A colleague once observed that most companies had to be great at what they did in order to have a good business. Asset managers, on the other hand, he noted, need only be reasonably good to have a great business. For decades, that observation, if anything, understated the generous economics of asset management. Shops that vaporized client assets by pulling in huge sums at the peak of the tech boom, thus making them net destroyers of capital over most if not all of their existence, still enjoyed levels of profitability that most corporations could only dream of. In money management, for much of the past five decades, you could be demonstrably rotten at wealth creation and still have a highly profitable business.
Those days, at long last, are gone—and it’s a good thing. Investors don’t win in a game where there’s little penalty for those who create bad experiences. Capitalism demands winners and losers. In healthy markets, better players are rewarded and losers suffer. Only in state-sponsored enterprises, the type young socialists currently praise, is mediocrity rewarded to the degree it has been for so long in the asset management business. Real competition has come to the mutual fund world in the forms of passive strategies and exchange-traded funds. It is already clear that the asset management world of the future will little resemble that of the past. Greater convenience and lower costs for investors are now the industry’s dominant themes. The customer is at last king.
One industry that may offer a clue to how asset management evolves is the music industry. In my youth, music revolved around vinyl record albums. Like mutual funds with 8.5% loads, these albums wrapped what you wanted—the music and to a lesser degree the accompanying artwork— in a bundle of expensive distribution costs. The bulk of what you paid for went not for the music, but for the ancillary costs of pressing vinyl, opening retail stores, paying for sales clerks, truck drivers, marketing, and mall rents. In time, innovators recognized that by unbundling the content listeners wanted from the packaging they didn’t, they could drop costs and add convenience. Napster, MP3s, iTunes, and Spotify changed forever the world of music. In financial circles, passive investing and ETFs offer a similar bargain to investors, lowering cost and increasing accessibility. Active managers supplying model portfolios follow in a similar vein, offering instant MP3-like access to the content that investors value without all the distribution costs that weigh down returns.
The process of unbundling content from packaging brought on even more profound changes to the music industry. Once, artists engaged in moneylosing tours in an effort to promote the sale of their albums. Today, musicians often give away their music in order to encourage attendance at their live shows and the sale of band-themed merchandise. I see a similar thing playing out among active managers who are losing market share to passive strategies and ETFs. Some of these managers will morph from trying to sell their creativity (their funds being the equivalent of songs) and focus instead on the “live performance” of their creations—in this case putting their funds into action via portfolio construction for the end client. Fund managers will move into financial planning—a service for which investors are still willing to pay the generous basis-point fees that active fund management once enjoyed. We’re already witnessing this trend as fund shop after fund shop launches target-date funds, adds robo-advice, or creates similar portfolio construction services.
In a sense, it’s the perfect revenge for active managers who have been abandoned by planners now using passive products. Moreover, active fund managers have long complained that financial advisors buy and sell their funds at inappropriate times—piling in after good results and bailing before rebounds. The reality of that behavior is undeniable—most investors have asset-weighted returns that greatly lag their time-weighted returns and most investors use a planner. Active managers have long thought of themselves as far wiser and better trained than the financial planners who sold their funds. Whether these managers truly are superior to financial planners or if they have all the people skills good advisors bring to the table is an open question, but it’s a fair bet that the belief of many portfolio managers that they have superior skills will lead them to move in this direction—witness Vanguard CEO Tim Buckley’s recent proclamation that most financial planners should leave portfolio construction to firms like Vanguard, rather than tackle it themselves.
Just as the increased competition on active management from passive offerings led to lower costs and generally better outcomes for most investors, so too will increased competition for financial planners from traditional fund companies also likely lead to lower cost and better outcomes. Such a shift addresses one of the weak links in asset management today. The problem is no longer money going to bad funds—as happened regularly in the 1980s and 1990s. Today, money goes to good funds on both the active and passive sides of the ledger. Yet, investors still assemble flawed portfolios, loading up on what they wish they’d bought three years ago, rather than what will best prepare them for the future. That situation will likely improve somewhat as scores of CFAs, disgorged from jobs in active stock selection by the trend toward passive, move into portfolio construction roles.
As a result, portfolio construction will become more sophisticated, more homogeneous, less costly, and more efficient. Investors, on the whole, will be better off. Asset management shops will be in a whole new world, one where they now have to hustle and adapt like other businesses in order to continue to enjoy success. Great businesses among asset management firms will be rarer, good ones harder won, and mediocrity no longer a viable growth strategy.
This article originally appeared in the Summer 2019 issue of Morningstar magazine.
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