It seems strange to speak of disruption in asset management at a time when foreign inflows into Indian markets are booming and domestic inflows to asset managers, especially in the form of SIPs, resemble a tsunami. Hiding under the large accretion to funds is a shift in the way the industry works - a function of a new tech-savvy generation beginning to gather assets, regulatory changes and greater technology use.
A shift to passive
From 2007 onwards, many actively managed equity funds in the US have shut, with only about 51 per cent of those in 2007 surviving up to 2016. Worse, over 80 per cent underperformed their benchmarks. The performance of debt funds is similar. This has not led to a reduction in fund inflows - just that flows to passive funds have increased.
The world's second largest mutual fund Vanguard gathered over $277 billion in 2016. Vanguard's strategy of growth of offering low-cost index funds to investors is resonating with investors tired of paying high costs for poor investment outcomes. Investors invested over $505 billion in index funds in 2016, while withdrawing $340 billion from costlier, actively managed funds. This trend is not new. In 2014, PWC forecast for the fund-management industry in 2020 had laid out the data as shown in Table 1.
An interesting data point is the expectation that the ratio of active to passive investments would change from 7:1 in 2012 to approximately 3:1 in 2020. The trajectory seems to be holding out.
BlackRock, the world's largest asset manager with $5.1 trillion, uses exchange-traded funds, called iShares, to offer low-cost options. These too gathered $140 billion net in 2016, while the active-management business lost $19.3 billion. Under a new leader, BlackRock recently moved over $30 billion from active management to a quantitative approach.
With markets delivering subdued returns, high-cost fund managers are finding it difficult to beat the market after costs. Millennials prefer to use passive funds, thereby saving on the fees paid. Asset managers have reacted by offering passive and quasi-active funds through the use of quantitative methods that help replicate some of the functions of an active fund manager.
Low fees have led to mutual fund revenues stagnating, even as assets increase. With little product differentiation, a race to the bottom can be witnessed in the industry, and a no-fee fund may not be very far away. ETFs, despite their rapid growth, are still a small part of the industry (see Figure 1), but higher indexation increases the danger of reduced market efficiency over time as passive investments become a larger part of the market.
Death of equity research
Regulations are typically meant to improve markets and make them more transparent but they sometimes have unintended consequences. European regulators have mandated that 'MiFID II' be operational from the year 2018. This requires that brokerages charge their clients separately for research and execution. This service, thus far bundled, forces asset managers to show research costs separately to clients and consequently pushes down these costs.
Importantly, it also severely restricts access to research to smaller fund managers who cannot afford to pay large sums. One large brokerage is reported to have demanded $10 million per annum for access to its research. This may be a small change for managers like BlackRock but can be back breaking for small managers. Importantly, the revenues for brokers will fall dramatically as execution commissions are already under pressure and managers will negotiate hard on research fees.
European asset managers are expected to cut spending on outside research by as much as 30 per cent (see Figure 2). While this will partly be offset by larger internal teams and perhaps specialised inputs from outside units, it may make research less easily available to smaller institutions and retail investors.
Technology - the great leveller
The use of technology - robo-advisory, artificial intelligence and network of payment technology providers will open up the market for mid- to low-net-worth investors who have thus far been ignored by asset managers. The use of social media and crowd sourcing of information will also provide tools to the retail investor, which can lower 'information arbitrage'. Crowd-funding platforms can make 'alternative investments' more democratic and open them up to a wider class of investors.
India - both behind and ahead of the curve
Institutional investment in India has still not become the norm, with many retail investors continuing to prefer to invest by themselves. Only over the past couple of years, as market volatility has reduced and mutual fund performance improved, have flows to active mutual funds become larger and more meaningful. Even now, investment in equities forms a small part of the average financial holdings of savers. 'Institutionalisation' of investment flows seems to be a given.
Internationally, the trend points towards more passive investing - through ETF's and index funds. As these trends converge on the Indian market, it appears possible the investors will use a mix of active investment funds, passive investing and direct investments to create their portfolios.
ETF flows are not discerning when it comes to valuations of individual companies. It is not surprising to see that overpriced companies continue to remain so in a market where ETF allocations form a large part of the inflows. Such pricing disparities will provide opportunities for outsized returns. Whether institutional investors will benefit from these or remain bound to the index and thereby not add value to their investors (as in the case of global funds), only time will reveal.