- The arrival of disruptive innovation via new collective vehicles, pricing models, advice models and the unbundling of investment returns represents a fork in the road.
- Growth in demand for unbundled distribution and investments is being driven by generational preferences, technology and regulation.
- The future of the asset management industry belongs to those who are able to innovate and adapt.
Recognizing that Yogi Berra didn’t really say everything he said, one of my favorite aphorisms attributed to him is, “When you come to a fork in the road, take it.” I interpret this to mean that when facing a difficult change or choice, it is better to make a decision and do something than do nothing.
Unbundling: The fork in our road
The asset management industry in general and managers of active strategies in particular are at a fork in the road. The industry faces the unbundling of its services and fees with potentially significant consequences for investors, distributors/advisors and managers. There are two apparent areas of change: the vehicles used to deliver asset management solutions and the unbundling of sources of investment return between beta, smart beta and alpha. The principal catalysts for these changes are generational preferences, technology developments and regulatory pressures.
In August, Mohnish Pabrai took part in Brown University's Value Investing Speaker Series, answering a series of questions from students. Q3 2021 hedge fund letters, conferences and more One of the topics he covered was the issue of finding cheap equities, a process the value investor has plenty of experience with. Cheap Stocks In the Read More
Our dilemma is not unlike that of the cable TV industry. Younger generations who want to take advantage of new services and technology such as Netflix and Roku are looking to unbundle the services they pay for. This leads to greater scrutiny on the transparency of the bundled price. For example, most people recognize ESPN as a ubiquitous component of the bundle, but do they really understand how much of the bundle price for basic cable is attributable to ESPN? Consumers and regulators want greater transparency. I recently unbundled and dropped elements of the bundle in favor of a faster/broader internet connection and subscriptions to various services. While I may not be saving that much and am probably incurring more inconvenience, I feel better about paying for my choices—not choices someone else made for me.
Turning to our industry, do investors really understand the myriad services and fees bundled into the price of their investment? There are several fees that pay for the investment advisory, administrative, custody, shareholder and distribution services required to run a mutual fund. These fees are disclosed and typically can be disaggregated to understand the expense of each service. Returns may now also be unbundled due to improved technology. While sources of return have been understood for a long time, today’s technology allows market and investment returns to be parsed, analyzed and risk-attributed—potentially allowing them to be offered or at least valued individually. Exhibit 1 shows the sources of return topographically, rather than literally.
Exhibit 1: Relationship between scarcity, contribution to return and price
Understanding risk and return in the context of unbundling
The beta (?) of an investment portfolio is a measure of the amount of risk inherent to its exposure to the broad market. Investors in U.S. equities often use indices such as the S&P 500 Index or the Russell 1000 Index as proxies for the broad market. Therefore, a portfolio that replicates the broad market or its proxies has a beta of exactly 1. Beta 1 investing is also known as indexing or passive investing. Modern technology and new investment instruments have made this technique relatively abundant. Basic economics suggests that goods or services that are abundant will attract a low price.
Smart beta (S?) is a relatively new term covering rules-based investment techniques that create an investment portfolio with a beta other than 1. Keep in mind that beta is a term like speed, or more accurately relative speed; it is not confined to a single number or ratio. Most drivers intuitively understand the variability of relative speed and closing speed when they assess overtaking and braking compared to other vehicles. Many active portfolio managers use different techniques for adjusting the beta of their portfolio relative to the broad market. According to Wikipedia, “A beta below 1 can indicate either an investment with lower volatility than the market or a volatile investment whose price movements are not highly correlated to the market. A beta greater than 1 generally means that the asset both is volatile and tends to move up and down with the market. Negative betas are possible for investments that tend to go down when the market goes up, and vice versa. There are few fundamental investments with consistent and significant negative betas, but some derivatives like equity put options have large negative betas.”
Utilized by portfolio managers for many years, these techniques have not been available in an unbundled format until recently. They include but are not confined to varying the portfolio exposure to size, value, growth, yield, momentum and quality factors. The trend toward unbundling has led to growth in smart beta products, primarily via exchange traded funds (ETFs). It is confusing that such products are referred to as passive investments. They are seeking an advantage over the broad market. However, the most popular approach is to create a new index, capturing the advantage versus the broad market, and then create an ETF that replicates that index. Smart beta products are simultaneously passive versus their new smart index and active versus the broad market index. As Exhibit 1 illustrates, the unbundled price for smart beta is not as low as beta 1. That’s because smart beta is more complicated to design and manufacture, requires higher intellectual capital and is consequently less abundant.
Alpha is a relatively scarce component of investment return. It has become popular to refer to it as the excess return of an investment portfolio versus the appropriate broad market index. This is incorrect, but serendipitous for the industry given the high price alpha commands in the marketplace. Alpha is the idiosyncratic component of the return not explained by the relationship to the broad market. Along with its contribution to return, alpha is a diversifier as it does not have a high correlation to the broad market. If it occurs with reasonable frequency, then the combination of perceived manager skill to create it and its diversification properties make alpha highly prized and highly priced.
There is growing clamor about the number of actively managed products that do not outperform their benchmarks. While this claim is undoubtedly contributing to the growth in unbundling, I believe it needs much more careful examination. That analysis needs to be across individual asset classes, volatility-adjusted, and before and after fees. Also, there is a different solution to products that may outperform before fees but underperform after fees, versus products that underperform on both measures. The first issue may be solved by adjusting the design of the fund or the fees; the second issue needs more radical measures. However, even if you accept that more products outperform than is currently popular to believe, that does not mean they do so with alpha.
Assume the broad market return is 10% and a portfolio with a beta of 1.2 returns 11%. While the portfolio outperformed the broad market by 10%, its beta-adjusted return should have been 12% (1.2 x 10%). Therefore, the alpha was -1. Given the premium price attached to alpha, it is advantageous for our industry to refer to the excess return as alpha. However, the return in this example should be attributed to the beta—but that would attract a lower price. The knowledge and experience to apply “smart beta” factors that impact the expected return of the portfolio should be valued by investors, just not as highly as scarce alpha. These factors are more abundant and offer less diversification than alpha.
Recognizing the need for disruptive innovation
I began by stating that growth in demand for unbundled distribution and investments is being driven by generational preferences, technology and regulation. While the priority of regulators may change with the political climate, the trends in demographics and technology are inexorable. These trends mean the move to unbundling is structural, not temporary or cyclical. In his book, The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail, Clayton Christensen suggests that successful companies overemphasize established needs and current assets, failing to adopt new technology or business models that will meet their customers’ changing needs. He argues that such companies will eventually fall behind. According to Christensen, the anticipation of future needs and trends is disruptive innovation.
The arrival of disruptive innovation via new collective vehicles, pricing models, advice models and the unbundling of investment returns means that we are at a fork in the road. The prospects for growth in the asset management industry look very exciting, but that was true for the data storage industry a couple of decades ago. The amount of data stored has grown enormously, but the companies benefitting are not the ones who produced 5 ¼-inch floppy storage disks 30 years ago. Innovate, adapt or fail!
Link to “Not so great expectations,” by Mark Burgess: “Not so great expectations”
Link to “Credit triggers: When will the long-running credit cycle end?,” by Jim Cielinski and David Oliphant: “Credit triggers: When will the long-running credit cycle end?”