By Jason A. Voss, CFA
For over five years now I have been thinking hard about the future of active management. Specifically, does it have a chance to survive, and if so, to thrive?
Let me cut to the chase, I think that the answer is a resounding YES. However, I also believe that the industry needs to change.
What follows is a potentially radical thesis, but frankly, I just do not see another way for the industry to evolve. Here is what I believe will unfold over the next 7-10 years. See if you disagree…
A Race to the Bottom.
Given the lack of demonstrated success of active management relative to passive strategies in beating the S&P 500, competing on performance is increasingly going to be replaced with competing on cost.
Passive products, as the very definition of a commodity, will see the most intense competition, and will end up as loss-leading offerings designed to get customers in the front door, in order to sell them higher value-add (and higher priced) services. But those higher value-add services need not be active investment products, which are relatively expensive to run.
Instead, they might be things like:
- Sophisticated monthly budgeting
- Use of portable EKG and EEG micro machines with smart software to examine a customer’s real risk profile
- Hyper-refined asset allocation, tailor-made to the unique characteristics of a client’s situation
- Mobile payment apps that update clients in real-time about how their spending affects their achievement of financial goals
- Feedback, including bio-feedback, about a client’s emotions and biases in response to financial market gyrations.
There is not one firm doing all of these things currently, and, in fact, very few are doing any of them. But five years ago, when I first made my prediction about passive products being offered as loss leaders, many colleagues considered that an impossibility. Now, Fidelity Investments is offering some of its products at a 0% management fee.
I have written elsewhere that for firms constructed as AUM agglomerators, the only response to preserving profit margins is consolidation. Expect to see tons of this in the next ten years. Firms gobbling firms, and gobbling more firms. Funds that underperform will have their assets gobbled into funds that are (currently) outperforming. Rinse. Repeat. Ouch!
To not just survive, but thrive, traditional investment managers are going to have to change. How? They need to offer fewer, more complex strategies.
At a firm level, management has to stop managing their funds like elements in an overarching, grand portfolio management style. Today, it’s typically the case that only a few funds in a firm’s overall offering are 4- and 5-star rated, and that’s where the assets are concentrated. The rest are offered, buffet-style, to advisors looking for breakpoint (i.e. cost) advantages for clients.
Randomly, there are always going to be outperforming funds, which firms market the heck out of. Then when performance randomly shifts, the marketing emphasis switches to the new outperformers. But chasing performance is exhausting and expensive, index funds now offer investors a cheaper, simpler alternative to flipping from fund to fund, and advisers are no longer getting rebates for advising them to do so.
I believe that next-generation investment management has firms managing at the fund-level, where every fund strives for exceptional results, and advisors who care about alpha will have more options. The jig is up for agglomerators playing the old game of capitalizing on retail investors’ propensity to chase performance – the index funds are quickly eating that lunch.
But to make room for alpha-generation, charters have to change.
Active managers have for too long traded alpha-generating strategic freedom for alpha-destroying style box handcuffs. This Faustian bargain was made because it has always been easier to grow AUM through marketing than generating performance, and marketing demands style boxes. In a race to the bottom, this strategy will not survive.
So, funds are going to go back to shareholders and ask to be less and less constrained.
Look first for the market capitalization handcuff to be removed as funds start to include small-, mid-, and large-cap assets. Then, look for asset classes to be expanded so that opportunities may be found in equities, fixed income, preferreds, convertibles, and anywhere else the PMs believe it can be found. We might even see some once-narrow funds investing in private companies, startups, or becoming long-short, merger arb, and so on.
Whoa, wait a second, but that means mutual funds will look like <gasp!> hedge funds, private equity, and venture cap. Yup, that’s right. Said another way, funds become boutique and sophisticated… again. After all, the fund management business did not begin to metastasize until the mid-80s.
In the above scenario, active management as an industry survives by embracing, not avoiding, complexity. Can you name another way forward?
Given the constraints of the human mind – of which I am a profound fan – active managers need to become more sophisticated in how they utilize technology in order to embrace this complexity.
This means that on the front-end of the research process, firms need to trust artificial intelligence-driven machines to replicate much of what human analysts are doing today, but at a global scale, and in an asset-agnostic, industry-agnostic, and country-agnostic way. Eventually, I see every firm that seeks to compete on performance taking this approach.
For the record, I am dubious that machines are going to replace people ever. But that is a digression rabbit hole for me, so strong is my belief. Just trust me on this. In any case, our profound abilities at creativity, intuition, and judgment remain out of reach for machines always. Human beings remain human. And this is, and always has been, alpha: doing what no one else is doing; same definition as creativity. Duh!
OK, so human beings remain human. Uh, oh! Oh, no! Jason, did you not get the memo from Kahneman, Tversky, Thaler, Ariely, and everyone who ever studied psychology? I did. Not only that, but I chose my words very carefully. Human beings remain human. So, guess what? Markets remain markets.
Research conclusively shows that financial markets are not rationally pricing securities, with hundreds of persistent statistical anomalies/opportunities existing. Why? Because human beings remain human. Our behavioral biases are a large part of what drives securities prices. And that we are biased is:
- Entirely predictable; and,
- The Final Frontier for that elusive beast known as α
Mastering our behavioral biases on the front-end – within the investment process – as well as on the back-end – through unabashed critical review of outcome — is the way forward. The very difficulty of doing this is what makes it the most valuable pursuit for active managers.
All of successful portfolio management boils down to three essential skills:
- To see the world for what it is, not what we would prefer it to be.
- To be decisive with this understanding.
- To learn from doing the first two activities.
In skill #1, it is our behaviors and biases that dictate our ability to see the world for what it is.
Skill #2, becomes irrelevant if we haven’t got skill #1 down. Being decisive based on a biased view of the world doesn’t help. And being decisive without any view of the world won’t work, either – luck is not a long-term α-generating plan.
Finally, if we are afraid to look in the mirror, as #3 insists we do, then we can never get better at the first two skills.
Notice something here? For all three of the crucial portfolio management skills, it is process – governed by behavior – that drives α-outcome.
Do you have a handle on your own behavioral biases? Do you have transparency into them, and methods for mitigating them? My prediction is that the active managers who survive the “race to the bottom” that’s being led by passive products will be the ones who are curious enough to embrace this concept and brave enough to put it into practice.