In 1965 Intel cofounder Gordon Moore predicted that computer processors would double in performance capability every two years. Moore’s observation about the exponential advances in technology proved so accurate that his framework is now called Moore’s Law. Half a century later Moore’s Law is changing the nature of market efficiency: we are witnessing the emergence of sophisticated investors armed with supercomputers that capture and eliminate market inefficiencies in microseconds.
Operating on lightning quick networks, today’s supercomputers have fundamentally changed investors’ chase for alpha (where excess returns of a fund relative to a benchmark index is alpha).
It’s now near impossible for a typical fund or wealth advisor to consistently deliver superior investment performance and subsequently, returns. The numbers don’t lie: in the first quarter of this year 81% of US equity funds and 94% of US large cap funds failed to beat their index.
In response, droves of investors have been abandoning the pursuit of alpha and embracing index ETFs. The rationale is simple: if you can’t beat the market, then join the market (Figure 1).
Figure 1: Total Net Assets of Equity, Bond and Hybrid Index Funds
Source: ICI 2015
The trend towards index investing is likely to continue for two principle reasons.
First, as index funds become more popular they also become cheaper to invest in, creating a positive feedback loop: lower prices makes them more attractive, and more investors results in still lower prices (Figure 2).
Figure 2: Asset-weighted Expense Ratios – by fund type
Secondly, even after years of strong growth index funds only account for 32% of US stock market assets: there’s still room for a lot more growth in this space (Figure 3).
Figure 3: Passively Managed Assets as % of Total Managed Assets
Source: SimFund, BofA Merrill Lynch Global Research
Wealth and asset managers that market funds on the basis of superior investment performance should pause for thought. With the commoditization of returns, investors can turn to low cost robo-advisors which will achieve market returns for as little as 10bps. Investment performance is no longer an obvious ‘value added’ component in the wealth advice relationship.
The silver lining in these trends is that although alpha is shrinking, investors still clamour for managed accounts and professional investment advice. From 2010 to 2016 managed assets increased by 80% while transactional assets increased by just 10% over the same period. To wealth and asset managers this means clients still place significant value on advice – but in alpha’s absence, firms will need to create new ways of delivering investment value.
One solution for wealth and asset managers is to align client portfolios with their priorities and preferences. These preferences will of course vary from segment to segment- some investors may focus on the investment process, finding value in transparency, reliability or convenience. Other segments may prioritize the impact of their investments. For example, are their holdings environmentally responsible, or helping to inspire positive social change?
From a product development standpoint, asset managers need to understand the segments they serve and must in turn create products that optimize the value proposition for each client segment. From a distribution perspective, wealth managers need to more deeply profile the clients they serve to create customized portfolios based on each client’s priorities and preferences beyond investment returns.
This fundamental change in market efficiency will create new sets of winners and losers across our industry. The bad news is that firms can no longer rely on beating the market in order to attract and retain clients.
The good news is that there is a tremendous opportunity for firms to deliver non-alpha investment value to clients. In our view, firms that understand their clients well enough to capitalize on these trends will emerge as truly differentiated providers of investment value, even in this new era of post-alpha wealth management.
News from the world of wealth:
MoneyFarm launches UK wealth management app (Finextra)
Where’s the money going in 2020? Six trends driving wealth flows (wealthmanagement.com)
Thought of the week:
“If you want to have a better performance than the crowd, you must do things differently from the crowd.” John Templeton, American-born British stock investor, businessman and philanthropist.
Coming events in the world of wealth:
Author: Peter Keuls, Partner, Global Head of Wealth Management at McLagan and Scorpio Partnership.
Expertise: Peter advises leading wealth management firms on performance and pay optimisation through client experience improvements that enhance sales effectiveness and productivity improvement. He also consults on firm economics, cost reduction, branch distribution effectiveness and incentive plan design.
Background: Prior to joining McLagan, Peter was at Merrill Lynch where he was the Director of Marketing Strategy and Planning in the International Private Client group.