alpha generators are perceived to be expendable and interchangeable this can only lead to a degeneration in their focus, motivation, creativity, discipline and, ultimately, quality.

Conversely, those organisations that create the right environment for fund managers and commit significant amounts of money to their investment capabilities, will reap the rewards.

Transparency is also going to be vital. The FCA has said it wants consumers to have confidence that when they buy a fund they know it will do exactly what it says on the tin, as well as deliver value for money.

It has already come down hard, showing it will have little tolerance for managers who fail to evolve their semi-active models, with £34m in fines being paid to consumers from managers who have been outed as ‘closet trackers’.

Incidents such as these show the market is being more discerning as the increased professionalisation of fund buyers sorts the wheat from the chaff.

Only those active managers who are skilful, aware of the limitations of their competency (including AUM management), and willing to invest in their alpha capabilities will be allocated to, and therefore survive.

Arthur Grigoryants is head of investment strategy at RWC Partners