Active equities managers are in a difficult position right now.
While the headlines have been drumming on about the demise of active management for years – a slow death against the rise and rise of index investing – some have brushed it off as merely cyclical pressure, with literature suggesting the forward-looking environment will be more favourable for stock-pickers.
But unfortunately for managers in the Australian market, there’s a whole new business challenge in the picture. Margins on local institutional business are increasingly getting squeezed, so much so that many have willingly handed back assets to clients just to keep the rest of the business profitable.
From discussions at the most recent Investment Magazine Fiduciary Investors Symposium in the Blue Mountains, NSW, it was clear that asset allocators have different opinions on the level of exposure to active management they want in their portfolios.
However, what was largely unanimous was a belief that active managers still play an important role in the market – that active management is not dead, and asset owners don’t want it to be.
Asset owners confident
AMP head of portfolio management Stuart Eliot told the symposium that active management is needed for index investing to work well.
“You could make the argument that index investors are getting a free ride from people who are willing to pay active fees because you actually need the research and the active management in order to do price discovery and reflect new developments in the market,” he said.
“I think there will always need to be a certain amount of fees paid out to the active management industry to ensure that we can get efficient returns on the index part of our portfolio.
“You don’t want Roaring Kitty being the one who controls how well your portfolio is going or otherwise.”
More super funds would likely resonate with this sentiment than not. Managing director and founder of strategy consultant 1886 Consulting, Doug Talbot, told Investment Magazine in an interview that “anecdotally, outside of Vanguard, there aren’t any asset owners I speak to that don’t have some allocation to active management”.
“It will be, though, up to the philosophy of the investment committee, the chief investment officer and their asset consultant as to the how much weight there is to active management,” he said.
This view is echoed by bfinance director Sebastian Mays, who said many institutional investors are still believers in active management’s ability to outperform after fees, but said regulations like Your Future, Your Super have reduced the appetite for certain strategies.
The tolerance for highly volatile active returns has reduced, for example, even though it “may well deliver long-term outperformance but underperform at various points in the interim”, Mays said.
“Some asset owners have described this as a pursuit of ‘sustainable alpha’ with as much emphasis on the path of returns as the magnitude.,” he said.
Mercer chief investment officer Kylie Willment said at the symposium that the only area where the fund doesn’t have high conviction in active management is US large-cap equities.
“I think that dynamic and the concentration there has just gotten to a level where it is very, very difficult for active managers…to be able to manage that,” she said.
“We have far higher conviction around alpha generation or opportunities in areas like small cap and emerging markets, where it’s perhaps parts of the universes that are less well researched and don’t have the same level of concentration risks
“Active management, yes. But you’ve also got to be selective around how you deploy that active risk budget, which often does link to fee budgets as well.”
Tough negotiators
However, from the managers’ perspective, the main problem is that they are struggling to service super fund mandates at a level of profitability that meets their expectations of the past.
Despite ballooning retirement savings, some say the Australian institutional market has actually become less lucrative for active equities managers for reasons including asset-owner investment internalisation, high fee sensitivity and a pivot to private markets.
Not to mention that Australian super funds are now known around the world to be tough negotiators when it comes to investment fees. This begs the question: how much lower can asset managers go?
“I think what it does is that asset managers will likely demand large mandates, in order to be able to meet the demands of the superannuation funds,” Talbot said.
“However, the challenge with this… as an asset manager, is you might have capacity constraints, particularly if you’re an Australian equities manager, or a long-short manager. You may actually not want to take such a large allocation and use up all of your capacity from a fund that is demanding a low fee.
“You’re asking the question of whether asset managers can go lower, but the question is not whether they can, but whether they really want to use their capacity in that way.”
Talbot said the continuous pressure on fees in the Australian market – which is unlikely to change in the short term due to the regulators’ focus – will be an “interesting scenario” to play out over time.
“If you’re an Australia-only manager, it could be quite challenging to remain profitable because your ability to attract global capital at a higher fee will likely be very constrained,” he said.
“If you’re a global manager, it just means that you source other pools of capital, whether it be North America or Europe.”
They might also pivot their distribution channel to be adviser-facing which, rather than working against regulatory trends, will tap into the government’s plan to get more Australians better advised, Talbot said.
“If you take a forward view, the government and industry want Australians to be better advised than they are today, we have a broader middle-Australia advice crisis that the government is trying to address,” he said.
“And it won’t be just this government, it will be subsequent governments as well.
“If the broader cohort of Australians are able to get advice, that may connect with growth in managers that can support those advisers, then that could lend itself to a medium- to long-term growth proposition of the local asset management industry.”
Lower the expectations
Looking at the business environment ahead, industry veteran Richard Brandweiner said at the symposium the biggest challenge is asset managers now have a mismatch between their fees and cost bases.
Brandweiner has seen both sides of the story. Formerly the First State Super chief investment officer, he also spent years leading both Perpetual and Pendal – two iconic Australian active managers that became one just last year, and whose fate has again become uncertain after the KKR deal this year. He is now the chair of Impact Investing Australia.
“The biggest challenge fund managers face… is that the current fee level in the market is fundamentally lower than the legacy fee structures that most older fund managers have embedded in their business model,” he said.
There could be opportunities for active managers, Brandweiner said, “but fundamentally, it’s not at the price that they would have sold [their services] a couple of years ago”.
Technologies like AI might even further complicate the situation, he said.
“When you think about active equity fund management and debt, fundamentally you are packaging up other people’s assets and putting it into a portfolio. That’s a skill, we call it alpha,” he said.
“But as markets become more efficient, and as information becomes more readily available, you could argue that the margin between a human organisation doing that [skill] and an algorithm might shrink over time.”
But Talbot is of the view that “you have to look at these mega trends [like AI] as an opportunity rather than as existential threats”.
“Positively, there could be additional efficiency gains that come from leveraging AI as it relates to distribution and client reporting, investment process, and analysis and research,” he said.
“The headwind is what AI means to the disruption of both fundamental and quantitative investment processes for public market managers. I think private markets managers are probably where AI could play an even bigger role.”
However, both Brandweiner and Tabot, speaking on separate occasions, reaffirm that if active managers might see good times again if they can outlast the current headwinds.
“If they carried out through this cycle with some good alpha, they might be back like bonds,” Brandweiner said.
And Talbot said it could be “a scenario where there’s more pain ahead than there is help” for active managers.
“However, sometimes when an industry is fundamentally shifted, it presents new opportunities for renewal,” he said.
