The future of Asset Management: Reinventing the wheel or staying still?
Over the past decade, the asset management industry experienced rapid growth, largely due to equity markets. The S&P 500* averaged a 10% annualised return over the past 90 years, ~7.5% (2001-21) and ~16.5% (2011-21). In the ten years ending 2022, inclusive of last year’s challenges, the index averaged 12.7%, almost 30% above the 90-year trend.**
Over the last decade, declining U.S.1Treasury rates have made long duration investments very attractive, but also ensured future capital gains from duration would be a challenge until the Fed normalised interest rates. Last year certainly proved this. The hunt for yield drove credit spreads in public markets to low levels. Private credit markets offered additional spread in exchange for low levels of liquidity. For many investors, an additional 50 basis points of yield when cash paid almost nothing was a lot more attractive before cash started yielding almost 5%2. Low base yields, high returns for equities levered with low-cost capital and high returns for growth companies enhanced by low inflation all worked to shape the asset management industry we operate in today.
Global AUM3 grew over 8% annually from 2011 to 20216. Although exemplary, the net flows have not been. Revenues driven by net flows offset by fee pressure provided almost no growth in revenues for the industry. Passive and alternatives’ share of global AUM grew from 21% in 2005 to 40% in 2021. Their share of the fee wallet grew from 33% to 51%, with passive topping out at only 15% of the total fee budget in 2021. Alternatives’ share in absolute dollars is almost 90%4 of the active manager share. These numbers demonstrate that the percentage of AUM and wallet share of fees for traditional asset managers have persistently and dramatically declined.
The cause of the decline is simple: only a minority of active managers have delivered outperformance, net of fees, over a full market cycle. The effect is that allocators will continue to move money away from traditional managers until their value proposition changes or the results of the other products become less attractive.
Given the investing environment of the last decade, allocators sought to mute the volatility of public securities, which sped the growth of private capital pools. These pools offer smoothed returns, enabling more leverage without reporting increased volatility. Investors received higher returns for surrendering flexibility and liquidity; a seemingly “free lunch”.
However, the holdings in these private vehicles are similar to those in public vehicles, but such levered assets should result in greater economic volatility. The fees paid to managers who oversee, originate and sell these assets are also materially greater than those charged in public vehicles. Therefore, the increased leverage must produce a gross return high enough to cover these fees. Assuming it does, the investor still owns a riskier asset owing to the leverage. It begs the question: have investors correctly measured the additional compensation necessary for accepting the increased economic return?
Consider, for a moment, the past ten years of economic activity, the macroeconomic trends, the inflection point we face in treasury yields and the allocation of assets by investors to passive and alternatives moving away from traditional areas. What do we think the next ten years will look like? Of course, we don't know, and broad predictions are interesting but hard, so I will attempt at the unambiguous risk of being very wrong.
There is a wide diversity of alternative manager businesses including hedge funds, private equity, real estate, venture, infrastructure, commodities, private debt and liquid alternatives. Hedge funds have not been, and I believe likely won't be, a growing asset class. I expect the growth of private equity will slow, reflecting the inability to maintain its torrid pace, the challenge of producing acceptable returns at increasing size, the impact of weaker returns across growth equity, headwinds caused by higher borrowing costs and, finally, a much smaller venture world reflecting fewer attractive opportunities with slower crystallisations.
Private debt faces an interesting refinancing cycle. Since the meteoric rise in this activity engendered by the GFC5 and regulatory actions affecting bank lending, there has not been a proper credit cycle. As a result, there is no reliable data on credit defaults and on losses for this period. How private credit performs over the next few years will determine its long-term future growth trajectory. Commercial banks may reclaim some of this market segment as JP Morgan has announced its intentions6.
I believe allocators will adjust to more effectively balance liquidity and locking up capital for lengthy periods to generate returns. Private credit, high yield, CLOs7, and bank-driven lending will coexist. I suspect there will be continued growth in niche businesses that can aggregate $10 to $30 billion in specialised areas and charge primarily for performance rather than asset size.
This activity, in the aggregate, will become a larger part of the asset management industry. Scale businesses such as passive, low-fee, low-return, low-risk or essentially enhanced index businesses like ETFs8 or actively managed portfolios with low tracking error will benefit from consolidation. Fee pressure for them will be offset by scale, squeezing out smaller players.
Large organisations may shift from performance-based business models to asset accumulation engines and client service models. Their franchise value will be organised around brand recognition, distribution prowess, cost efficiencies and client service. They will look more like wealth management and/or service- or solution-based organisations versus alpha engines.
The movement to passive should continue. The simple reason is alpha is hard to achieve, and the more money managed, the harder it is to deliver. Traditional asset management will unlikely be able to reverse this trend until it shrinks much more and manages far less money. Companies will react strategically as they have by buying or building passive or alternative businesses, but that won't arrest the trends we've seen in the core business. Some managers will migrate to different incentive systems where those models primarily charge for measurable performance. This will help restrict the capacity of capital they manage, allowing them to improve the probability they can outperform. Allocators will have to come to grips with the fact that more and more of their capital will be run passively. To achieve better-than-index returns, they will need to be willing to allocate to capacity-constrained managers whose principal financial incentives are to perform.
Peter Kraus, Chairman and CEO Aperture Investors