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Building a Resilient Firm to Weather the Next Market Cycle

AN INSIDE LOOK: SunStar Strategic Webinar Series

Featured speaker: Warren Miller, CEO and founder of Flowspring, moderated by Marilyn Dale, SunStar Strategic Creative & Digital Services Director

February 4, 2020

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SunStar Moderator: Good afternoon.  Thank you all for joining us for Sunstar's An Inside Look. Today we'll be hearing from Warren Miller. He is the CEO of Flow Spring. Before we start I want to mention that at the bottom of your screen you'll see some controls.  There is one marked Q&A. If you open that at any time during the presentation you can type in a question.  We will hold the questions until the end of the presentation and Warren will be pleased to answer them for you.

Warren Miller is the founder and the CEO of Flow Spring. Previously he was the head of Asset Management Software and Quantitative Research at Morning Star where he led a global team of quants, developers and data engineers toward the development of global multi-asset class risk models, quantitative investment signals and systematic institutional investment strategies.

Warren's been quoted extensively in publications including The New York Times, The Financial Times, The Wall Street Journal and more.  As the founder and CEO of Flow Spring, he leads a company that provides advanced, competitive intelligence for asset managers. Flow Spring aims to give quantitative support to all business decisions that are faced by asset managers from product launches and rationalization to optimal pricing strategies and M&A activity.

Warren studied industrial engineering and economics at Northwestern University and he earned his MBA from the University of Chicago, the Booth School of Business and he is a CFA charter holder.  So without further ado, Warren, take it away.

Warren Miller: Thanks, Marilyn.  I appreciate the introduction and thank you all who are joining us and lending us your attention today.  I appreciate the opportunity to get in front of you and hopefully this is productive for you as well.  We're going to talk about asset managers, what kinds of things you can do with your firms to reduce your exposure to market cycles, market volatility and really improve your operations throughout a range of market conditions.

I'm going to start with what we already know. Everybody on the phone already knows that we're in an essentially a prolonged bull market at this point.  We could have a whole other webinar on why the bull market has lasted as long as it has and as strong as it has, but suffice it to say we're long in the tooth with the roughly 11-year bull market here where the rising tide has essentially lifted all those in the asset management world, right. 

We've all benefitted from the capital appreciation that has come from this bull market. And as a result asset managers have not quite had to rely on the organic growth as much as they might if the capital appreciation wasn't there.  But to borrow an expression from Warren Buffett, when the tide goes out we will see who has been swimming naked, right. 

So it's inevitable that the bull market will eventually go away, capital appreciation will turn negative and all of a sudden those organic growth rates start to matter quite a bit for keeping you afloat.  All the more so given the extra pressure, our industry is under in terms of feed pressure, the passive versus active debates and so on and so forth. So interesting times here whether you think a bear market is imminent or whether you think that we've still got many more years, it's important to think ahead and try and prepare yourself for that eventuality.

And what I want you to understand and feel good about at least is better than fearing these recessions or bear markets view them as opportunities.  When we look at the data, the organic growth rates of asset management firms in recessionary periods versus non-recessionary periods, of course one of the things we find is there are firms that have more pronounced negative growth in recessions. That's just natural.  Flows are going to move around during a recession. But the upside during a recession is more pronounced as well.

So the numbers you're seeing on your screen right now these are organic growth rates, annual organic growth rates for the top quartile in blue and the bottom quartile in black, during recessions on the left and not during recessions on the right.  So the range of possible outcomes during a recession is much greater and as, you know, accordingly that represents an opportunity for all of you to really go out there and gather assets and grow yourselves organically during these recessions if you can position yourself well enough and not necessarily be fragile to that recession.

And today many asset managers are fragile. There's a number of things behind that. We're going to talk about them today. So there's a reliance on too few products.  Pretty self-explanatory.  Undifferentiated products, the me-too stuff that's out there. It's not good for you from many angles and we'll talk about that. Prioritizing thrust over drag in your organization can be a big problem and that might be a little opaque to you, those terms right now, but we'll define those and we'll dive into what that means.

Charging too much for effectively passive returns – this has been a problem since the dawn of fund management itself and we're going to get into some actual numbers on what that looks like for some real examples. And finally an over-reliance on performance to sell your funds – that can be a big problem going into market cycles.  So let's dive right into some of these.

There is an insidious theme or narrative that I hear sometimes among asset managers that – and this often happens in the institutional channel – is that you hear institutional investors say we want to invest with asset managers who are super focused, who are not distracted by a plethora of investment strategies. They do one thing and they do it super well.  And what happens then is this leads, especially small asset managers, to say well we're just going to have the one product. The slides are moving a little bit on their own here.  Let's see if we can get back to – there we go.

It leaves asset managers to say we're going to have this one product. We're going to do it really well and we're going to gather assets that way.  And the problem with that is it leads to big operational vulnerabilities to your business.  If you have a period of large outflows in that one product because you had a period of under-performance or a manager decided to leave or any other number of reasons, that can be hugely detrimental to your ability to continue to manage that particular product and ultimately detrimental to your investors.

So that's why I call this particular narrative insidious is that it's not good for the end investor for asset managers to have an undiversified product lineup.  So instead I really believe it's incumbent on all of you to start making the case for the fact that you can operate multiple products at once and that it's in the best interest of the investor to invest with a firm that can be stable through a market cycle or through a downturn in any one particular product.

If I came to you and said, you know, gee, I have this great mutual fund idea for an investment strategy but I'm not going to be distracted by dozens of stocks out there.  I'm only going to invest in one that I study really well. And sometimes I'll put money into it and sometimes I'll take money out of it.  you'd throw me out of your office and you'd tell me I'm crazy.  Like nobody is going to invest in that particular investment strategy. But we use that logic all the time on the business side of asset managers to justify why we only have one product.

So what I want you to take away is that product diversity is not a weakness. It is not a bad thing for your investor. It is a good thing for your investor for your firm to be strong enough to weather the market cycles. And so you do need to build out a diverse product lineup in terms of asset classes or categories.  That doesn't mean you throw your investment philosophy out the window and come up with another one. It just means you can expand to other areas that are sometimes in favor when your initial strategy isn't.

What we're looking at here, the data on the screen is essentially a chart of volatility of organic growth on the X-axis. We're using drawdown for that number. And then average organic growth rates on the Y-axis. 

Now what we find is the more volatile your firm's growth rates then essentially the worse the firm does on average – so the bigger your drawdowns the worse that you're going to do. And you have those big drawdowns in any one particular period because you don't have a diversified product lineup. You don't have a product that's going to do well while another product is doing poorly. So it's really important that you think of your products just like a portfolio that it needs to be diversified in order to weather a market cycle.

Now I talked about drag and thrust a couple of slides ago.  These are terms that I draw from the world of swimming actually.  And in swimming, especially long-distance swimming, what you find is swimmers work extremely hard on their technique in order to bring down their drag, the coefficient of drag on their bodies so that they can achieve much faster times.  They don't focus so much on building muscle to generate thrust because that's not as important in long distance swimming. Drag is going to have a much bigger impact on your results.

And the same is true in asset management. What we find is that when we define drag and thrust for asset managers, drag is sort of related to the amount of thrashing around you're doing with you flows. So someone with a lot of thrashing, meaning they're generating a ton of growth outflows and a ton of growth inflows, and really not going anywhere, that's drag.  So big growth flows in either direction but not a lot of movement in any particular direction versus someone who might have low drag, might have very low growth outflows and very low growth net new sales. And again, we don't know which direction that will come out to on net, but they're smaller out and in.  That's low drag.

And we find these low drag firms actually on net do much better than the firms who are thrashing around and generating a ton of growth flows in either direction.  And the take away here is well how do you impact that drag or that thrashing around you're doing?  You want smaller growth flows in either direction and really what that means is smaller redemptions. It's much more important that you focus on minimizing redemptions, keeping the investors that you have than it is to go out and constantly find new investors to replace the ones that are leaving.  That would be a thrust kind of strategy. Reducing redemptions is more of a drag kind of strategy.

And if you think about it it makes a lot of sense because investors, they're really is if you think about the pool of investors who might invest in your product over a short time period that's roughly fixed and over a long time period it probably grows very slowly.  So if you're churning through those investors very quickly then a lot of people have already left your fund and they're very unlikely to come back to it. And so you're going to – that well of new investors that you keep trying to go back to is going to dry up. So that's why in the data what we see is these firms who churn through investors very slowly do much better than the ones who churn through investors very quickly. They have low drag coefficient.

Now everybody on the phone is probably feeling fee pressure, right? You're probably talking about the funds in your lineup, what you're charging for them, would dropping the price bring in more flows and would that offset the revenue lost for the cut?  Those kind of questions are happening everywhere right now and I think it's important to think about well fundamentally what is it that justifies the price that you get to charge for your product. 

And at Flow Spring we study this, and we break it down into different factors that are characteristics of a fund that do garner extra fees and others that essentially garner lower fees.  And I've highlighted some of the ones that I think are most interesting in blue here.  So portfolio concentration – if you're in the top quartile of portfolio concentration you can justify charging 12 more basis points for your fund than if you're in the bottom quartile of portfolio concentration. Turnover ratio – if you have higher turnover ratio you can charge more. If you have a lower number of holding you can charge more. If you have a lower degree of passiveness, meaning you're more active you can charge more.

So think about what these things I just summarized sum up to right.  Portfolio concentration, turnover, smaller number of holdings, smaller degree of passiveness – this is all saying active funds can charge more.  But the key is you actually do have to be active.  And what I mean by that, we studied this particular factor, this one characteristic, degree of passiveness and we went back to sort of our micro-economics 101 base, right.  We wanted to measure elasticity of demand, price elasticity of demand, meaning if you increase the price how much does that change demand for the product.

And we measured this across all the funds that are out there globally and we bucket it based on the most passive funds versus the most active funds.  And what we find is that gee, when you are at a passive index fund and you raise the price you're going to get hurt by much more than if you are an active, unique, differentiated product that gets – that product will get hurt much less by raising the price. 

So high elasticity of demand for very passive products, low elasticity of demand for very active products. If you want to be able to maintain some level of profitable pricing at your asset management firm you have to be different. You cannot be benchmark hugging. You have to have some active component that they can't get elsewhere.  And this sort of circles back to what are you actually charging for in your fund? In this slide we're going to do a little bit of math, but I think it will be illustrative to you of just how bad some funds out there are today.

This is a real fund I'm going to walk you through.  This fund has a 99.9 percent passive return meaning I can replicate 99.9 percent of its returns using a passive benchmark that has a 1 basis point expense ratio. Yet this fund charges 68 basis points.  So it's charging 68 times what the passive replicating portfolio would be.  And what you're getting for that is .1 percent active return that you couldn't get with the passive fund. So there's this .1 percent active return that is unique to the fund we're examining but 99.9 percent could be passively replicated at 1 basis point.

This particular fund has $31 billion in assets.  So if we multiply that $31 billion in assets times the .1 percent we get $3.1 million in effectively active assets, right?  Only .1 percent of that funds' assets are effectively active out of the 31 billion, so that's $3.1 million of effectively active assets. And if we multiply the 31 billion by .68, the expense ratio, it's got $215 million in total fees. So $215 million in total fees for essentially $3.1 million of effectively active assets.

We would only be paying about $3.1 million in fees if we were using the passive portfolio instead in order to replicate that 99.9 percent passive return. And so if we take that 3.1 Million away from the 215 million we're left with $212 million that we're paying for the active part of the portfolio, the $3.1 million that are active.  It translates into a 6700 percent effective net expense ratio on the active part of this portfolio. And I don't know about you but I don't want to pay an expense ratio that high on anything.  It's simply not even close to worth it for this particular fund.

So I would encourage you all to go back and examine frankly your portfolios, your funds, and see how much of the return is passive, how much is active and based on that figure out how much you're charging for each of those parts and see if it makes sense.  Now I've chosen this example specifically to illustrate how bad it can be in a real fund. But there are plenty of examples of funds charging between 10 percentage points and 100 percentage points a year for their active part of their portfolio.  It's a really damaging thing to do and it's frankly it's no wonder that passive funds are doing so well on in-flows when this is what's being charged for the passive share – for the active share of active mutual.

Now with a name like Flow Spring, you can imagine we think hard about flows. And we're constantly trying to dissect what's driving flows. And I have a lot of conversations with folks and often times on the investment side of asset managers who say Warren, I don’t know why you focus on quantitatively identifying the various things that drive flows when all I have to know is which funds performed better over a given time period because flows are going to go to the better performers. And that leads to a lot of interesting conversations because they're flat out wrong about that particular point.

It turns out that performance of course is a big driver of flows, but it is dwarfed by the importance of product characteristics.  And why I say product characteristics, what I mean are things like your net expense ratio, the makeup of your management team, what category you're in, whether you're active or passive, whether it's an ESG product or not.  These types of things are much better explainers of differences in flows across the universe than performances. 

And that's a really key point that I hope you will all take home because most people today are building their distribution and marketing and even product efforts around the idea that they're going to deliver better performance. They're setting that expectation for investors coming into their fund that you should come to us because we have better performance.  Except the problem is that there are periods of time when everyone under performs. The best investors in the world under perform all the time.  And what that leads to is missing the expectations that you built for these new investors and then redeeming from your fund, which goes back to the drag problem, which we know is an issue.

So if you are building out your entire strategy, marketing distribution product around performance, you're going to have a roller coaster of flows.  It's going to be very volatile. You're going to be fragile to market cycles.  On the other hand, if you build your advantage around product characteristics, whether you're ESG, whether you're active or passive, which categories you're in, you're management teams experience and credentials, those types of things change much less frequently than performance, right? 

Those are sort of evergreen characteristics of your product lineup. And if you built advantages for yourself into those characteristics, that's an evergreen advantage on flows, steady throughout time. You don't have to be so worried about market cycles because you know the organic growth will be there because your product is more attractive than better aligned with investor preferences.  So I encourage you all to look at your existing product lineup or your product development plan and really think very hard about the product characteristics and how you are going to build a strategy and marketing and distribution tactics around those as opposed to the performance idea.

Last thing I wanted to leave you with before we open it up for discussion and questions is that we did a study recently where we looked at the 25 largest asset managers in the world and we tried to stress test them.  We put them through a number of simulations of what the next bear market-recessionary period might look like. 

So we had to simulate what various asset classes and categories might do in terms of capital appreciation and then how investors would behave and how organic growth rates would respond to those types of downturns in various capital appreciation and various areas of the market. And then we combined that with information about how strong the brand and distribution capabilities of these different funds are and we ran them through thousands and thousands of simulations to figure out just how bad could it look for any of these different fund families.

So we looked at the 10th percentile where 90 percent of scenarios were better than this particular scenario and this is what it looks like.  Pimco comes out at the top for a number of reasons. They've got a very strong brand, very strong distribution but they're also very exposed to fixed income which is likely to get hit by lower orders or magnitude than stuff that is exposed to equities.  Jackson National, on the other hand, doesn't quite have the distribution or brand recognition as some of the other firms and it's also more exposed to equity as is T. Rowe.  So you see those two firms at the other end of things as much more exposed to market downturns.

This type of analysis I think is really important for you to start doing on your own firm, stress testing yourselves. And as you do so I'd encourage you to think about things we've talked about today.  So whether or not you have too few products and you could stand to diversify yourself into other asset classes or categories, whether or not your products are undifferentiated or if they are differentiated, you know, how you're justifying the ability to maintain pricing levels where they are rather than continually having to cut them, whether organizationally you're prioritizing redemptions and trying to minimize those as opposed to maximize new investors in order to keep that drag low, whether you're charging appropriate amounts for the active part of your funds versus what could be easily replicated for very low prices in the passive portion of your fund and then finally whether or not you built a marketing strategy around performance or whether around product because if you focus on those few things I guarantee you will show up much better on an analysis like this where you're stress testing yourself against the next market downturn. You'll be much more resilient.

So on that note, I'd like to turn it back over to Marilyn. I think we can open it up for some discussion and questions. And I just want to thank you all again for tuning in and your attention today.

Moderator: Great. Thanks so much, Warren. I think you've given everyone a lot to think about and plan for the future.  We are ready for the Q&A so I will just remind you at the bottom of your screen you should have some controls, one of them being Q&A. And if you click that open you can type in your question.  So we have a couple right from the start here. And I will read them for you, Warren.

Moderator: Regarding fee pressure, for active funds is it necessary or even paramount for them to reduce their fees in order to get the love from advisors due to the various screens that they use or could they not reduce the fees as long as they're offering a really good, active product with good performance and a good story?

Warren Miller: Yeah. Great question.  You know there are so many advisors out there who do use very simplistic screens on fees that don't necessarily help them judge whether they're getting what they're paying for.  And so that's been the case for a while. What I think we're going to see going forward is that advisors and really the industry as a whole is going to get more nuanced on some of the key analysis that they're doing and what they're getting for what they're paying. 

And so I've shown a little bit of where I think the world is going to go today where you can decompose what you're paying for the passive part of the portfolio versus what you're paying for the active part of the portfolio.  And for firms that really do deliver a very unique, active part of the portfolio that can't be easily replicated by passive, I think those firms do continue to have strong pricing power. They can stay static or even in some cases, we've seen firms that have been able to increase their prices for what they're delivering because it's unique enough.

So I would say, you know, dissect your current product lineup and see what you're delivering first, right.  If you're delivering 99.9 percent passive returns and .1 percent active I really hope you're not charging 68 basis points for that.  You're not going to be able to sustain it. But if those percentages were to flip, you know the sky is really the limit if you're delivering that kind of performance.

Moderator: Warren, you mentioned management when you were talking about product characteristics and what you can maybe build a story on. Could you elaborate on what type of management is ideal?

Warren Miller:  Yes.  There's a number of characteristics of the management team that we look at. So things like their experience in the industry, their tenure at this particular fund, their credentials so whether they have a CFA or a Ph.D., the percent of managers that are male versus female and finally the number of managers of the fund.  And what we find is for some of these they're just universally preferred so more experience and more credentials are just generally universally preferred. 

The press have uncovered some of our stuff recently and as you can imagine they like to ask questions about the male versus female question and what we find is that when funds are strictly male managed or strictly female managed neither of them garners flows quite as well as the funds that have a mixed management team. And the theory there -- again that's what bears out in the data – the theory there would be that a mixed-gender management team may have different experiences that they're bringing to the table, different analytical insights that they can bring towards assessing portfolio construction and security selection.  So that's what we see on some of those different variables.

Moderator: Approximately what percentage of funds have defensible pricing for their active strategies and how many funds have you looked at regarding this question?

Warren Miller: So that example I walked you through, that's a number that we run for every fund in our database, which is, you know, over 200,000 globally, ETF, open-end funds, closed-end funds, you name it. So we can sort on all of that stuff.  I would say it's fewer than a third are charging a reasonable amount for the active portion of their portfolio. And the reason for that is because active managers still have just massive passive parts of their portfolio.

I mean on average it's about 90 percent of returns in any fund that we would typically call active.  About 90 percent of their returns could be replicated passively.  You know certainly, there are some that are much lower than that, but there are also funds that are, you know, 99 percent replicable. You know I'm thinking of a lot of things in the large-cap value category in the US for example.  That's just really easy to replicate most of what they do and so really there's just a small sliver of what they do that is the active part.

And you know when you charge a very large fee for the overall fund and only deliver a small amount that's active it's just very unreasonable. So if you have questions about individual funds feel free to reach out to me.  I'm happy to share some of our data on that.

Moderator: You mentioned diversification in terms of product offerings. If a firm has only one product, for example, one equity strategy, and that's pretty much all they offer what recommendation would you make to that firm in terms of diversifying?  Should they open fixed income, ESG, something else?

Warren Miller: It's a good question.  And I think it's largely dependent on the investment philosophy of the firm.  So if you think there's a way to apply your investment philosophy to fixed income then that is a wonderful way to diversify, right, because now you're in an entirely new asset class that has different return profiles and all kinds of differences from the equities that you started in.  So I would encourage you to think broadly about how your investment philosophy can be applied, right. 

If you're a value investor we buy high-quality companies at cheap prices. Well how can you apply that same kind of analysis, you know, throughout the capital structure of the firms that you're analyzing because maybe then that gets you into high quality fixed income or maybe convertible or preferred.  Whatever it is, you may be able to expand into that second asset class without, you know, doubling your cost essentially. You may be able to get more out of the analysis you're doing.

Moderator: Part two for this question - What would you say is ideal or does that make sense, two products, three products? What does it take to diversify enough?

Warren Miller:  Good question. I mean it's, of course, going to depend on just how different those products are, but it's pretty similar really to, you know, the rules of thumb you might see when building a portfolio. So when you're building a portfolio you often hear rules of thumb that once you get past 20 or 30 stocks the diversification benefits start to wean, right. They start to slow. And so I think those are probably reasonable numbers to be thinking about in the fund world is that, you know, certainly two is a heck of a lot better than one.

You're going to get most of the benefit from going one to two and then slightly less going from two to three and slightly less going from three to four, but you know, getting to a sweet spot in the tens of funds it's, that's a fantastic thing.  Now that's difficult, right.  I don't mean to imply that everybody who's on the phone right now can just boom, launch ten new funds and that's the answer to your problems. 

But if you're thinking about long-term goals, where do I want to get to if I still want to be thought of as maybe a focused manager, I don't want to be thought of as a Vanguard, for example, who's got a fund in every category.  I want people to think of a particular investment philosophy when they think of me. Well you know that's probably what you're looking at.

Moderator: What would you say is the number one most important action that a smaller asset manager could take today to be better prepared for a market downturn?

Warren Miller: I would suggest that you take a look at some of the slides in this presentation, some of the numbers we've put together and try and do the same for your firm to identify which of these things is your biggest opportunity. Is it launching another product to diversify it? Is it somehow changing our existing product to make it more unique?  Is it gee, we've got a ton of redemptions.  Let's really work on lowering that number so our drag is lower.  Maybe you've got a big problem in terms of how passive your funds are or maybe you're marketing strategy is entirely based on performance. Whatever it is, figure out which of those things represents the biggest opportunity for you by doing some of this analysis on your own funds and then attack that.

Moderator: You discussed drag and keeping clients as one of the best strategies to have.  Any thoughts on how asset managers approach should be on these points?

Warren Miller:  Yeah.  You know the biggest mistake I see on that one and I tried to touch on it a little bit before is that if you build your sales strategy and everything around performance like gee, we're super smart and we're going to give you all this great performance and you're going to do well with us because of you know these three reasons, you're setting yourself up to lose those investors when inevitably performance doesn't match expectations that you've set. Right?

So you brought them on board by sort of promising all of these things and you can probably deliver that in a lot of different scenarios but maybe not all. And if that's all they bought into you for then you're going to lose them very easily. They're not sticky in other words.  On the other hand, when you build your strategy around having great product that aligns with investor preferences then you attract people because of your product characteristics more than promising them the world around performance.  And those people will be much stickier investors than the performance chasers. 

So that's what I would encourage people to do is again focus on product and how your product can match up with preferences much more than the whole hey, our fund just hit five stars; invest with us kind of thing that we see all the time.

Moderator: Well that is all the questions we have. That was a great give and take. Thank you so much, Warren. Thank you to all of our participants for sending in your questions.  I just want to remind you we will send around a replay link probably later this week, and if you have any other topics anybody would be interested in hearing about in Sunstar's Inside Look webinar series we would love to hear from you. So just give us a call or drop us an email. And that is it for today. Again, Warren, very insightful.  Thank you so much and thanks to all our participants.  Bye for today.

Warren Miller: Thank you.

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