The Impact of Technology on Active versus Passive Management

I was joined by Tom Secaur, CitiSoft’s Global COO, to moderate an industry roundtable at the Fixed Income Leaders Summit in Boston on this very topic. We all know the trend is real, but what are the root causes, is it sustainable, and what is the outlook for the industry? These were some of the points we sought to address with a distinguished group of participants representing a diverse group of asset managers on both sides of the fight.

We opened the discussion with the graphic above. The trend is real and there is no denying it. But does that mean active management is dead and investors should pack up and move everything to a giant indexer? The answer we got from the group and from the clients that we work with here at SimCorp is decidedly ‘no’. Below are some of the key factors that have produced the trend and how those factors might be mitigated in the coming years.

Fees

One thing everyone in the room agreed on was that one way or another, fees for active management are going to have to come down. Even with a sustained period of outperformance, fees will stay under pressure. The headwind of 100 basis points or more was looked at as an almost insurmountable obstacle and would have to change.

An interesting discussion broke out regarding the recent news that AllianceBernstein will start offering plans that link fees more closely to performance. While that linkage has existed in the hedge fund world for many years, and some panelists pointed out even in traditional asset management, without much advertising, this is the first time a major asset manager is widely publicizing such a structure. If the concept is successful at AllianceBernstein, the group felt that we may see this more broadly across the industry. Despite it being an attractive marketing pitch that may be embraced by some investors, it is not an idea without its own set of challenges.  Since this model shifts the profit risk to the asset manager, that could incentivize managers that have fallen behind to take on more risk to catch up and ensure profitability (and payment) in a given year.

Performance

Let’s be honest, if the majority of active managers had bested their benchmarks consistently for the past few years, this would not have been much of a roundtable discussion. The reality is that only around 20% have been able to beat their benchmarks consistently over the past decade or so.

Interest rates have been at historic lows, some would argue artificially so, for more than a decade. Combined with the Volatility Index close to all-time lows and a market that has generally gone straight up since the financial crisis of 2008, the macro climate has not been kind to the active manager. The pressure of passive management has also produced the perfect storm environment for closet indexing. If the markets march upwards, some managers may feel it might be easier to just tag along with the benchmark, but unfortunately that virtually guarantees underperformance net of fees.

Even when performance is acceptable, some managers are still losing assets. I shared a story about a USD 40B AUM manager I recently met with that had just lost USD 500 million from one of its large cap growth funds, not because performance had been poor…it had been solid, but simply because the client was feeling pressure to have more assets under passive management. This unpleasant reality that passive management has become a bit of a buzz word and an “everyone into the pool” mentality was a scary, but recognized, concept to the active managers in our session.

It was not all doom and gloom however, and no one was willing to argue that active management was dead or that there was not room in an overall portfolio for both active and passive management.

Question:  So, if the end is not actually near, what do active managers feel good about?

Answer:  Complex instruments. The graphic below was published in Fund Fire in February 2017 and depicts which active managers outperformed or underperformed the benchmark for each asset class net of fees over the past seven years.

Based on the relative performance depicted above, it seems like there is a simple solution to the problem of underperformance; move out of large cap growth equities and into asset classes such as emerging markets fixed income or mortgage-backed securities.  While our audience agreed that those areas were asset classes that were well suited to the active manager, there are significant operational challenges to expanding into new asset classes and/or geographic regions that make this easier said than done. Many complained that their order management systems or portfolio tools were not well suited to trading complex assets.  Even bigger problems arose when trying to perform investment accounting, risk or performance activities on these instruments. The consensus was that a firm’s technology landscape needed to be up-to-date to successfully move away from more traditional asset classes.

It was a very interesting and lively conversation and provided a lot of validation to the approach we take at SimCorp. A large percentage of our clients engage in active management and SimCorp takes pride in providing tools to overcome many of the obstacles discussed above. As a natively global and multi-asset front to back platform, the goal of the platform is to optimize operations and empower clients to nimbly invest in any instrument or region where they see opportunity. When we meet with prospective clients, one of their top complaints is the struggle they have with legacy systems supporting new asset classes or regions. Many of these systems were designed and deployed before some of these asset classes were even invented, so the resulting limitations presented are not that surprising.

While active managers have faced obstacles recently, no one in the room was ready to read active management its last rites. In fact, most felt optimistic about the benefits of a rising interest rate environment and the potential for greater volatility in the coming years. More aggressive fee structures are a near certainty and will also provide immediate performance relief.  So while no one expects the trend to reverse in the near term, there will always be room for quality active management, particularly in more complex and illiquid instruments, provided your firm is equipped to handle them.