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.”