Active management has been taking its lumps as of late. This has been subtly on display both on stage and off at the advisor-friendly Morningstar conference as for the last three years a growing passive voice and the increasingly polite reception to the “smart beta” concept that was at first harshly criticized. Even in these advisor friendly confines, it can be argued the passive voice has been growing.  Enter Morgan Stanley’s Equity Analyst Michael Cyprys. He sees a continued widening of the performance gap among active managers, but thinks the fear of the passive trend has extended past its reality.

Morgan Stanley, Active Managers, Industry Disruption
“Disruption looms” ahead for active managers that don’t adapt

The trend change is undeniable. In unemotional fashion, the numbers tell the true story, as they often do. Since 2007 the migration out of actively management equity funds, at nearly $700 billion, is stunning. Where did that money go? “Passive has taken in more than five times the flows of active managers,” Cyprys noted. The nearly $800 billion bump in allocations that has gone that has been allocated towards passive index and category investments came at the expense of active funds.

Year to date, it’s not getting much better. In 2015 only 34% of active managers beat their benchmark. Through May 2016, only 16% of active managers are outperforming their “benchmark,” half of last year’s weak performance. Mention the word “benchmark” around active managers and they view such performance comparison in harsh terms.

Cowan Asset Management

With the rising problems, Cyprys nonetheless thinks reporting on the death of active management is overdone. There will be winners and losers amid restructuring, he said in a July 18 video report.

Under headline of “Disruption Looms,” Cyprys said “the death of asset management is… exaggerated.”  The disparity between strong and weak asset managers will grow, but the active – passive argument overdone.

Looking ahead, Cyprys looks at six primary disruptive threats and six potential solutions for asset managers along with recommendations.

Morgan Stanley, Active Managers, Industry Disruption

Six disruptive threats to the asset management industry

The current low interest rate environment is hurting the active management industry. Some in this industry, including some in actively managed CTA funds, use interest on margin deposits to boost returns. But more significantly this has created a market environment where finding value has become more difficult, as witnessed by the performance disparity between active managers and their benchmarks. The low interest rate environment may be here for some time, which might not be good for active management.

Part of the rise in passive versus active is the large portion of returns that are actually “beta,” or deriven by performance of the overall market. The rise in passive investing is benefiting from the dropping cost of beta to investors. This comes as fees in smart beta are beginning to fall. The lower the premium investors need to pay to find exposure to “beta” the more pressure active manager fees come under.

There are also rising regulatory threats, most specifically enunciated through the Department of Labor’s new fiduciary standard that compels financial advisors to recommend investments that are in the investor’s best interest. Active managers that charge high fees but don’t deliver performance could be among the first to suffer.

Rounding out this list of disruptive influences is new competitors, changing demographics such as the growth of millennials and the fall-off of baby boomers and the related threat of technical disruption.

With these threats looming, what should asset management firms do? Along with six disruptive forces, Morgan Stanley also noted the solutions.

Solutions for asset management firms who want to adapt

Firms that embrace disruption and preemptively respond might be expected to survive, while those who ignore the threats will have their profit margins pressured and their business model fade.

He recommended that asset managers “optimize investor returns net of fees and taxes” as well as adding new products. He suggests they “tune up engines” with a “Quentamental” analytic approach that combines quantitative and fundamental analysis closer together.

The active manager value proposition needs to be redesigned and asset managers should target millennials with ESG investments that tout a positive environmental, social and governmental stance on issues.

Other strategies include a shift from a product distribution mindset to a client acquisition strategy and looking to fill product and distribution gaps through mergers and acquisitions.

In this environment Cyprys recommends investments in Blackrock, Blackstone, Invesco and Oaktree – each of whom have very different alternative investment strategies, a topic not covered in the analysis. He is neutral weight Legg Mason and slightly negative on Wadell & Reed, which was initially accused of being causation for the 2010 “flash crash,” as well as Janus.

Year after year active managers cannot manage to beat their benchmark, and this shouldn’t come as a surprise. Study after study has raise the issue that few can consistently beat their stock market benchmark over time. But lately the underperformance has become stunning that active managers must do something.

“The playing field has tilted in passive investing’s direction,” noted Paul Smith, president and CEO of the  CFA Institute. He argues that active investors serve a critical role in society by providing a price discovery function. “It is a mathematical certainty that, after fees, more assets will underperform the benchmark that outperform. Is this really the best active managers can do to justify their existence?”

Perhaps we could just avoid performance comparisons all together, that might help certain managers in the debate. Or perhaps active managers might actually deliver some outperformance.