Morningstar Magazine - June/July 2017 - 36

Spotlight: The Future of Investing

For Active Funds, Winter Is Coming
Over the next decade, $1 trillion could
leave actively managed funds,
a lethal amount for hundreds of firms.

ACTIVE

Jeffrey Ptak

Actively managed funds accounted for about
63% of U.S. open-end and exchange-traded-fund
assets on March 31. Only three years ago, it was
around 72%. Given structural shifts in the
market, it's reasonable to suppose that passive
will take another 10 percentage points of market
share in the next decade or so.
What does that translate to in dollar terms?
Passive funds, including strategic-beta ETFs,
recently held around $6 trillion of $16 trillion in U.S.
fund assets. Given a semiconservative 4%
annual growth rate on the U.S. fund industry for
the next decade, passive assets would vault to
around $11 trillion by 2027. Depending on
assumptions for sources of future growth (market
appreciation or flows), that would imply at
least $1 trillion in outflows from active. To put that
in perspective, active funds managed to rake in
around $600 billion in assets over the decade
ended March 31.
Get Smaller

Would the industry be prepared for a sharp
reversal? It does not appear so. As of March 31,
there were 760 fund families that offered
at least one active fund. The top 10 families
accounted for 53% of the market, the bottom 500
a mere 0.9%. More than 500 families
managed less than $1 billion, and around 300
managed under $100 million. In other words, the
active-fund business is highly fragmented.
Many subscale players will have to merge or
shut their doors.

36

Morningstar June/July 2017

There has always been a life/death cycle in
the active-fund business, reflecting the industry's
attractive high-growth trajectory, potentially
lucrative payoffs, easy entry, and the attending
high failure rate (easier entry makes for less
fear of failure and, thus, more failure). But a few
factors are likely to make this phase quite different
and more lethal to vulnerable firms:
3 The shift toward automation
3 The pressure on distributors
3 The preference for low cost
3 Unbundling (alpha from beta; strategic-beta/
factors from alpha)

Previously, the industry was largely unaffected
by big technological and regulatory shifts.
Fund companies had to adapt as business moved
toward the web, but it didn't fundamentally
transform the way investment-management
services were packaged and delivered to investors.
However, the move toward passives, including
strategic beta and factor investing, mechanizes
investing, while innovations such as targetdate funds automate tasks such as rebalancing.
This does change the nature of investment
management itself and, in turn, how value is
perceived. Most notably, it exerts strong
downward pressure on fees.
It's not just automation that's seen to this.
So, too, have dramatic changes in the way advice
is rendered and priced. The opening up of
platforms, increasing prevalence of fiduciary
standards, and accompanying move from
commission to fee-based business models have
had a profound impact on advisors' preferences.

They've flocked toward low-cost investments,
passives in particular. They had to find savings
inside of the portfolios they were assembling, so
as to keep the all-in cost of their service to clients
in line with where it had been previously.
With that came other pressures: Distributors
have leaned on asset managers to offer
"institutionally" priced versions of their strategies,
atop which they can layer their own fees. This can
shift the cost for distributor platform access
from the investor (paid out of fund assets via 12b-1)
to the fund company itself (paid out of pocket).
What's more, amid heightened regulatory scrutiny
and the need to economize, distributors have been
purging hundreds of funds from their platforms.
Thus, whereas in the past firms could differentiate
through some combination of boots on the
ground and revenue-sharing (financed largely
via 12b-1 fees), they now must pay for shelf space
and compete to keep their place. This will
put a further premium on scale and investment
capability and put the squeeze on smaller players.
Distribution challenges notwithstanding, evidence
suggests there are too many professional
investors chasing too few ideas. Yes, this is felt
more acutely in the later stages of an extended
bull market, when ideas are scarcer. But prefee excess returns have trended lower over the
past few decades, perhaps denoting a "skill glut"
that is strangling opportunities for profit. This
has likely been exacerbated by the discovery and
increasing popularity of risk factors, which
has shrunk some of these premiums. Net-net,
active funds have had greater difficulty keeping up
with their indexes in recent years.
Some of these performance woes are cyclical,
and as those headwinds abate, active-fund
performance is likely to perk up a bit. Moreover, a
bear market should at least slow the mass
migration toward passive funds. But the structural
changes-toward automation, open architecture,
low cost, and unbundling-appear irreversible.
A smaller active-fund business seems inevitable.
Become Cheaper

Not only must active funds shrink in number, many
of the surviving funds will need to cut prices.



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