Forward-looking investment management firms are searching for ways to outperform their peers. The firms that we see succeeding are executing based on a combination of focused business models, agile operational competency, and strong cost discipline, especially around core investment and risk functions. In this first blog post, Quantifi and Celent examine a number of key trends that are reshaping the industry including the shift from active to passive, growth in multi-asset and broadening of investable asset classes and increasing demand for tailored, outcome-focused investment solutions.
The post-global financial crisis environment has been largely favourable for the investment sector in terms of asset gathering, AUM growth and also revenues for the industry as a whole. This has been fuelled by quantitative easing and also by the general appreciation of asset prices globally. Until last year, these favourable conditions have largely masked certain fundamental aspects of the industry’s growth. We see this particularly around the contraction of margins as well as the business case to address a number of structural challenges and trends that are reshaping the industry.
This article explores the key trends affecting asset managers and asset owners and examines their impact from an investment management technology and operation standpoint. It is important to note that some of the data points strongly suggest that these trends are not merely cyclical but structural in nature and therefore would require concerted response from both asset managers and asset owners alike.
Key trends impacting the asset managers and asset owners
- The shift from active to passive
- Growth in multi-asset and broadening of investable asset classes
- Increasing demand for tailored, outcome-focused investment solutions
- Staying operationally lean and nimble
- Technology enablement and next generation capabilities
The shift from active to passive
The first trend is the ongoing shift from active to passive investing and we expect this shift to continue its momentum. For example, the move from equities to fixed income ETFs will be significant in the next few years and this will put pressure on margins as well as the broader economics across the investment industry. Active management will still represent an opportunity for many firms, but only for those that can demonstrate value for money and also the sustained ability to generate alpha as a whole.
Despite changing economics and the ongoing downward pressures on margins due to price competition from the onslaught of passive vehicles and ongoing regulatory scrutiny, the industry has experienced largely positive AUM growth over the last decade. However, Figure 1. shows that in 2018, growth fell for the first time in many years.
Historically, cost structures are stubborn to change and as shown by the orange line in Figure 1. aggregated costs across the investment industry have been increasing over the past decade. The current combination of persistent margin pressures, uncertain business conditions and also slowing revenues are leading many investment firms to rethink or reshape how they go to market operationally.
Figure 2. shows where investment managers are rationalising costs and directing investment. Even core areas such as portfolio management, dealing and trade execution are under the spotlight to undergo cost reductions and streamlining. Firms are also looking to address operational inefficiencies and cost associated with siloed and fragmented systems.
On the other hand, as indicated by the green bars, new technology is viewed as critical to a firm’s competitive advantage as it facilitates better investment decisions as well as streamlining regulatory operations. This can be observed in Figure 2. where we see increased investment in new technology like machine learning and Big Data. There is also the ongoing trend to digitise operations in areas such as compliance in order to make processes more efficient. The key take out here is that asset managers are attempting to defend and enhance their core investment engine. We see a growing number of firms changing their operational and technology models to ensure a more defensive position in the light of growing uncertainty in the coming years.
Growth in multi-asset and broadening of investable asset classes
Changing economics as well as investor demands are generating expansion into alternative assets. Since the global financial crisis, the expression ‘multi-asset’ is becoming a term that implies a broad gamut of alternative assets. This is not just limited to fixed income and equities but also extends to relatively established asset processes such as private equity hedge funds and real estate. This also continues to broaden into other so-called emerging alternatives too, such as infrastructure, private debt, insurance and bank related assets.
As a Portfolio Management Solution provider, Quantifi has seen buy-side firms across the spectrum, irrespective of risk appetite, broaden the domain of their investable asset classes. Much of the broadening is in established asset classes but we have also observed an interest in market segments that buy-side firms have not traditionally played in. This expansion into established asset classes includes increased allocation of assets to asset backed securities (ABS), for example, CLOs, agency/non-agency CMBS and RMBS. Other variants in this space include CLO warehousing or the revival of the dormant structured synthetic credit market. We are seeing a growing interest in synthetic CDO structures, so much so that there is ramp up on the sell side as well, to cater to increase demand for these products.
Some firms are opting to expand into completely new market segments and new structures such as direct lending. Many banks have stepped out of this business and this void is being filled by buy-side firms. We are also seeing variations on this, for example direct lending banks typically offload loans from their balance sheets, the variations is not transferring the loans out of their balance sheets but just buying protection for credit risk. We are seeing a great deal of credit risk transfer structures, an example includes regulatory capital trades where buy-side firms write protection to banks on credit risk associated with the bank loan books. We have also come across hedge funds that are writing reinsurance cover to insurance firms.
These are just a few examples of the new asset classes being explored by buy-side firms. Some of the key drivers for this trend are:
- Sell-side firms are moving away from traditional businesses because of the amount of regulatory capital they need to hold to support these businesses thus opening up opportunities for others to step in
- Opportunities for regulatory arbitrage so banks wanting to get risk off their balance sheets
- Search for increased yield on the buy-side
- Increased skills and expertise to manage complex asset classes on the buy side
Our opinion is that these satellite alternative portfolios must not, if possible, be allowed to degenerate into independent asset class silos from a technology and data standpoint. One lesson that the investment sector can take from the banking industry is that they should find ways to embrace operational strategies that actually converge rather than allow systems to remain siloed and fragmented across the firm.
Increasing demand for tailored, outcome-focused investment solutions
In line with this expansion of assets, investors are also asking for more from their asset managers. Investors are now looking for more tailored, outcome-focused investment solutions, beyond the traditional relative benchmark investing. They are coming up with requirements to achieve a total return, or to enable more sophisticated hedges, or to meet dynamic risk and return type profiles. These would usually involve more complex derivative strategies as a whole.
Given the complexity, demand on resource and cost involved in building custom in-house solutions, we are seeing an increased demand for external technology solutions. On the retail and institutional side, demand has increased for custom solutions that also cover a broad range of asset classes, which relates back to the previous trend. The level of sophistication demanded in terms of analytics and risk management is also much higher.
The key take away from this is that when providing clients with this level of customisation and more complex solutions, it requires asset and wealth managers to have access to advanced tools and data environments that can combine quantitative and qualitative research. Firms require environments that can handle forward-looking strategy, modelling and back-testing via a true cross-asset lens. They also need the ability to enable portfolio teams to collaborate share analyse strategy ideas in order to quickly design and assemble tailored portfolios for client mandates.
Read Part 2: What is Driving Firms to Streamline Technology and Operations?