What is the worst case scenario for IM

What do you guys think is the worst case scenario for investment management over the next decade or so? There's a lot of talk about eliminating the capital gains tax, so that cap gains would get taxed at ordinary income rates. Would this completely kill the business model/ bonus prospects at most mutual funds, HF, etc.? I'm guessing that would cause funds to slam the brakes on hiring for a few years?

I suppose a prolonged slump in the markets could have a similar effect. You'd think assets under management should be at a peak right now given that the baby boomers are just starting to retire. I wonder if total AUM will start to decline as the boomers eat into their nest eggs? Any thoughts?

Disclaimer: I don't work in IM, but will be heading back to b-school in the Fall and I'm hoping to break in from consulting.

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Comments (7)

May 14, 2010 - 6:24am

I'd be most concerned about the largest segment of the American population attaining age 70.5 beginning in 2012 and facing mandatory distributions on their retirement accounts. Massive selling pressure on the market that won't abate for at least a decade.

Best Response
Oct 8, 2015 - 1:17pm

Wow, nice power bump (unless you were just editing out something?). I had forgotten about this one...

I've actually been thinking about this issue again recently, although probably through a bit more nuanced lens than I had pre-business school. I've spent the past 3+ at a big long-only mutual fund. I'm not going to lie, I have some very real concerns about the durability of the long-only Asset Management industry in its current incarnation. There is a very obvious osmotic pressure building due to the fee differential between the long-only active managers and passive strategies/ETF's. In many cases, this fee differential can be as high as 10x, with long-onlies earning a 1% management fee, and ETF's generating something like 10bps. It won't all happen overnight, but eventually this dynamic will lead to a sustained secular shift away from actively managed equities for retail investors, barring exceptional performance. Net of fees, active managers do not beat their benchmarks over long time horizons in any meaningful, sustainable or predictable way (with a very few exceptions).

I do not necessarily think this spells the death of the active management industry entirely. I think what it means is that a significant number of retail investors will be shifting out of the mutual fund industry and into ETF's/Vanguard/Dimensional etc.. This is a trend that already has been happening for several years. However, I expect the high net worth individuals, along with pension fund managers and endowments to pursue a more sophisticated strategy. I think many of these will seek to get beta exposure from low cost passive strategies, but will overlay an alpha driven strategy on top of this with some percentage of their capital. This has been the mandate at places like Yale and Harvard's endowments for decades, and I expect this to spread to other more traditional managers as well. This trend clearly favors the hedge funds over active mutual funds, and I think it advantages the long-short market neutral strategies in particular (which are pursuing a pure alpha strategy). I think the vast majority of AUM growth will accrue to the most established managers with the best long-term track records, e.g. scale is going to be increasingly important. This is structurally a positive for HF's, and I think a secular negative for the long-only guys. Again, some long-only's will be fine, but it is going to be a shrinking addressable market so competition is likely to be intense.

I am less worried about the sustained outflows issue from retiring baby boomers that I mentioned in the OP, given that a lot of this will get masked by international inflows from wealthy investors and SWF's abroad. The U.S. remains the least dirty shirt. It could eventually become an issue, but I don't think it's at the forefront yet.

Anyone else have any thoughts on this?

Oct 9, 2015 - 12:12pm

In my opinion, long only isn't going anywhere and active Asset Management isn't going anywhere. Perhaps in its current form no, but I don't think you'll see the industry shrinking by 50% or something like that. I think the active and passive will swing like a pendulum - when too much money is invested passively, active management will outperform passive - we've just seen it swing passive for many years. I think passive has become a good way to weed out managers who suck and charge outrageous fees and is a good starting place for people to invest, so I think this is in fact a positive for the industry as managers who shouldn't be in the space who are screwing up the system are weeded out. Long only is scalable, and once lower cost alternatives really start affecting the bottom line, you'll see some fee compression to compete with other vehicles or rolling out of some other strategies. So perhaps lower pay for some or less people in the industry, but what's new about that? I do see there being a bit of compression in the industry, but I think it's both structural and the result of some competition, but AM firms run lean already, so it's not like you can keep running if you fire half your staff. Mutual funds are in big need for some regulatory upheaval given the advances in technology and I think that's part of the reason why they are so clunky and undesirable at the moment, but I guarantee you that when active asset management is being threatened, they will respond by introducing whatever else the market wants (ETFs, shorting, alts, etc.)

Also, Hedge funds cannot simply 'scale up' as you describe - sure maybe a long/short fund or an activist fund, but the best strategies are not the ones that can blow up to the hundreds of billions, and there currently is no ability for retail investors to get into most hedge funds. Although if demand is warranted, I can't see why long only funds wouldn't reach into the space and that is likely what will happen is that long only Asset Management becomes long/short or all types of asset management.

Like any industry it will evolve with the times, but fundamentally, unless you think markets are perfectly efficient, I think there will always be a place for long only active - it'll just look different from what you see it as today.

I don't have an answer to what's the worst that could happen...
Technology disrupts active management (firms like motif, not so much robo-advising)?
Sluggish global economy for a prolonged period means poor returns for both active and passive?
Retiree selloff?

Oct 9, 2015 - 10:58pm

Asset Management isn't going anywhere, but it may change a lot. In terms of where how investors decide to allocate their portfolios. Let's start with Mutual Funds. A lot of this could apply to Hedge Funds as well. I place active management into three tiers: the consistent outperformers, the occasional outperformers, and then there's simply just the bad fund managers.

The consistent outperformers are here to stay. I'm talking about the Dimensionals, GAMCOs, and elite Fidelity funds of the world, etc... A good portfolio manager will always be in hot demand. They consistently produce returns that beat the market (say 7 out of 10 years). When I say beat the market, I'm referring to the after-fee total return numbers.

The occasional outperformers are facing a real threat. These are the guys who may beat the market 4 out of 10 years and charge insane management and load fees. With the rise of smart beta ETFs, cheaper mutual funds/ETFs, and much more scrutiny of the fee structure and returns funds produce, it's difficult to imagine this part of AM will not change.

The bad fund managers will be eliminated. I'm talking about the manager that made one awesome bet or had one good year and the other 9 years has not beaten the market. These guys have gotten lucky because a lot of investors don't want to change the way they've invested since the 1980's when there wasn't a prevalence of passive funds and ETFs. This small segment of investors, rather than diversify into cheaper vehicles, have simply accepted this as THE way to invest in mutual funds. These investors are those who may be either unsophisticated, rooted in tradition, or both. Again, this is a smaller group of investors.

For hedge funds, it's largely the same story. Many have not been outperforming and investors are beginning to recognize the ridiculous fee structure they're still able to charge despite not exceeding expectations. A lot of the above still applies to hedge funds. The best hedge funds run by star managers are the ones investors will still go into. The middle tier and bottom tier will have a hard time, especially as investors like pension funds start to challenge them or simply eliminate the HF allocation in their portfolio.

In terms of the individual investor, I think they'll shift out mostly into passive investing. Robo advising will see an increase in assets as well, but I think more so from the average individual who's retirement accounts is basically their entire investable portfolio. The fact of the matter remains that the individual investor does not make up a large portion of the entire market. That's the institutional side.

Institutions could change AM a lot because of how much power they hold. A lot of major funds have most of their assets coming from big sophisticated institutions. Now that they have access to much cheaper passive funds and smart beta funds that replicate a lot of what Active management does, it's hard to see them not at least reducing their allocation towards HF's and active MF's. Especially as we see the new generation leading these institutions, who their entire careers have been exposed to cheap vehicles and understand how infrequently active management beats the market.

I believe ETFs and passive funds will naturally see growth as fees on funds continue to scale down even further and price competition amongst AM firms has increased. The cheapest vehicles will be the best off in the long run, just because of how much scrutiny fees have gotten. Investors are judging the vehicles at this point, which is another fundamental change in the industry.

To summarize, I think the best funds and the best managers will be around for a long time. There's simply no replacing the human capital and long term value they add to an investor's portfolio. The lagging funds could see a big shift in assets out of their funds. Again, I think a lot of the same logic applies to Hedge Funds.

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Oct 10, 2015 - 11:26pm

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