A Passive Present
There is no arguing that 2017 was a particularly rough ride for active managers, who faced continued disruption from several directions. From technology innovation, to a deluge of regulation, and the encroaching growth of alternative asset managers, elbowing their way into private debt and other sources of illiquid alpha. And let’s not forget the elephant in the room; the reign of passive investment.
Actively managed funds have struggled in recent years to varying degrees across the globe. According to the much anticipated 2017 SPIVA U.S. Scorecard from S&P Dow Jones Indices, some 66 percent of large-cap active managers in the US failed to top the S&P 500 in 2016. It’s no surprise then, that active managers continue to experience record outflows, as investors persist in pouring money into the booming global market of passive and smart beta Exchange Traded Funds, now over two decades old and worth an estimated $2.9 trillion (Financial Times, 2017). Asset Owners have shown a clear preference for these transparent, low cost investment vehicles, affording them access to diversified range of asset classes, with satisfying returns.
Moreover, the surge in Smart Beta ETFs, which provide many of the same benefits as index-based investing, with the addition of an alternatively-weighted or strategy bias, offer the investor a cheaper, hybrid alternative to actively managed funds. In fact, in the last two years we’ve even seen fund houses muscle in on the action. The latest entrants into the Smart Beta arena include JP Morgan Asset Management and Fidelity International.
The question on everybody’s lips; Is this the end for active managers? The answer is No, far from it. The tide is swiftly turning. We now see heightened volatility, evidenced with the recent spike in the VIX. We have also seen the Federal Reserve raise interest rates to 1.75% with hints that more hikes are to come. And then there’s decreasing liquidity, caused by central banks pulling back from monetary measures like Quantitative Easing (QE). All of this bodes well for the active manager to make a comeback.
Combined, these factors have already panicked many investors in the first quarter of 2018. Just weeks ago, Traders Magazine reported that February marked the US ETF industry’s first monthly outflow in two years. And it continued in March. State Street Global Advisor’s latest ETF report estimates the outflows at $1.7 billion. The first consecutive monthly outflows since February 2008. Does that year sound familiar?
And this panic behaviour is set to continue if veteran Manager, Mark Mobius’ recent prediction is anything to go by. Having predicted the start of the bull market back in 2009, Mobius is now prophesying an impending market correction of around 30%. What’s interesting is that if this were to happen, the scale of it would be magnified by the mass pull out from the very ETFs that have been seen as low-risk.
Resourcefulness and resilience form the very nature of active managers and together with the return of volatility, increased inflation, and current caution around ETFs, they now have a real opportunity to make a comeback. Both investment technology and operational strategy, will play a major hand in defining this opportunity. The right strategy will not only deliver the operational efficiency desired to create a distinct competitive edge, but also the returns required to attract and retain customers.
‘Computer, Set the Course for Consolidation’
Against this backdrop, the ability of active managers to produce alpha from complex and illiquid
Instruments, such as fixed income, is essential. Interestingly, amid the ETF commotion, Fixed Income ETFs are one of few ETF types that continue to gain fresh inflows of $5.3 billion in March. To make active management strategies even more competitive against these passive alternatives, special attention must be paid to improving investment operations.
Taking this all into consideration, together with increasing technology complexity, and the continued electronification of Fixed Income trading, the argument for consolidated investment management, has never been stronger. In fact, in a recent WBR Insights Fixed Income report 66% of the 100 North American Fixed Income professionals surveyed, cited reducing operational cost and improving profitability of the fixed income desk as their number one strategic priority for 2018. It is clearer than ever before that operating on a ‘golden master’ or single source of data across investment operations, establishes the operational transparency required in institutional investment today. This is no new phenomena of course; a consolidated or single investment system is an operating model adopted by many asset managers globally. For active managers though, it holds significant operational and business benefits, particularly now.
For one, it gives them the ability to manage multiple asset classes, by using a unified IBOR (Investment Book of Record) at the core of their investment system. Active managers need only add new instruments once in the system, meaning faster product innovation and go to market timeframes. Secondly, when you look at the typical asset classes that have outperformed in recent years, they often include; small cap equity, international emerging markets and fixed income. These are asset classes, which active managers traditionally have excelled in, but are now restricted from, by the inhibiting collection of best of breed systems struggling to cope with today’s diversified investment strategies.
Emerging markets are another opportunity well suited to active managers, but expansion into new geographies, using legacy technology, that cannot traverse multiple time zones and manage multiple currencies, has to date proven an operational nightmare for many growing firms. This means one of two things; holding back vital alpha generation or creating more front office manual workarounds that require further resources and increased costs, not to mention risks.
When talking to the buy side, one of the most common complaints I hear is about the use of decades old order management systems or portfolio tools that fail to support the trading of today’s more complex asset types. Furthermore, years of accruing disparate systems have now led to widespread operational challenges, such as limited access to firm-wide exposure in the front office. In the earlier mentioned WBR Insights Fixed Income report, as many of 81% cited challenges in understanding firm-wide limits and counterparty exposure. Other daily challenges include access to timely and accurate start of day positions and measuring investment performance diligently. The sheer number of Excel spreadsheets still playing a critical role in piecing together the investment lifecycle, is both unbelievable and unsustainable.
The general consensus is that best of breed technology has run its course. The regulatory assault, decreased liquidity, increased fragmentation and the electronification of fixed income trading, have all combined to make the fixed income markets tremendously complex, but at the same time still a source of quality alpha for active managers. To successfully operate at maximum power, active managers should look to lower their total cost of ownership and consolidate underperforming systems to an integrated, multi-asset platform that can perform in today’s markets. This eliminates some of the biggest costs, including; the testing expense associated with upgrades, cost of lost latency and the incalculable cost of talented front office resources spending their valuable time on manual processes. Equally important is the reduction in vendor risk, associated with having so many moving parts.
Consolidating investment processes from front to back also delivers significant automation to a firm, across reconciliation, collateral management, corporate actions, cash management through to reporting. Using an integrated IBOR and ABOR (Accounting Book of Record), ensures a firm can access fully traceable data that can be easily managed. This not only makes regulatory implementation and compliance straightforward, but also enables firms to approach regulation as a competitive advantage, grasping the business opportunities they can bring, and also the strategic positioning they offer against lesser-prepared peers.
What’s in store for the year ahead?
At this pivotal time in the market, where conditions are expected to ‘go back to normal’ active managers are faced with a fresh break. With the Federal Reserve’s rate rise in March to 1.75% it is evident we are no longer stuck in the stagnant low-interest rate market of the last decade. There is now renewed optimism over margins and the returns that active management may once again deliver. The next few quarters will prove crucial, as many investors watch and wait. Those active managers who break free and set their course away from the status quo of the past, and towards consolidation now, will be the first beneficiaries as the scales tip back in their favour.
*This article was originally published in Traders Magazine.