(Article from Registered Funds Alert, January 2019)
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Seismic changes in investor preferences and regulatory requirements are reshaping the landscape of the registered funds space. Potentially disruptive technologies loom on the horizon, and fee pressure and margin compression continue to affect all parts of the industry with no signs of abating. As investors wonder if the 10-year bull market will finally come to an end, investment managers will have to continue to innovate to attract and retain investors in 2019. In these challenges, however, we see some of the clearest opportunities for distinction and growth from managers and areas where regulators can take helpful actions. In this Alert, we explore the state of the industry as we enter 2019 and discuss what trends and themes we expect and hope to see throughout this year.
State of the Industry
The expectations, sophistication and cost-sensitivity of retail investors are all in flux. Investors’ willingness to pay fees for market-matching performance has plummeted, as the historic bull market run and rise of exchange-traded funds (“ETFs”) has brought low-cost index investing fully to the forefront of retail investing. Of the top 20 registered funds by net inflows in 2018, 13 of them were ETFs, and index funds generally dominate
the list.
At the same time they are pursuing lower-cost strategies, investors are expecting more for their money. Notwithstanding the immense fee pressure on the industry, customers are demanding elegant interactions with their portfolios through online portals and smartphone applications and even smart speakers, through which they expect professional investment advice delivered directly to them on demand and in the format that best fits their lifestyles. Investors are now also more interested than ever whether their investment portfolios align with their personal beliefs.
All of this is set against a regulatory backdrop that has seen the SEC undertake significant regulatory reforms that the industry must adopt mid-stride.
How the industry will continue to respond to the changing landscape will largely define the major trends of 2019, and we think there are three main strategies that will be deployed: innovating ways to sell new products, reimagining fee structures, and expansion and consolidation through merger and acquisition activity.
Innovation in Customer Interaction and Products
For investment management firms, reducing friction in the customer experience is a significant part of attracting and retaining new clients. From the moment of account creation through managing tax documentation and other materials, keeping and retaining customers requires adjusting to changing consumer preferences. Millennials, for instance, overwhelmingly prefer to interact with their investment management platform through intuitive smartphone applications and web portals. Platforms that do not provide a smooth customer experience struggle to attract younger clients, while those that excel in those areas are booming.
Artificial intelligence (“AI”) has been discussed for many years as a direct investment tool, but the technology may also have promising applications in enhancing the customer experience. Sophisticated investors have used technology that is loosely referred to as AI to interpret massive amounts of data and follow simple algorithmic rules for decades. Historically, its primary use has been geared towards improving investment selection, but now AI is being used to augment the way investment advisers interact with their clients. At least one firm has begun integrating an AI-based customer service enhancement initiative into its platform. The technology works by evaluating communications with clients by analyzing e-mails, text messages and other notes. It then applies machine learning to evaluate other ideas that can be suggested to the client with the aim of improving the overall investing experience.
Similarly, investors may soon be able to get advice from Siri or Alexa. At least one U.S.-based investment management firm is working towards offering investment advice through digital voice assistants (“DVA”). These DVA-based services may advise clients on the amount they need to invest or suggest portfolio allocations based on targets set by the client. As the ultimate goal of most DVA technologies is to seamlessly replicate interacting with a personal assistant, the regulatory issues regarding licensing and disclosure are complex.
As more of these potentially disruptive technologies come to market, it is likely that regulators will attempt, but struggle, to keep up. There are several potential regulatory issues with the integration of technology into providing advice, and the SEC and other regulators may deem some problematic while others permissible. This could lead to regulatory authorities effectively dictating the winners and losers in the race to bring new products and services to market, potentially increasing the entrepreneurial risk of such developments. Industry participants will have to weigh the advantages of being cutting edge with the uncertainty of looming regulation. Historically, such uncertainty has tended to allow smaller, more nimble advisers to experiment and push the envelope first, and those that do so successfully become prime targets for acquisition as larger investment managers will often acquire firms that have pioneered new technologies. We expect that we will see a marked increase in acquisition activity targeted towards tech-forward investment management firms that have developed scalable advisory tools and technologies for enhancing customer experience.
In addition to improving ways of reaching customers, investment managers will also be looking to respond to shifting customer demands through new product offerings. Technology has ushered in the rise of transparency, and it appears to be here to stay. Retail investors want to know what they are investing in and now have the tools to find out in a few keystrokes. It is no surprise then that the practice of integrating environmental, social and governance (“ESG”) factors into investing has exploded. ESG factors cover a wide spectrum of issues that traditionally are not part of financial analysis. This might include a corporation’s response to climate change, its stance on water management, metrics regarding how effective their health and safety policies are, how sustainable their supply chain is, how they treat their workers, etc. Millennials seem to be more socially aware than prior generations, or at least more interested in congruity between their values and their actions. We expect investment managers that provide options allowing investors to express their own values and to ensure that their savings and investments reflect their preferences (especially if it can be done without compromising on returns) will be in a prime position to capture and retain business in 2019.
Products that offer alternatives to traditional equity funds also appear ripe for expansion in 2019. With the potential for the bull market to come to an end, managers offering private equity options to retail investors may be well-positioned to succeed. Private equity buyout funds have consistently outperformed equity markets, especially so in worse overall economic conditions.[1] Access to such investment strategies would be a boon to retail investors, especially for long-term retirement-focused saving. Traditionally, registered funds have had relatively little exposure to private equity. Among other reasons, the long lock-up periods involved are generally incompatible with funds that have daily liquidity needs, such as traditional mutual funds. With respect to closed-end funds, which are not subject to daily redemption, the potential for growth is limited by the fact that the SEC staff presently takes the position only accredited investors may invest in public closed-end funds that invest more than 15% of their assets in private equity funds.
As we discuss in greater detail later in this Issue, we believe for the private equity trend to really take off among retail investors, regulatory changes would be necessary. Specifically, in 2019 we hope to see the SEC staff adopt the proposal of the Committee on Capital Markets Regulation and reverse its position on applying the accredited investor standard on a look through basis to public closed-end funds that invest more than 15% of the in assets in private equity funds. Chair Clayton has signaled his willingness to explore opportunities for retail investors to gain exposure to private equity, and revisiting this position may be an efficient way to open private equity funds to more retail investors. Alongside the SEC’s modernization proposals (which we also discuss in greater detail later in this Issue), we believe the SEC staff could take major steps in 2019 towards allowing registered funds to offer innovative products to retail investors while simultaneously streamlining their operations.
Reimagining Fee Structures
One of the main drivers of falling fees has been flows into lower-cost funds, primarily illustrated by the outflows from active funds and inflows to passive options. Also contributing to declines have been aggressive fee cuts for passively managed index funds, which in turn have drawn strong inflows relative to more expensive passive options.
The funds winning with respect to fund flows are doing so by leading on cost. As mentioned above, low-cost index funds dominated the list of top 20 U.S. funds by net inflows. The average expense ratio among the top 20 registered funds by net inflows in 2018 was 0.14%, nearly 40 basis points lower than the average registered fund.
Even among the top-tier, low-cost index funds, however, a fee war has raged and resulted in multiple managers resorting to the nuclear option: (ostensibly) no-fee funds. These funds have an expense ratio of zero, no expenses for marketing, and when you buy directly from the manager, there are no transaction fees. One of the hurdles to offering zero-fee funds is creating and maintaining proprietary indices rather than licensing a well-known index like the S&P 500, but now a number of firms are launching proprietary ETF indices allowing them to lower their expense ratios. We expect to see the trend towards low- to no-fees index funds that utilize proprietary indices to continue.
While it is the broad-based market funds that have gone to this model, the precedent has been set and pressure on this portion of the market will persist. With the advent of zero-commission platforms, some managers are shifting their revenue generation models to securities lending, record-keeping services for 401(k) plans and shareholder servicing fees; changes that are most profitable with significant scale. That trend also looks to continue in 2019, and will continue to drive mergers and acquisitions among the large asset managers seeking the critical scale to compete in the space.
Active funds are also looking to innovate on fee structures through the so-called “fulcrum fee” model. A fulcrum model links fees to fund performance and charges a base fee if a fund does not outperform its benchmark. To the extent a fund does exceed the benchmark, an additional performance fee is assessed. The argument is that variable fee structures will ultimately deliver better net returns to investors and incentivize fund managers to focus on performance rather than fundraising. We have our doubts about these fee structures, and indeed believe that shareholders would be better served by performance fees that only compensate managers for over-performance (compared to fulcrum fees), but nonetheless expect to see more asset managers experiment with this approach in 2019 and beyond given the prohibition on most other performance fees for registered funds.
Growth Through Acquisitions and Consolidation
As we have discussed in a previous Alert, the asset management industry is in a period of increased levels of merger and acquisition activity, and we expect that to continue through 2019 and beyond. Larger investment managers have effectively used their scale to bolster profit margins, while continuing to drive down costs. The gap is only widening between leading and lagging asset management firms, and this trend shows no sign of slowing. We expect the wave of smaller asset manager acquisitions to continue as many struggle to maintain profitability in the face of considering whether to make the significant capital investments in technology and product development to match the expectations of investors. Meanwhile, many larger investment managers will seek strategic acquisitions that will bring new product offerings, investment capabilities or technologies under their umbrellas.
In addition to wholesale mergers or acquisitions, we expect to see a continued uptick in minority stake investments in 2019. Certain businesses that are in adjacent spaces, such as micro-investing, may prove to be attractive targets to traditional asset managers. For instance, a leading U.S.-investment manager recently invested in micro-investing app Acorns with the hopes that it will provide them insight into younger investors. We expect to see an increase in similar transactions throughout 2019.
All of this is occurring against a backdrop of divided control on Capitol Hill and, as of this writing, a potential second government shutdown that may grind the gears of the SEC to a halt again, just weeks after a prolonged shutdown. One prediction we know will come true—2019 will be interesting, if nothing else.
[1] Robert S. Harris, Tim Jenkinson and Steven N. Kaplan, How Do Private Equity Investments Perform Compared to Public Equity, 14 J. OF INV. MGEMT. 14, 17 (2016).