Thriving In Asset Management
Focused on small asset managers, you'll see data on key drivers of fund pricing and flows and the importance of adapting your distribution strategies for the long term.
My name is Warren Miller. I am currently Managing Director at ISS Market Intelligence. That's a relatively new role for me. I've been in it for three months and it came about as my prior startup, which I founded, called Flowspring, was acquired by ISS. So together we're very excited about ISS, which has this great data on flows and competitive intelligence in space, and Flow Spring having a great amount of expertise and producing analytics and intelligence in the space coming together for some really great combined insights.
Prior to founding Flowspring, I was the head of asset management software at Morningstar and prior to that I was their head of quantum research. So today I am hopeful and excited to give you some very quantitative insights into our industry and about how to thrive in asset management. And as Kathryn mentioned, please submit questions as they come to mind in the Q&A panel.
As I think about how an asset manager can become more competitive in our space, I think about five levers, four of which I have pictured on the screen. And when we think about these different levels you can pull to get better at the asset management game, there are two types of things that you want to think about. How controllable is this particular lever and then how durable and long-term will the success from this lever be? We think about product for example. The products you launch to market are 100 percent within your control. You get to pick your expense ratio, you get to pick your management team. These things define your product and they're very strategic in nature. Once they're set you change them very infrequently. But the product you have on market determines your long-term success, and I'm talking five, ten years' worth of success here.
Building advantage – competitive advantage in your products can be very durable success. Marketing is also 100 percent within your control. You control the message you put out there to your audiences. You control where you put that message out to your audiences. It's all 100 percent within your control. It's a little bit more tactical than product, right? It's not quite as strategic so it helps you in the medium term and it is also an area where you can build very durable success if you build a resonant and consistent message, and we're going to talk more about what that means in the remainder of the presentation.
Distribution is the most tactical of all, so it helps in the shorter term. With that being said, it once more is 100 percent within your control. You control which advisors, which gatekeepers, which home offices you're going out to talk to. You control the message you give to them. You control the comparisons you make with your competitor funds. It is within your control 100 percent, and also as you'll see some data in the latter part of this presentation, this is a very durable competitive advantage if you can build out a systematic process-driven distribution strategy.
Finally, the fourth lever, the one that we as an industry obsess over and spend far too much time thinking about is performance. Now if you're just one of the best asset managers in the world, then maybe there is some control to your performance and maybe you can on average over longer periods of time deliver out performance for your funds. But you don't get to pick when those periods of out performance arrives, so it's much less in your control than any of these other levers. However, I will concede that performance is one of those things that when you have it, it can be a very durable advantage to have over all time periods. The only issue is that it's transient. Some years you have that out performance, some years you don't. It can be a very temporary driver of success and we'll talk about whether or not you want to build your strategies around temporary drivers of success.
We’re going to talk about each of these levers and we're going to start with product. And when you engage in any sort of product discussion at your firm – whether it's a product launch, whether it's thinking about making changes to your products, I want you to engage in this thought experiment. Imagine that you are required to charge a five percent net expense ratio for this new fund and then ask yourself what does this fund have to look like to still bring in assets at that level of expense. If you engage in that exercise you will very quickly come to the realization that no one is going to pay that level of fee for more of the same. And as a small asset manager you have to find something that people are willing to pay for. You can't be charging single-digit basis points for your funds. It's not gonna be profitable for you. You have to find something that people are willing to pay more for, and that means differentiating.
I've spoken at the SunStar Conference and other conferences before, and that used to be where my message would end. I'd say differentiate, differentiate, differentiate, because frankly there's a lot of me too products out there. That's still the message, but I'm adding to it now. I want to say differentiate consistently. What I mean by that is that I get asked by asset managers all the time, hey we're thinking about launching into a particular category. What if we put an ESG mandate on that fund? Would it really drive more flows for us? And the answer more often than not is absolutely not because they're just slapping an ESG mandate on something. It's not a consistent form of differentiation for them. Now if this was a firm that was entirely ESG-related, all of their fund products had an ESG mandate and they built their marketing collateral around that, then yes, absolutely ESG can help you.
But that's what I'm talking about, find your differentiator and weave that thread through all of your different products. If your answer to this question about the five percent net expense ratio is to generate alpha – we're different because we generate alpha – it really doesn't even matter the reality of that statement. Maybe you can generate alpha and maybe you can do it reasonably consistently. But are people going to believe you when you make that claim? The answer is, less and less people every year believe that claim. If your answer is all about generating some amount of alpha, you need to go back to the drawing board and find a different differentiator. That's not going to fly going forward.
Now I want to move over to the right-hand part of this slide. What I'm showing here is a very data-driven analysis of different characteristics of funds. And what went into this analysis was ETF open-end funds, closed-end funds globally. What I'm showing you is for that characteristic how much extra can you charge for being in the top quartile of that characteristic versus the bottom quartile. So if you're in the top quartile of portfolio concentration, you can charge 11 basis points more for your product than if you're in the bottom quartile. So portfolio concentration – that's sort of a proxy for whether you're active or not--allocation to cash, same thing. Eight basis points more if you have a higher allocation to cash because allocation to cash is one more proxy for whether you're active or passive.
Turnover ratio – one more proxy for active or passive. Seven basis points there. Let's go to the bottom. Minimum investment. Obviously, if you're going to be high on the minimum investment, that's because you're pursuing institutional or very high net worth individuals. They're going to expect that for putting that amount of money into your fund that they're going to get a lower price. So naturally you have to price less as your minimum investment goes up. But degree of passiveness, this is a very direct way, a returns-based way of measuring how passive you are, you have to charge 15 basis points less if you're in the top quartile of that one.
So you see the characteristics that are floating to the top and the bottom here. Most of them have to do with whether you're active or whether you're passive. So one of the messages that I want you to take away today, and if you only take one message away today, is that if you're going to be an active fund, be a really active fund. We're going to see more data on that in a minute. Now, I can't sugar coat the active-passive situation. When an active manager significantly underperforms, for every dollar that walks out the door 73 cents goes into a passive fund, meaning someone's become disillusioned with active management and is now putting money into the passive space. Conversely, if a passive manager underperforms, for every dollar that walks out only 33 cents goes into an active fund.
It's very clear that there's a disadvantage to being an active manager when it comes to fund flows. However, and this is a big however, the headwind is directed at "active," meaning sort of active. Not truly, extremely active funds. What I'm showing you here in this chart is an active-passive continuum. As you move all the way to the left, we've got the most active funds in the universe. As you move all the way to the right you've got the most passive funds in the universe. And what we're seeing in these bars is how much the assets of each of these buckets has grown over the last five years. So the most active funds, the stuff in the one bucket, have grown 390 percent in assets over the last five years. That's a higher percentage growth rate than the stuff in the ten-bucket, the most passive bucket, which is a growth rate of 87 percent. And everything in the middle has shrunk.
Let me explain what's going on here. Investors have become more fee-conscious, and that fee-consciousness has led them to look at their "active funds." Really, truly what I'm talking about are closet indexers. They see these funds and they realize that they're achieving about 95 percent passive returns with only about 5 percent being a truly active return. But they're paying an active fee for it. What they've realized they can do is they can take those 95 percent of their assets and put them in something that's purely passive and pay a much lower fee on that bulk of their assets, and then pay the 5 percent that's truly active, take it out of the closet indexer and put it into a purely active fund and pay it – be willing to pay the actual active fee on that 5 percent.
Now they've got the same mix of active and passive returns, but they pay a much lower fee level, and that's why we see a barbell-like curve here. If you're going to be active, be really active. That concludes the product lever.
Let's move into marketing and distribution. The game in marketing and distribution is getting harder, and let me tell you the evidence that we have for that. Michael Mobison is one of my favorite writers in the investment field, and he talks about skill and luck consistently and how that plays out on the returns side of the world. What he cites is this idea of something called the paradox of skill, which says that in any competitive game, as the aggregate skill level rises the relative differences between the best and the worst players of that game starts to shrink.
We see this in batting averages in baseball for example where compared to decades ago the difference between the best hitters and the worst hitters is much smaller than it used to be. Same with pitching. We see it on the return side of the world in mutual fund out performance. So overall, because we see that shrinkage of the difference between the best and the worst players, we can conclude that investment managers, portfolio managers are getting more and more skilled over time and that should make intuitive sense. I'm sure the PMs of today with the tools and technology and data that they have would love to go back 30 years and compete against the competitors of 30 years ago. They'd clean up. The same is true on the distribution side of things.
At Flowspring, we measure something called distribution alpha, or you can think of that as the amount of flows you bring to your firm that's purely due to how good you are distributing them and marketing them, not due to performance or product characteristics. We measure that distribution alpha and we see the same phenomenon, but the difference between the best and the worst is shrinking, indicating that the average level of skill and distribution and marketing continues to increase every year. Think about that. You'd love to take all of your skills and expertise and technology and data and use it to compete against fund managers from 20 years ago. You would clean up on the distribution side.
The game is getting harder, but I want you to understand you can build a durable competitive advantage on distribution marketing. What I'm showing on the left-hand side here is distribution alpha from one year on the X-axis to the next year on the Y-axis for all the different firms in our database. What you see is that because there is persistence in distribution alpha, we see a 43 percent correlation between distribution alpha one year to the next. If we saw a 43 percent correlation in mutual fund return alpha among some funds, they would be the biggest funds in the world. Everyone would put their money with them. But we don't, right? That alpha is very transient. Distribution alpha on the other hand, very persistent.
If you can figure it out, if you can systematize it, then you can year over year bring in more flows to your fund than they truly deserve based on their performance and their product characteristics. So very, very important to focus on distribution and marketing and not just imagine that these funds and their performance will sell themselves. There are things that I see successful marketers and distributors doing are messaging consistently. We talked about consistency on the product side before, weaving that thread through all of your products that is consistent. Well that will help you be very consistent on the marketing side.
The second thing is to organize and adapt around your target audience. We're in the middle of a global pandemic. No longer can distributors, wholesalers walk into the office of an advisor. Now you have to engage with them via Zoom meetings and phone calls and electronic media. So it's very important that you are in a situation and able to organize yourself in a way that can adapt to new situations like that because the change is only going to keep coming. We can't think about this as a static way to organize yourself, but an adaptive way to organize yourself.
Now you may have caught when I first presented this slide that I mentioned. There were four levers pictured, but I believe there are five levers to how you can become more competitive as an asset manager. The fifth lever is all about what happens in the white space of this particular slide. It's how product connects with marketing, coordinates with distribution and matches up with performance. It's how you tie all of those pieces together and the decision-making that you layer on top of it. It is the white space, or the ether of that chart.
And so what exactly happens in that white space? I've mentioned consistency several times in this presentation so far already. Consistency across products--find that thread. Maybe it's that you're an extreme value investor. Maybe it's related to your investment philosophy. Maybe it's related to ESG. You're a very socially responsible firm and that's the audience you're targeting. Maybe it's that you dominate thematic investing. Whatever it is, you need that thread and you need to question when you launch your change of product, am I strengthening that thread across products or am I weakening that thread? Because that thread is what you build on in your marketing consistency as you message not only across all your products, but across all your channels. What do you say to the advisor? Do you say the same thing to the gatekeeper? Do you say the same thing to the home office?
You should be because the more you repeat the message, the better it will resonate with the audience. And that means consistency through time as well. This is where we come back to investment performance. If you build your message around investment performance and outperformance, you're going to have a hard time with consistently messaging your product because there are going to be years where you don't have investment performance on your side.That can be a piece of it, but do not make it the cornerstone.
The next thing, make better decisions. I think we would all love to make better decisions in life. If you break it down how people make decisions, if you have the right information in front of you, you can make the right decisions. You need to build a strategy around how to get the right information in front of you. If I asked most of you on this call today to manage your investment portfolios, your client portfolios with the amount of data and analytics that you're using on the business side of your organization, you would laugh in my face and rightly so. Most of you are using so much more sophisticated and robust analysis to pick securities and build portfolios than you are even coming close to using in terms of understanding investor preferences, understanding the competition, understanding the pricing you're using.
Now this can be a heavy lift, especially for small active manager. There are two ways to do it. You can work to build something like this internally or you can work with a third party, and Flowspring and ISS are obviously those kinds of third parties. We're happy to help you with those kinds of things. But the thing you need to realize is that you're either using this data and pulling insight from it and making decisions from it, or it's being used against you. There's no in between ground where you get to be safe.
Lastly, setting and meeting expectations – again, we come back to the problem of messaging too much around performance means that that's the expectations that investors come into your fund with. And as soon as you don't meet those expectations you lose those investors. We saw from the earlier site it's not necessarily about bad performance. It's about performance that misses the expectation of the investor that you brought in. That's what leads to people leaving your funds. The problem with that is it creates more churn in your investor base and most folks have a limited audience that they can go out and pursue to bring into their fund.
If you've churned through them all already, meaning they've come into your fund, they bought the pitch at the beginning and then they left because your performance didn't meet expectations, it's ten times harder to win that person back. If you churn through them all, you're just making your sales game much harder in the long-run. So keeping investors, avoiding churn, it starts with setting the expectations right around not just performance but how you're going to service that client. Bring the investors in the right way who will also help you build an identity around your firm and your products.
The last thing in the prepared remarks before I go into some Q&A is that Kathryn and the SunStar team were kind enough to share some of the folks who had signed up to view this conference today ahead of time. I wanted to run you guys collectively through some of our analytics. Collectively I ran this group of participants through and I said who have they lost assets to and who have they won assets from? What I found is that despite this group being largely small active asset managers, you are currently going head-to-head against some of the biggest firms in the industry and in many cases winning very nicely.
Collectively, you won $415 million from PIMCO this year; $377 million out of Invesco and so on down the list. I don't want anyone to walk away from this presentation pessimistic about their chances, about their ability to go in there and win money from the largest managers out there. You have competitive advantages, and if you continue to execute smartly on these things, as we've talked about in the presentation today I think you can do very well.
What is the number one thing a small asset manager can do to improve competitiveness?
I think the number one thing that a small asset manager can do to improve competitiveness is work on their decision-making capabilities, and that goes back again to the data question. And really more than data – information and intelligence. Everybody's got all the data that they could possibly want at their fingertips. It's not leading many firms to make better decisions yet. So you need to have a strategy around what data – focus on what data is really going to move the needle in a small part of your firm. Build those out and start making good decisions in that small piece and then just broaden that program until you're making good decisions all across your firm.
How does this apply in a world where centralized professional buyers are making investment selection decisions?
In a world where centralized buyers are making investment selection decisions, then the power – the control of assets is shrinking. It's becoming more concentrated. So one, that makes it all the more important that you focus on not churning investors, because if you lose one of them, you had them and then you lost them and it's ten times harder to get them back, well that's ten times harder to get back a much bigger chunk of assets now than it was ten years ago when maybe you lost a financial advisor. Losing the home office, much bigger problem. I think it's all the more important you focus on that churn, and the way that you solve the churn problem is bringing investors in with the right set of expectations, expectations that you can actually meet that are within your control. Not alpha or outperformance-based expectations, but expectations around other pieces of your business.
What are some of the weaknesses of large asset managers that small asset managers can take advantage of?
Good question. I would say that large asset managers are very – there's a lot of inertia. That's how I would put it. A lot of inertia, meaning that as new ideas come into our industry, they have a much harder time adapting and taking advantage of them early on. So a nimble, small active manager can truly innovate faster than a large asset manager. Now that's scary, right? Because innovation as a small asset manager might mean that you're taking a huge chunk of your potential assets or resources in terms of human resources or financial capital and putting it towards something new, and that's scary when you're not big. However, it is also a huge advantage because you can be nimble, you can take advantage of trends much faster than they can, so that's what I'd say the biggest advantage you can take advantage of.
When will the tailwind for passive investing come to an end?
I would say, and I don't think anybody knows the answer to that question exactly, but if you go back to what I was saying on the active passive front, the ends of the spectrum are cannibalizing in the middle. And that middle is truly not – they've been historically called active, but the majority of the returns they've delivered have been passive. Once that middle has been fully cannibalized into pure passive and highly active, that's when we'll start to see a slowing in the trend of these assets going from active to passive.
What's with PIMCO? Why have we won so many assets from them and what further weakness can we exploit with them?
That's a good question. Off the top of my head, I don't have an answer for why in particular PIMCO – PIMCO is obviously an active manager in the fixed income space is what they're known for. Fixed income is a space where active management is probably even more appreciated than in the equity space because the ability to outperform in fixed income as an active manager is higher. I haven't followed PIMCO closely enough to give you an exact answer, but perhaps they haven't met performance expectations and that's led people to leave PIMCO and come into some of the smaller funds that may have more of a differentiated offer.
American Funds seems to go against the grain of being very active, yet they gather significant assets. What's their distribution alpha and how does a small manager compete or not?
Yes, American Funds is an interesting one. I'd say they're a fund company that has built a strong identity around what they do and they have a very specific way they go about distributing those funds. Both on product and distribution, they've been very distinct, very consistent. They're hard to compete with. I think the way you've got to go is they're a big firm. Find the holes and differentiate from them and come up with something that is unique from their offerings. I think that's the way to do.√