An Industry in Transition
The investment management industry has enjoyed rising revenues and attractive profit margins. Investment firms benefited from the accumulation of assets from the baby boomer generation and from rising markets that created a multiplier effect for asset and revenue growth. However, it's no secret that the investment management industry is in the midst of significant fundamental change. Greater recognition of the connection between costs and investor outcomes is an important catalyst, as is the disappointment of many investors in the results from actively managed investment products.
Speculation about the future of investment management is common. Unfortunately, far too many forecasts are slanted to favor the business interests of the commentator. Passive managers often discuss a future in which index or factor-based investments predominate, and are critical of the performance track record and fees charged by actively managed strategies. Active managers often highlight active management successes or speculate about doomsday scenarios in which the demise of active management causes a breakdown of the price-setting mechanism of markets.
Hedge funds are frequently a target of misleading attacks. A recent commentary published in a San Francisco newspaper suggested that pension plans should cease investing in hedge funds because the average hedge fund has trailed the Standard & Poor's 500 index for eight consecutive years. Most hedge funds aren't trying to beat the S&P 500, so the comparison was misleading and based on a false premise. There may be reasons to criticize pension fund investments in hedge funds, but underperformance relative to the S&P 500 isn't one.
The Portfolio of the Future
My firm invests in both passive and actively managed products, and I have extensive background with hedge funds and private investments. Consequently, I think I have a well-informed and reasonably unbiased perspective about the future of the investment management industry. Index and factor-based funds should continue to gain market share, but active management will still play a meaningful role in investor portfolios. Many investors will gravitate to portfolios that include core investments in low-cost index or factor-based funds, supplemented by active funds in selected asset classes. This "core/satellite" approach is already widely used by advisors and institutional investors, and may become the norm for a growing share of the investor population.
Index or factor-based strategies are likely to dominate ultracompetitive asset classes such as large-cap equity, providing low-cost, tax-efficient market exposure. Active strategies may thrive as satellites around a core allocation to index or factor-based strategies, providing return enhancement or risk management benefits.
Actively managed strategies may provide return enhancement opportunities in asset classes in which skilled managers can develop a sustainable edge and provide superior risk-adjusted performance. Despite the many negative headlines about active management, active managers have enjoyed success in asset classes such as international small-cap equity and core fixed income.
Actively managed strategies may also be used in asset classes in which indexes are flawed or are highly fluid in nature. For example, high-yield credit indexes are dominated by the companies that issue the most debt, a structure that can lead to unintended and undesirable consequences. High-yield credit indexes may not be completely investable or may carry very high trading costs, demonstrated by significant differences in performance between passive high-yield funds and their benchmark index.
