Demand for innovation threatens biggest firms

Large money managers are facing threats to growing their business in the ever-expanding defined contribution market.

These large firms already are losing market share among defined benefit plans, endowments and foundations. Now, despite taking an early lead as providers of target-date funds and other traditional DC investment options, large money managers face challenges from smaller, niche players as investors seek more alternatives, unbundled fund options and customized target-date funds with multiple managers.

Customized target-date funds would favor smaller managers that can add value to portfolios, said Benjamin Phillips, Darien, Conn.-based partner at Casey, Quirk & Associates. He added that innovative, packaged target-date funds could include alternatives such as private-equity-like investments, real assets and real estate.

“It's an equally rough-and-tumble situation in defined contribution (as in defined benefit and endowments and foundations) because of the quest for new innovative products,” Mr. Phillips said.

But there still are hurdles for alternative managers to increase their presence in the DC world including the challenges of calculating daily valuations and providing accounting transparency, Mr. Phillips said. However, managers with funds of funds should see more opportunities as those strategies can likely get over any liquidity hurdles.

Large managers could cut into the share of alternative managers with replication strategies, such as for hedge funds, but those strategies are pretty experimental right now in the DC world, Mr. Phillips said.

The next three to five years will really focus on product development and differentiation and “moving away from anything that looks like closet beta,” Mr. Phillips said.

As other traditional asset classes such as large-cap core equity are in “remission,” managers need to adapt to survive and expand globally with products that shift to different markets, said John Siciliano, New York-based managing director at PricewaterhouseCoopers Consulting.

“If you are below the top 20 managers today, (with total AUM of) about $300 billion to $400 billion, you're going to have some real survival challenges,” as global assets are still hovering around pre-crisis levels and fees are down, Mr. Siciliano said.

It's an issue that is already evident in the defined benefit, foundations and endowments world.

“As asset owners look at allocations, they are basically asking for investment strategies traditionally managed by smaller managers,” said Ben Olmstead, Atlanta-based head of product strategy at eVestment LLC.

Several reports released in recent weeks have highlighted the continuing and growing trend away from traditional equity and fixed income.

Cogent Research LLC reported last month that the share of assets in DB plans, foundations and endowments managed by the 41 leading managers it identified dropped to 40% in 2012 from 45% in 2011.

Pension funds used the leading broad managers for 49% of assets in 2012, compared with just 32% for non-profits, which traditionally have much higher allocations to alternative investments.

“If the leading managers want to thrive in the market, they need to recognize the shift and establish themselves in the foundations and endowments world,” said Linda York, practice director of syndicated research at Cogent and author of the third annual U.S. Institutional Investor Brandscape report.

All of the 10 largest managers are still growing assets, but while alternatives made up less than 5% of assets 10 years ago, they now account for about 10% to 12%, said Gary Shub, Boston-based partner and leader of global asset management practice at Boston Consulting Group. However, midlevel managers could have the most problems moving forward, he said.

The managers that make smart choices on the asset classes on which they focus and then build expertise or differentiation within those focus areas will continue seeing positive flows, Mr. Shub said.

Equity searches are expected to make up 46% of all DB search activity this year, according to the 2013 Consultant Search Forecast survey produced by Casey Quirk and eVestment, but the majority of activity will be to replace existing managers. Fixed-income searches are expected to make up 22% of total activity, down from 25% last year. In contrast, alternatives are expected to drive 24% of all search activity, up one percentage point from last year, and 28% of new or expanded accounts, up from 26% last year.

Emerging markets equity was identified as being the most sought asset class this year and some of the larger managers are entering the fray to compete with the newer, smaller managers in that sector, Mr. Olmstead said. Emerging markets equity and debt each saw more than $50 billion in inflows last year.

Even if larger managers get into emerging markets strategies, they won't likely be able to wrest much share from smaller competitors, so there is likely not a huge opportunity to gain market share.

“It's not too late to get in (to emerging markets), but (managers) need a highly differentiated product in the way they run money that is not correlated to beta,” Mr. Phillips said.

In a separate Casey Quirk forecast, the money manager consulting firm predicts that 90% of net new revenue over the next five years will go to firms that can develop and enhance capabilities such as uncorrelated and superior active management, cost-efficient indexing and exchange-traded funds, and expertise in areas including multiasset class solutions, liability-driven investing, target-date funds and outsourcing services.

Another newer area of investment is in alternative beta, or smart beta, where investors can get an index-like exposure to alternatives with much smaller fees, said Matthew Stroud, New York-based head of strategy and portfolio construction at Towers Watson Investment Services Inc.

There's a combination of traditional and specialized managers that are capitalizing on this trend, but it is easier for small managers to adapt to new needs, and it is institutional investors' fiduciary responsibility to find managers that have strategies ready now, he added.

“It's harder to move a large organization on a dime,” Mr. Stroud said.

Big managers do recognize smart beta as a key area for growth, however. Andrew Astley, Boston-based senior managing director and head of global product and marketing at State Street Global Advisors, said SSgA's alternative beta strategies have seen a “huge pickup in traction over the past two years,” as investors look for strategies not actively managed.

“The three places where we're voting with our feet” are alternative beta; launching products in traditional alternative asset classes, such as managed futures hedge funds; and partnerships, such as the bank loan ETF partnership with Blackstone's GSO Capital Partners LP that has alternatives and income characteristics, Mr. Astley said.

Placing alternatives into DC plans is a hot topic of conversation right now, Mr. Astley said. SSgA saw $500 million flow into real assets in DC plans last year. “It's not a ton of money, but definitely a trend we noted,” Mr. Astley said. He added the firm is looking to incorporate more real assets into target-date funds.

PeterPaul Pardi, London-based managing director and global head of distribution at BNY Mellon Investment Management, said the company still has a large base of assets in traditional strategies, helped by the increasing move to passive investments. Its structure of acquiring boutique managers and allowing them to remain independent with their brand also allows the firm to gain assets across most asset classes.

BNY Mellon is also eyeing the DC market to gain more assets. It already has more than $40 billion in DC AUM, focusing on multiasset and full solutions and is looking to increase alternative offerings, Mr. Pardi said.

“For the defined contribution market, you're looking at huge growth,” Mr. Pardi said. “We're investing in that very significantly.”

Both large and small managers, however, still face a number of due diligence hurdles in bringing alternative DC products into the market including product construction, education, governance issues, and reporting and valuations, Mr. Siciliano said.

“Flows into alternatives in the next one to 10 years will be very significant,” Mr. Siciliano said, adding it is still in the early stages of development. “A lot of the large managers want to be able to get into the space ... A convergence is beginning to occur where alternatives are going to be delivered by traditional and long-only firms.”

In DC plans, the concentration of assets is more pronounced with a few managers than in the DB world. But as plans move away from mutual funds into separate accounts with negotiated fees, they are not going to be tied to one provider, making them more likely to allocate assets to more managers, including smaller players in niche areas, said Kevin Turner, Seattle-based managing director, consulting, at Russell Investments. n