Morningstar Magazine - June/July 2017 - 46

Spotlight: The Future of Investing

EXHIBIT 2

Cost-Conscious Investors are increasingly choosing cheaper share classes.
ETF

Institutional

Load

No Load

Other

Retirement

Market Share by Fund Share Class Type

100%
75
50
25
0
2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Source: Morningstar Direct. Based on U.S. Open-End and ETF AUM tracked by Morningstar; does not include money market and fund-of-funds AUM.

2016, assets invested in open-end indexed mutual
funds and ETFs expanded more than fourfold
to $5.4 trillion and made up 36% of the industry's
more than $15 trillion of assets.

We expect assets invested in passive products to
grow at a much higher rate than actively
managed funds over the next five years. By the
end of 2021, we expect 48% of the industry's
forecast $24.9 trillion in assets to be invested in
passively managed funds and ETFs. While
many investors and their advisors will be focused
on low-cost passive investment options, there will
still be room, in our view, for active asset
managers that have scale, established brands,
solid long-term performance, and reasonable fees,
and that are perceived to be safer from a
regulatory and legal standpoint.

type. Another approach is to diversify-
offering a variety of well-supported investment
capabilities and services that will appeal to
a much broader set of clients. Differentiation is
likely to take many forms, but we expect it
to be a key theme among active managers as they
look to navigate the industry disruption we see
occurring over the next decade.

For active asset managers to survive and
thrive during the next decade, they need a combination of traits: differentiation, low-cost funds,
repeatable investment processes, and adaptable
business models.

Low-Cost Funds
Good partners for the next decade will offer
inexpensive funds. By lowering expense ratios,
187.491 pt
asset managers will give their investment products
a leg up and increase the odds that they'll
outperform passive competitors. Lower expenses
and better performance are more likely to improve
scale, but we still see asset-manager profit
margins declining over time, as more capital is
expended to improve investment performance and
enhance product distribution. Asset managers
who historically have been mindful of costs
are under less pressure to dramatically lower fees
in the near future, giving them a competitive
advantage and resulting in steadier profit margins
and healthier earnings over the long run.

Differentiation
In an era when investments are expected to
face a greater degree of scrutiny, active managers
must be able to differentiate their approach
and offerings from the pack. One way is by scaling
up their level of assets under management.
Others may do so with a deep, well-known
expertise in a single asset class or investment

Repeatable Investment Processes
Active asset managers will need to have reliable,
repeatable investment processes that yield strong
performance overall to be successful. These
processes must be backed up by an experienced,
stable investment staff that's well-resourced in
terms of personnel and tools, including riskmanagement analysis. The resulting investments

Actively Managed Funds for the Next Decade

Morningstar June/July 2017

should have predictable return patterns, making
them better tools in a diversified portfolio.
Firms that have such investment processes in
place are also likely to avoid key-person
risk through thoughtful succession planning.
Adaptable Business Models
Finally, active managers will need to be
adaptable. When growth is harder to come by,
firms are likely to take a variety of actions.
They may overhaul their leadership or the
investment process, buy a competitor, or branch
out into passive or strategic-beta strategies. We
expect these responses will become commonplace
in the coming years, and the impact of each
shift requires careful evaluation. In general, we
look positively on firms whose actions are
designed to protect their economic moat, or
competitive advantage, and we look skeptically
on firms that are working to repair a serious
deficiency (as such repairs have traditionally been
difficult to execute well).
Industry Consolidation Is Inevitable

As active asset managers adjust to the new
world order, where revenue and profit margins are
being pressured, industry consolidation will be
inevitable. We expect to see a fair amount of
consolidation-both internally (as fund companies
consolidate funds to increase scale and eliminate
underperforming offerings) and externally (as
large and midsize managers look to increase scale
and product breadth). Most of the acquisition
activity will likely be concentrated on the U.S.

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