Money managers need to shift to outcomes from alpha
Report, consultants say industry needs to change approach
By Barry B. Burr | November 12, 2012
Traditional active money managers will have to revise their investment approach away from seeking alpha and relative performance, which dominated the industry for decades, to meet outcome-oriented objectives, according to consultants and a new report from McKinsey & Co.
Growth opportunities upending traditional money management are shifting rapidly to three key categories: passive products; outcome-oriented solutions; and alternatives, the report said.
The report, “The Asset Management Industry: Outcomes Are the New Alpha,” released Nov. 1, said, “Institutional investors, particularly sponsors of defined benefit pensions, are ... actively seeking outcome-oriented solutions as they attempt to cope with worsening plan deficits and liability management.”
Pension fund clients have directed their “focus a lot on alpha, on return relative to benchmarks” but now “investors have really shifted their view,” agreed Philip Kim, director-fiduciary services, Russell Investments in New York.
“It's not how well I want to do in (for example) the U.S. equity space” in relative return performance, but refocusing to solve a “problem with my pension (plan) ... with addressing my liabilities, or in supporting my operating budget for this endowment or whatever. There are lots of different objectives depending on the type of investor,” said Mr. Kim, who read the McKinsey report.
The financial crisis helped drive the reorientation of the investment management business, Mr. Kim said. “A lot of pension (funds) were very focused on their return or maybe even on volatility.” Even if relative return was positive and outperformed, if liabilities grew because of declining interest rates outpacing assets “that actually hurt ... (The pension fund) actually lost in that scenario.”
As a result, plan executives are rethinking their “investment decisions (to be) much more liability-responsive because, at the end of the day, that's the problem we're trying to solve,” Mr. Kim said.
McKinsey expects solutions-oriented assets to double to $2 trillion within the next five years, the report said.
The trend McKinsey identifies in the investment management industry has been good for pension funds, said Richard L. Nuzum, president and global business leader of Mercer Investment Management Inc., Boston, who also read the report.
“Clients should spend their time on ... the focus on outcomes,” Mr. Nuzum said.
“Historically, the average plan sponsor has spent 70% of their governance time on manager selection and trying to get alpha,” Mr. Nuzum said. “It's not clear that ever made sense, but it certainly is clear it doesn't make sense” as the focus turns to outcome objectives.
Quantifying the trend, the report noted that more than $1.3 trillion combined flowed into the three categories from Jan. 1, 2008, to June 30, 2012, while some $400 billion flowed out of relative-return equity strategies over the same period.
Among the three growth categories, passive investments includes index and exchange-traded funds; solutions includes target-date funds, Treasury inflation-protected securities and 529 college savings funds; and alternatives includes strategies in 130/30, long-short, options arbitrage, absolute return, volatility and currency trading.
“Traditional means to achieve growth — namely beating a benchmark — are no longer proving sufficient and account for just over one-third of the average asset manager's growth,” the report said. “More critical now is meeting a changing set of client needs, which increasingly means shifting from alpha to outcomes.”
“Focused business models — for example, global specialists or retirement specialists — have gained share at the expense of generalist firms that have spread their bets, often in an unfocused way, and failed to win in any of the big three growth categories,” the report said.
Since 2007, a few “focused asset managers have been capturing a highly disproportionate share” of inflows within each of the three fast-growing categories — from 59% to 100% for the top 10 firms alone — “but with few winning across more than one category” and none across all three, the report said.
Active management “is still a really good business,” Mr. Nuzum said. ”If you have good alpha product, relative (return) management, you are going to be a part of ... the solutions on the defined benefit and defined contribution sides.”
Most active managers will thrive best — and plan sponsor clients will benefit most — from an open multimanager structure, rather than a closed structure in which a single manager provides all the asset-building portfolios toward meeting a solutions objective, Mr. Nuzum said.
A single manager cannot be the best at everything “even if you have all-stars” in some asset classes, Mr. Nuzum said. “I'm not sure it's a useful strategic path for a lot of asset managers to take, unless they think they have best-in-class solutions across all the requisite asset classes.”
In particular growth areas identified in the report, such as traditional passive management, “I think a handful of firms have been successful” and dominant, Mr. Kim said, citing BlackRock (BLK) Inc. (BLK), State Street Global Advisors and BNY Mellon Asset Management.
“But once you start thinking about alternative passive or different ways of getting passive exposure, or what you might call smart beta” — or alternative rules-based indexing or strategies — “there may be places for different providers to do some of that” and not just the megamanagers, he said.
“For solutions, it could (mean) target-date (funds), it could be volatility management, it could be inflation protection ... lots of different nuances on who could be successful,” Mr. Kim said.
“There's lots of opportunity, so investment managers will be able to adapt“ to the growth trend, he said.
As a business, however, the McKinsey report found some ground for concern in money management.
The North American money management industry was off 19% in terms of profit as of Dec. 31, from the pre-financial crisis level of 2007, because of increased costs of doing business, reduced productivity and lower fees, according to the report. Money managers' own projections show a slight improvement for this year, forecasting profitability to be off 16% in 2012 from 2007.
Overall growth has stagnated, with aggregate assets under management recovering from their pre-crisis level, up a predicted 2% in 2012 from 2007.
“Market performance is accounting for virtually all asset growth in the U.S.,” the report said. Market performance “is now the lifeblood of the industry — clearly, an unstable foundation on which to move forward.”
“We aren't surprised there hasn't been a lot of net growth in assets once you control for market appreciation,” Mr. Nuzum said. “The federal government has given funding relief several years in a row now for defined benefit plans. You'd think that with poor capital market returns and declining interest rates ... and if (the Pension Protection Act) requirements had been implemented and not relaxed ... DB plan sponsors would have to contribute a lot.” But “we're not seeing the wave of contribution into DB plans we might expect.”
While profit margins have been strong for most firms through the cycle — 28% on average and 46% for the top third — “deeper structural issues remain,” the report said.
McKinsey's Wealth Management, Asset Management & Retirement Practice prepared the 39-page report, surveying in the first half of this year more than 100 firms representing $15 trillion, or 65%, of assets under management in the North American money management industry, and conducting dozens of interviews with industry leaders on the topic of solutions during the first nine months of the year.
This article originally appeared in the November 12, 2012 print issue as, "Managers need to shift to outcomes from alpha".