Big Fund Managers Could Get Bigger Amid Continued Changes

There are three major trends that are all gravitating around the asset management industry, a McKinsey & Company report notes. Ultimately active managers, particularly at smaller firms, could be headed for increasing difficulty. In the wake of the 2008 financial crisis, a “new abnormal” has occurred – and McKinsey didn’t even touch market volatility when considering the abnormality.

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Even as passive management grows, its share of revenue remains consistent

While the passive asset management industry had grown from 12% to 18%, something odd has occurred: their share of industry revenue has remained consistent at 3%.

While passive management has seen increased assets under management, North American asset managers saw outflows for the first time since 2011.

In a survey of 100 North American firms what manage nearly 80% of all assets, some asset managers are doing well. But for those firms not in the top quartile, 2016 was a more difficult year than 2015, which itself was a challenging year. Top funds saw their revenues rise 5% while the vast majority of asset managers saw their profits drop 2%.

“Clients are hungry for yield and open to innovation, shifts in asset allocation are setting an unprecedented amount of money into motion, lower-performing players are being eliminated, technology is creating new sources of competitive advantage, and trillions of dollars of unmanaged assets are up for grabs,” Pooneh Baghai, Onur Erzan and Ju-Hon Kwek wrote. “In short, there is a massive opportunity to gain market share.”

New portfolio development methods focus on performance drivers and risk rather than asset classes

McKinsey sees several major trends shaping the industry. One is the change in how portfolios are built.

Portfolio construction is increasingly moving away from asset-based allocations and instead focusing on “risk-based portfolio construction.”

“Investors are increasingly recognizing the limitations of traditional asset allocation strategies, which use rigidly defined asset-class buckets and can mask underlying risk exposures,” the December 2017 report noted. “By reframing the portfolio construction process with respect to different types of risk exposures instead of types of asset classes, new approaches are blurring the boundaries between asset classes, creating competition across previously distinct categories.”

In addition to new portfolio sleeve allocations, factor investing is changing the landscape by challenging existing constructs. It violates rules of active management by focusing on sector selection rather than individual stock selection while at the same time challenging passive management by actively switching sectors and utilizing smart beta. “Factor investing seeks to go beyond broad market-capitalization-weighted indices to identify a more granular set of performance drivers, such as macroeconomic growth, currency fluctuations, or momentum.”

While major changes are taking place that threaten many active management practitioners, the top funds are prospering. Calling it a “Darwinian moment,” McKinsey notes the biggest and most prosperous funds are getting bigger.

“We expect that the closing and merging of laggards, which picked up pace last year, will continue,” the report said, pointing to significant market advantages for the largest firms. “This winnowing will result in a smaller, better-performing active industry.”

Are most hedge funds really "alternative?"

The hedge fund industry has the potential to come under pressure in this new world and is now “facing existential questions.”

“A number of large institutional investors have questioned the role of these strategies in their portfolios, either cutting back on capital allocations or in some cases removing the entire category from their investment programs,” as hedge funds are being questioned based on their true “alternative” nature. “Hedge fund leaders are repositioning themselves with a range of innovations, from significant investments in data, analytics, and technology to create new sources of investment advantage, to paradigm shifts in pricing.”